Market reaction: The further spreading of the coronavirus, especially in Europe, has, in the past few days, triggered a selloff in risk assets and high demand for safe assets (US dollar, Treasuries and gold). As markets reassess the spillover effects of the virus into the economy, volatility is likely to persist. Adjusting the economic outlook: The coronavirus is adding risk to an existing weak trend for global trade growth with fear that some stagflationary forces might result from this crisis (more de-globalisation / weaker growth). In this environment, our central scenario has darkened, with lower GDP growth expectations in H1. The shock could possibly prove stronger in the short term, but we stick with the view that the situation will stabilise at some point in the coming months, leading to a catch-up thereafter, with no long-lasting shock to potential growth. Additional support from central banks and governments to fight any further deterioration in the economic outlook is a key assumption regarding this view. The US appears more insulated and supported by resilient internal demand, while emerging markets and Europe should be the most affected over the short term. Investment implications: The main risk now is the unwinding of recent market complacency (risk assets at historical highs in February) and the reaction of “animal spirits” that can turn into overreaction. In the short term, some profit-taking, risk reduction and increases in hedging are warranted in order to protect investors’ portfolios. Our main convictions at the moment are in the credit space – ie, investment-grade Europe – and we also have a positive view on duration in US Treasuries for hedging purposes. From a cross asset perspective, we have become more cautious on equities (European and US), and we have moved to a neutral stance on EM equity. Beyond this tactical view, we believe that the coronavirus can provide opportunities to implement investment convictions that we have identified in our central scenario, exploiting entry points and market dislocations. Cyclical value vs growth, especially in European equities, EM equities with a focus on domestic stories, EM currencies, some areas of the bond market (higher yielding government bonds in EM and Italy) and credit markets (especially the names that are experiencing spread widening despite good fundamentals) should be the first to rebound once the risks of further virus escalation have receded. As the credit market is the main area of opportunity and the main channel of risk, a strong focus on credit selection is key in this phase of the cycle. In addition, a strong focus on liquidity is paramount, not only as a defensive strategy. Liquidity can be put to work to re-enter some attractive areas of the market once the situation stabilises.
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