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Our outlook on critical drivers of investment performance

With COVID-19, recession has become our base case. Our economists expect the US economy to contract -2% annualized in 2020, with growth contracting in each of the first three quarters before recovering in the fourth. The maximum pain will be felt in Q2 2020 with a contraction of   -10.5% (annualized, quarter over quarter (QoQ)). Peak to trough GDP decline is forecasted at 3.8% vs. a decline of 4% during the financial crisis. This time, it will happen in three quarters vs. six back then. Downside case: A more prolonged COVID-19 impact, with a peak-to-trough GDP contraction of -5.2% lasting five quarters and a  -2.7% hit to growth in 2020 including a contraction of -12% (annualized, QoQ) in Q2 2020. Upside case (small probability): COVID-19 turning into a seasonal flu with resumption of economic activity in the middle of Q2 2020, causing 2020 GDP to contract just -0.8%.

Pain is expected to be felt globally. Europe will most likely enter a deep recession this year (Germany forecasts a contraction of -5% in 2020) but Japan and China may start recovering in Q2 2020. Emerging markets may likely see output hits to their own COVID-19 cycles.  The world economy looks headed for the next recession.

One-off effects pushed inflation higher recently, both within Developed Markets and particularly in Emerging Markets. However, the steep drop in global commodity prices and sharply lower growth imply much lower readings in coming months, as is being predicted by our leading inflation indicator.

Equity valuations are in cheap territory despite recent earnings cuts. Equity yields relative to risk-free rates show markets as attractive. While 10-year yields are suppressed, even if we peg them at more normalized levels, equities look cheap.

Corporate spreads widened dramatically in March 2020 and entered the deep value zone. While we expect ratings downgrades and defaults to rise, central bank intervention (both the ECB and Fed will likely buy significant chunks of IG bonds) will start creating the much needed base.

For FX, the US $ entered the “expensive 3” club, based on purchasing power parity. Valuations, combined with shrinking interest rate differentials will make it a steeper climb higher for the greenback. However, we realize that COVID-19 uncertainty may keep the US$ well bid for some more time. A weaker dollar would benefit risk assets in emerging economies.

Global monetary policy has never been easier, both in terms of policy rates and in terms of central banks’ will to use their balance sheets. Yet, fears of a deep recession have considerably tightened the spread, equity and volatility components of our financial condition indices. As the announced monetary and fiscal measures work their way through, we expect a positive impact on spread (tighter), equity (higher), and volatility (lower) which may start easing financial conditions. While that is our base case, uncertainty will likely remain high as long as visibility on containing the virus in the US is low.

Systematic and risk-parity investors have reduced risk positions considerably.  Many momentum strategies are now short risk assets. Hedge fund beta to equities has reduced a fair bit. We believe rebalancing flows from global multi-asset strategies to be meaningful for risk assets. Assuming $4 trillion of such AUM, flows into equities for MSCI ACWI could be about $170 billion.

A nearly similar amount of money could flow out of sovereigns. Yet, some large sovereign wealth funds representing countries primarily dependent on oil revenues are likely to sell financial assets to fund domestic budgets.

At this stage, the key risks we envision are:

  • COVID-19 takes much longer to contain despite quarantines.
  • Bankruptcies pick up dramatically despite the promise of aid by governments.
  • Global governments remain divided. While central banks are working together, more coordination among heads of governments is needed.
  • The US election cycle creates volatility, especially if markets start pricing in control of all three branches held by one party (that hasn’t been a great period for markets historically).
  • From a longer-term perspective, socialization of economic activity through government aid will have strings attached. It could come with stricter laws on buybacks, distributions, leverage, etc.

As of 31st March 2020. These are the current views and opinions of Principal Global Asset Allocation and is not intended to be, nor should it be relied upon in any way as a forecast or guarantee of future events regarding particular investments or the markets in general

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This document has been prepared by Principal Global Investors for informational purposes only. The contents of the document should not be construed as an advice on legal, financial or regulatory issues. No person should rely on the contents of this document without first obtaining independent advice from qualified professionals. The National Bank of Ras Al Khaimah (P.S.C), its employees and consultants expressly disclaim all liability and responsibility to any person who reads this document in respect of anything done or omitted to be done by such person in reliance, whether wholly or partially, upon the contents of this document and shall not be responsible for the results of any actions taken on the basis of information provided in this document or for any error in or omission in this document.