Spotlight - With the US and broader European economies entering the ‘acceleration’ phase of their respective COVID-19 infection cycles, fiscal policymakers across Europe and the United States have begun outlining plans to bear down on this growing shock to demand and confidence.

Key points

  • Strategically, a clear casualty emerges in light of the policy response on the part of western governments – the US dollar. We expect the risk-off driven strength in the greenback to be nearing its end especially for Euro and Swiss franc referenced investors. Admittedly, it is still too early to assume the same for more cyclically oriented and emerging market currencies
  • Benefitting from the renewed zero interest rate regime for the USD is physical gold which should become a foundation of value in portfolios looking ahead.
  • Tactically, investors should expect a tug of war between the continued spread of the virus and policymakers’ efforts to increase their actions in response. Investors should seek opportunities when markets begin both to over- and underprice the prospect of outright credit contagion while continuing an active risk management regime to reflect the ongoing uncertainty.
  • In the face of liquidity challenges in the bond markets, we seek opportunities to stand next to central banks as they move to stabilise investment grade credit markets. In high yield credit markets investors should be selective.
  • In equities, we have begun to rebuild directional, long only exposure via quality growth stocks though paired with tail risk protection against policy error or a failure in containment in the weeks and months ahead

Infections set to peak in Continental Europe

While the humanitarian crisis continues unabated in many regions of the world, April should begin to see some respite in terms of infections starting first in Italy and hopefully continuing into other areas of continental Europe as well. As highlighted in the early-March Spotlight, COVID-19: A Framework for Markets, the time lag between the implementation of extreme quarantine measures and the ultimate peak and decline in infections is 2-3 weeks, using China and Korea as references. With Italy implementing a national quarantine on March 8, the peaking in daily infections from March 21-27 is consistent with this time frame. Moreover, with much of continental Europe following in Italy’s footsteps in the following weeks, a peak in infections for key economies on the continent should be expected in the weeks ahead.

More uncertain, however, is the situation in the United States where shutdowns have been driven at the state rather than at national level. As a result, the initial outbreaks along the American east and west coasts are now resulting in secondary outbreaks through key urban centres in the middle of the country, suggesting a national peak has not yet arrived.

Looking ahead for Europe and, once again, referencing the China and Korea timetables, shutdowns look set to continue for several weeks more to minimise and contain the prospect of secondary outbreaks which China is now experiencing.

While the timeline remains a concern, it is fortunate that the unimpeded run that COVID-19 had in February and early-March through Western economies is now being met with not only more stringent containment efforts, but also substantial fiscal and monetary measures to offset the demand impact on local economies. Indeed, looking at what has been announced, the UK, France, Spain, Italy and Germany appear set to deliver fiscal relief nearing 15-20% of GDP while the US’ $2 trillion in relief should deliver close to 10% of GDP in support.

USD bull market: A casualty of US COVID-19 policy responses

The double-barrelled – fiscal and monetary – response from American policymakers leaves the US dollar as a primary casualty of their ‘whatever it takes’ approach, according to Peter Kinsella, UBPs Head of FX Strategy.

In particular, USD strength in recent years has come as a result of the premium interest rates and returns available from USD assets. That rate differential has now compressed with the Fed’s return to the zero bound.

Though we do not anticipate the Fed voluntarily venturing into negative rate territory as some of its European counterparts have, the unconstrained purchases of its traditional assets – US Treasuries and mortgage backed securities – have now been matched by not only upcoming purchases in the US corporate credit market but also lending directly to American firms and support to loans to the American consumer via asset backed securities markets.

Moreover, the reinstatement of swap lines with major central banks globally means that even more US dollar liquidity is being released by the Federal Reserve to address not only shortages seen in the American economy, but the global economy as well.

These measures close the policy gap further between the US and other major economic regions, where central banks in the euro area and Japan have increasingly run out of policy flexibility.

With this flood of dollars into the system and in the absence of higher carry, markets should increasingly focus on the USD’s structural vulnerabilities – an exploding fiscal and current account deficit. Combined with the Fed’s implicit desire to impose negative interest rates adjusting for inflation, these deteriorating structural fundamentals should end the dollar bull market as investors reassess their FX exposures.

Gold: A strategic beneficiary of the new world order but near-term volatility prospects remain

During the early stages of the COVID-19 induced panic in financial markets, gold has not had the aura of a safe haven instead demonstrating volatility and, at times, meaningful drawdowns for holders of the metal. This reflects the USD shortage that characterised the early weeks of this crisis as the scramble for dollars that were in short supply led to liquidation across asset classes in favour of cash, much like in the Global Financial Crisis.

With the Fed having substantially addressed this USD shortage through its rate cuts, bond buying and most importantly for offshore investors, swap lines with global central banks, this headwind for gold appears tamed for now.

Instead, the structural vulnerabilities that we expect to weigh on the USD looking forward will simultaneously become a strategic Union Bancaire Privée, UBP SA | Spotlight – COVID-19: The Tug of War Begins | April 2020 3 | 5 tailwind for gold. With little in the way of carry on risk-free US dollar investments, gold’s lack of a regular income stream no longer poses a comparative disadvantage for the precious metal.

Moreover, investors will soon recognize that the ‘solution’ being implemented for the economic crisis that is accompanying the COVID-19 humanitarian crisis involves trillions of dollars of additional debt. This will likely only be extinguished via a return of inflation or default. The attraction of gold in either scenario should grow.

In the near term, admittedly, headwinds exist for more tacticallyoriented investors in gold. Uncertainty has kept significantly net long positions in the yellow metal at levels that have over the past decade coincided with pullbacks in the gold price. However, a key exception to this was in 2010 following the Global Financial Crisis where similarly net long speculative positioning did not stand in the way of a 27% rally in gold. Then as now, the Federal Reserve responded aggressively to a crisis by injecting significant USD liquidity into the global economy.

Beyond this, key buyers of gold may need to pause their purchases in the near term while emerging markets with more fragile economies may resort to selling gold to meet growing USD needs.

It is worth remembering that emerging markets have been consistent buyers of gold over the past decade. The global economic impact of the COVID-19 outbreak as well as the collapse in oil prices (a key dollar earner for several large EMs) may act to slow these purchases. Indeed, Russia, which bought 158.1 tonnes in 2019 and as much as 8.1 tonnes in January according to the World Gold Council, announced it was suspending its purchases of gold beginning on April 1.

As a result, strategically, physical gold should sit as the foundation for wealth preservation within portfolios. Tactically, we have also sought to augment these strategic positions by taking an asymmetric, options-based exposure – protecting against sharp falls as seen recently while participating in the upside – for a portion of our gold positioning.

A tug of war between COVID-19 demand shocks and policy responses lies ahead

With strategic weakness in the USD and long-term strength in gold expected to lie ahead for investors, in more traditional asset classes, a tactical approach will likely be required in the weeks ahead as the ‘whatever it takes’ mantra of global policymakers engages in a tug of war with ongoing demand shocks from COVID-19’s spread in the world’s largest economy.

While pockets of instability remain in markets around the world, we believe that the forceful actions of the US Federal Reserve have been sufficient to stabilise global liquidity in the near term and avert the risk of a broader credit contagion in markets. This leaves our scenario of a contained credit shock as seen in the 2015-16 US high yield market as our base case. In credit, we recognise that market liquidity remains poor and that we may still be at the early stage of a credit cycle. We are therefore

seeking selective opportunities to add quality credit exposure as central bank purchases help to mitigate a further widening in historically wide credit spreads. In the risky credit markets – such as high yield and emerging market debt – further volatility may lie ahead. This leaves us to prefer a selective, bottom-up, hold-to-maturity approach to capture cyclically wide spreads while seeking to mitigate near-term risks as the credit cycle progresses.

In equities, investors can tactically seek opportunities to capitalise upon markets overpricing the prospect of an outright credit contagion.

Based on our analysis, assuming a credit contagion scenario can be avoided, a revisit of 2020 lows across markets presents an opportunity for investors to add to quality growth strategies across markets.

Admittedly, while a credit contagion scenario has been reduced by recent policy action, such concerns have not yet been fully eliminated. Indeed, the risk to portfolios should they in fact be realised remains significant especially in light of the recent rally in global equity markets.

As a result, we have re-established tail-risk protection within portfolios via options on gold and equities. Undoubtedly, volatility will re-emerge as a normal part of even a recovery process as seen through 2010. However, our focus for protection is increasingly on any policy error which spurs a wider credit contagion or alternatively, a failure to contain the virus which forces lockdowns to extend well into the summer