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Investment Perspective February 2020

Exogenous Shock

As the coronavirus takes its toll on Asian markets, the U.S.'s smaller exposure to that region should contribute to U.S. market outperformance.


The media, and financial markets, have been consumed by the continuing spread of the coronavirus (now officially named COVID-19) and its impact on health, economic growth and financial markets. As can be seen below, financial markets have been discriminating, as the least-affected economy (the U.S.) has outperformed the most affected (emerging markets, particularly China). This matches up with the fundamental data, which shows a total of 75,300 confirmed cases with only 1,100 of those reported outside mainland China. Of the 2,000 reported deaths, all but six have been in China. The data remains of uncertain reliability, as highlighted by the spike of 15,000 reported cases on February 13th as the government changed its reporting practices. The death rate has moved up to 2.7%, still well below the level of 10% SARS caused in 2003.

From a financial market perspective, the COVID-19 situation is similar to other exogenous shocks, where the focus is determining the magnitude and duration of impact on global growth and inflation. With reported cases not having yet peaked, and news reports indicating that portions of the Chinese economy have ground to a near halt, the near-term impact on Chinese growth will be significant. Financial markets have responded by rallying interest rates and backing off inflation expectations, and there are now nearly two full 0.25% rate cuts by the Federal Reserve priced in over the next year. Reflecting the stability of the U.S. economy, this month we upgraded our U.S. outlook to a "positive surprise" relative to investor expectations while keeping the other major regions categorized as a disappointment. The U.S.'s relatively smaller exposure to Asian economies (see Equities section), alongside durable consumer income growth and spending, should make the U.S. economy an outperformer over the next six to 12 months.

With this upgraded outlook for U.S. growth, we increased our recommended overweight position in U.S. equities, funded equally from developed markets outside the U.S. and emerging markets. This keeps our overall risk level in a moderate overweight position, where we will benefit from a continued positive market environment without taking undue risk. We expect our theme of Structural Monetary Accommodation, which forecasts extended easy monetary policy globally, to support markets. Our risk cases include the impact of the COVID-19 virus on growth and policy in China, and the upcoming U.S. election, which could lead to significant policy shifts. While we are still comfortable putting new money to work in the market, we are favoring "lower-risk" risk assets and expect overall returns to be much more moderate than the robust returns of 2019.

Investment Perspective - February 2020 - Outlook


  • COVID-19 has driven growth and inflation expectations lower.
  • This has boosted demand for longer-dated bonds, flattening the curve.
  • Our underweight to investment grade bonds is in place to fund our overweight to risk assets.

Yields have fallen across the curve, with the 10-year U.S. Treasury yield down by as much as 40 basis points (bps) at the start of February, largely prompted by the COVID-19 outbreak and uncertainties surrounding China's ability to contain the virus. This has negatively affected global growth expectations and reduced inflation expectations. The market is now pricing in an additional 42 bps cut from the Fed over the next twelve months. With talk of the outbreak stabilizing, the decline in Treasury yields has slowed, although the full impact on growth and yields remains undetermined. Demand for longer duration has also ticked up during the early months of 2020. U.S. Treasury stripping data and futures buying data show substantial flows into the back end of the curve. In particular, recent stripping data shows a massive $20B in flows over the last three months, mainly concentrated in 30-year duration bonds; and the Commodity Futures Trading Commission notes that within the futures space, asset managers and hedge funds have recently bought $5.68B in bonds and ultra-bonds. These flows have led to the repricing of the curve to its flattest levels since October 2019. History suggests an increase in market stripping activity is often indicative of back-end yield demand.

Investment Perspective - February 2020 - Interest Rates chart


  • Investors have worried about the surge in BBB-bond issuance.
  • We believe the jump has been driven mostly by shareholder return concern.
  • Recent trends show a jump in issuers with an improving outlook.

The increase in the size and perceived risk of the BBB portion of the investment grade market continues to be a topic of conversation. Since 2010, this segment has more than doubled its market value to $2.5 trillion. The size of the market is more ominous than the actual rating changes within this sector. In fact, the volume of rising stars outpaced fallen angels in 2019 by the widest margin on record. Additionally, rising star volume in 2019 was the second-largest on record, behind only 2013. This ratings migration demonstrates a trend we have highlighted in the past – the growth of BBBs has been intentional. In the decade since the financial crisis, limited growth potential has incentivized management teams to lever their balance sheets in order to perform shareholder-friendly activities and invest in their businesses. The increase in BBBs resulted from capital structure decisions, not weak fundamentals, which often results in attractive investment opportunities after a downgrade occurs. Stable fundamentals, global accommodative monetary policy and recent rating migration trends suggest the potential for a significant increase in fallen angels is low in the current economic environment.

Investment Perspective - February 2020 - Credit Markets chart


  • Chinese economic activity likely slowing to a standstill.
  • Predicting when COVID-19 exposure will peak isn't feasible.
  • U.S. equities should continue to outperform emerging markets in this environment.

As the world struggles with the human and economic toll brought by COVID-19, U.S. equity markets have overcome modest initial losses to post new highs, and non-U.S. markets have proven resilient. At over 15% of global gross domestic product (GDP), China has more than three times the impact it did during the SARS outbreak 17 years ago. As an end market for U.S. companies, however, China is closer to 5%. The parts of the U.S. equity market that have exhibited leadership, including FAANMG stocks, have even less exposure. Among those leaders, China is only relevant to Apple, which has disproportionate exposure in terms of sales (17%), and as a supplier (nearly all of Apple products). The rest of FAANMG has minimal-to-no exposure to China as an end market and supplier. Supply chains are the most notable risk, but the recent tariff conflict led U.S. companies to diversify supply chains away from China, which should buffer the impact of COVID-19. Should the manufacturing shutdown in China persist for longer than anticipated, depletion of critical production element inventories could challenge production around the world. With the U.S. having the least direct exposure and solid underlying fundamentals, we continue to prefer U.S. equities and would underweight emerging markets.

Investment Perspective - february 2020 - Equities chart


  • Natural resource stocks rallied late last year with growth and inflation expectations.
  • The spread of COVID-19 has pressured these shares of late.
  • We recommend a moderate underweight to natural resources for inflation-hedging purposes.

Equity-based natural resources play an important role in our real asset portfolio, as they are the best hedge against the potential of an upswing in inflation. They are also a leveraged play on growth, as they tend to perform well in accelerating economies. The COVID-19 outbreak (the shaded period in the chart to the right) shows both falling growth and inflation hitting the performance of commodity-oriented shares. Investors started downgrading their growth outlooks in mid-January, and this also led to a drop in inflation expectations. Specifically, the 10-year expected rate of inflation increased 24 bps over the last two months of 2019, followed by a 14 bps decline from January 2nd to today. Commodities performed well off accelerating inflation expectations during this period, but gave back those gains over the last six weeks. We are moderately underweight natural resources, as we haven't been optimistic about the global growth or inflation outlook. We didn't change that position this month, as the significant sell-off likely shows the current weakness is discounted in share prices and indicates this may not be the time to further reduce exposures. We like the diversification benefits of natural resources in portfolios, especially the inflation protection they offer relative to the more traditional futures-based commodities strategies.

Investment Perspective - February 2020 - Real Assets chart


Investment Perspective - February 2020 - Base Case and Risk Cases chart


Investment Perspective - February 2020 - Global Policy Model chart


-Jim McDonald, Chief Investment Strategist



© 2020 Northern Trust Corporation.

The information contained herein is intended for use with current or prospective clients of Northern Trust Investments, Inc. The information is not intended for distribution or use by any person in any jurisdiction where such distribution would be contrary to local law or regulation. This information is obtained from sources believed to be reliable, and its accuracy and completeness are not guaranteed. Information does not constitute a recommendation of any investment strategy, is not intended as investment advice and does not take into account all the circumstances of each investor. Forward-looking statements and assumptions are Northern Trust's current estimates or expectations of future events or future results based upon proprietary research and should not be construed as an estimate or promise of results that a portfolio may achieve. Actual results could differ materially from the results indicated by this information. Investments can go down as well as up.

Northern Trust Asset Management is composed of Northern Trust Investments, Inc. Northern Trust Global Investments Limited, Northern Trust Global Investments Japan, K.K, NT Global Advisors Inc., 50 South Capital Advisors, LLC and investment personnel of The Northern Trust Company of Hong Kong Limited and The Northern Trust Company.

Issued in the United Kingdom by Northern Trust Global Investments Limited.

Jim McDonald

Chief Investment Strategist
Jim McDonald is an executive vice president and the chief investment strategist for Northern Trust. He is responsible for overseeing the strategic and tactical asset allocation policy for our institutional and wealth management clients globally.


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