The demand for “safe havens” is most likely to remain as we see further potential for downside, even as countries across the global are reaching their peaks in covid-19 cases, writes Andrew Harmstone, senior portfolio manager in the global multi-asset team at Morgan Stanley Investment Management.
This first phase may provide some reasons to feel short-term relief.
However, after the initial economic shock, the second phase is likely to bring second-order effects; such as increased unemployment and reduced consumption, which will weaken global economic growth.
We examine how traditionally defensive assets such as the US dollar and gold are behaving in this environment and how they are likely to continue to behave.
We also consider the case of municipal bonds, which may face some challenges ahead.
US Dollar
The US dollar has so far outperformed most developed market and emerging market currencies in 2020.
Support for the currency has been helped by a shortage of dollars that are needed to settle international transactions.
The shortage has been so severe that the Federal Reserve had to act to provide US dollar FX swaps to foreign banks to increase the supply of dollars internationally.
The Fed’s total rate cut this year, which currently stands at 150bps, has removed some of the strong support for the dollar.
That said, we expect the world’s largest reserve currency to maintain its strength in the short to medium-term, until there is more visibility on how the global economy is recovering from the impact of the covid-19 crisis.
With respect to the EUR/USD currency pair, compared with the US dollar the euro is facing multiple headwinds.
First, before the crisis the US had stronger economic fundamentals than the eurozone. Second, the economic damage to the eurozone as a result of covid-19 is likely to be more severe than the US, based on our forecast.
Factors such as the eurozone’s high exposure to tourism and manufacturing makes a deep recession almost inevitable.
Third, the US has more monetary and fiscal power to lift the economy out of a recession. As a result, we are more constructive on the US dollar versus the euro, at least in the near-term.
Gold
Gold is generally negatively correlated to risk assets during times of crisis and is often used as a geopolitical hedge.
However, as markets plunged in late February and through March, gold also sold off.
We believe that gold’s unusual behaviour was likely a result of liquidity pressures, as investors sought to sell any liquid assets to meet their obligations.
This appears to have been a temporary effect and, since the March sell-off, spot gold in US dollars has rallied more than 15%.
This recovery has been supported by the ample liquidity provided by central banks and governments globally, as well as demand for “safe haven” assets.
We expect real rates to remain in negative territory as central banks turn to unlimited quantitative easing.
We now see the main headwind for gold to be the US dollar strength and are closely monitoring the Fed’s forward guidance and upcoming US economic data for indication of how long the Fed intends to leave rates at the current low levels.
This supports maintaining our overweight to gold.
Municipal Bonds
Finally, we believe it is worth highlighting another defensive asset, which has potential challenges on the horizon. US municipal bonds, which finance state and local governments, may require a potentially significant Federal bailout.
Many states are currently facing large budget shortfalls, as they rely on retail sales and other transactions-linked revenue sources.
New Jersey’s governor, Phil Murphy has stated that this revenue shortfall has added to the state’s problems and it will run out of cash within four to six weeks.
Initially, municipal bonds (which have a market size of $3.8trn) saw spreads widen sharply during the sell-off, but spreads narrowed again once the Fed supplied liquidity.
However, the Fed cannot bail out a state or municipality from a budget shortfall.
The US Treasury acting on a Congressional appropriation could provide a bailout, but so far Congress has not approved meaningful funding to states. We will continue to monitor developments as they unfold.
Indicators to move into risk assets
Below is an update of our list of four factors which we are monitoring as indicators to move back into risk assets.
There is little change in the status of these indicators as we see only the fourth of these indicators,
effective monetary and fiscal policy, being truly in place:
Credible steps to contain the virus and flattening of the infection rate curve:
This includes strategies such as test and trace, as successfully demonstrated by countries who have managed to contain the virus, such as South Korea.
Some European countries are continuing to show signs of slowing the infection rate generally and easing lockdown.
In contrast, US infection rates continue to trend sideways, hovering around their highs and breaching the one million mark of total cases. However, we are encouraged by the increased testing in the US.
Extreme valuations:
Fixed income valuations were extreme in March, but were tempered after monetary policy intervention.
Valuations, particularly in US large caps are back well above measures of our assessment of fair value, which we believe is a sign of excessive optimism.
We continue to be far from valuation levels that we believe generally characterise a positive turning point in market direction.
Extreme positioning:
We continue to believe that many investors are too positive about the future market direction, driven by “fear of missing out”, which we interpret as part of the first phase, or short-term relief, referenced at the beginning of this update.
However, overall fear, characteristic of the second phase, has not yet replaced greed. We believe that at a market bottom, investor sentiment generally reflects “fear” not “greed” and equity positioning would be falling not rising.
Effective monetary and fiscal policy:
Policies are largely in place, but despite the unprecedented and continuous measures by central banks and
governments to support the global economy, there are challenges surrounding the implementation.
There may be more to come, but still may not be sufficient to prevent lasting damage to many areas of the economy. This week the Fed, ECB and BoJ each had their scheduled policy meetings.
Notably, the BoJ extended its corporate debt purchases and announced unlimited bond purchases. We expect that the majority of available actions have now been announced, though central banks and policymakers may continue refining them.
This article was written for Expert Investor by Andrew Harmstone, senior portfolio manager in the global multi-asset team at Morgan Stanley Investment Management.
