Overnight US news flow was important: first, “Super Tuesday” Democratic primaries have been a big win for Joe Biden while Bernie Sanders performed underwhelmingly. Bernie Sanders has to catch up against the moderates rallying behind Joe Biden. Second, the Federal Reserve announced an inter-meeting 50bp rate cut in response to the Covid-19 shock. The vote was unanimous and left the door open to further rate cuts in the meetings ahead. Do a moderate presidential candidate taking the lead in Democratic primaries and increased expectations of more global policy responses alter our asset allocation?.
Following yesterday’s Super Tuesday, more than one-third of the total 3,979 pledged delegates for the 13-16 July Democratic convention in Milwaukee have been allocated. Thanks to victories in eight states, including in Texas, Joe Biden has now taken the lead with 453 delegates. Among others, Bernie Sanders, the most liberal or progressive candidate in the race, won the California primary and now has 382 delegates.
A contest between Joe Biden and Bernie Sanders is emerging as all other candidates have been left behind: Amy Klobuchar and Pete Buttigieg fell out after the primary in South Carolina and are backing Joe Biden, whereas Mike Bloomberg won only one contest – American Samoa – and suspended his campaign. Elizabeth Warren, a progressive candidate, did not win any of the first 19 nominating contests and finished third in her home state of Massachusetts.
Let us remind that at least 1,991 pledged delegates are needed to win the nomination in the first round voting at the July Convention. The coming weeks will be crucial as 3,080 or 65% of Democratic primary delegates will be determined by the end of March.
Yesterday saw the 8th emergency intermeeting Fed cut in the past quarter of a century. The previous ones have occurred in three clusters: 1998, 2001 and 2007/08. Hence, yesterday’s cut was the first 50bp move since the 2008 financial crisis. The medium term performance of the S&P500 after these cuts were -4.3% over the following 6 months and and -9.2% over the following year.
We know that cuts in the Federal Funds rate are working when both equity markets and bond yields go up. This happened in anticipation on Monday but yesterday equities and bond yields plunged, the 10y US government bond yield falling below 1.0% for the first time in history.
So, did the Fed made a policy mistake by pushing the panic button? We don’t think so. In our view, the main motivation for yesterday’s move was a response to the sharp tightening in financial conditions since mid-February via a negative wealth effect due to falling stockmarkets and tightening credit markets.
Looking forward, market expectations of further policy easing from the Fed and other central banks remain high, in particular following the G7 central bankers and finance ministers commitment to use all appropriate policy tools. If the outlook and financial markets are starting to stabilize, we believe the Fed will stop easing. On the other hand, if recessionary dynamics develop, we think the Fed is likely to cut further and re-activate forward guidance and possibly QE. In Europe, the BoE has room to cut rates, whereas the ECB is likely to act on credit easing (e.g. targeted bank funding for SME loans, step up in corporate debt purchases).
In short, we maintain a slightly underweight equity exposure due to the uncertainty surrounding the coronavirus news and the lack of coordinated global policy response. We agree with Fed Chair Jerome Powell that “the virus, and the measures that are being taken to contain it, will surely weigh on economic activity, both here [in the US] and abroad for some time.”
The intensity of the shock on both supply and demand and the global policy responses will determine our next portfolio adjustment steps. For now, reliable information is scarce and we note that China’s February Caixin services PMI came in at a shocking 26.5 against expectations of 48 points.
We were overweight equities until end-January and became neutral on the 27th of January. We have been neutral equities since then and had derivative strategies in place to mitigate the effect of a market drop. They played their role. Last week, we became tactically slightly underweight equities.
We have focused the risk reduction on equities since it was the asset class that had shown the highest level of complacency and vulnerability to a shock. Elsewhere, we remain for now underweight duration. We are neutral EUR/USD and keep a long exposure to the JPY. We keep our preference for gold as a hedge.