As things stand today, there are many encouraging signs of a rapid economic rebound around the world, but uncertainties also abound. Federal Reserve Chairman Jerome Powell describes the prospect of U.S. economic recovery as “extraordinarily uncertain.”
This probably best characterizes the broad economic environment facing most investors. To be clear, we are still bullish on risk assets, but also think that a short-term set back in markets is very well possible.
Will The Bulls Continue?
Although the U.S. stock market has so far shrugged off the renewed viral spikes in Florida, Arizona and Texas, the increasing number of COVID-19 infections will remain a key risk to equities. At present, the market seems to be assuming that the viral spikes will likely be contained within these states, while the broad economic reopening in the U.S. will stay on track.
Over the past quarter we saw a combination of large-scale monetary and fiscal easing stabilize financial markets. The optimism of relaxing lockdown measures continued to spur the stock market recovery through April, May and June. The question on most investors’ minds is whether this new bull market will continue.
The next few months could be a precarious time as we see renewed virus outbreaks. Depending on how governments choose to steer through the next wave there is a high chance that stock markets will be volatile over summer and we may see again a short-term correction. However, we remain positive on equities versus bonds on a 12-month period.
Global equities have rallied strongly from their March 23rd lows. However, the fixed income environment in the past quarter paints a different picture. Bond yields have barely recovered from March. The US 10-year Treasury note is currently yielding 0.62%, down from 1.92% at the beginning of January and the 30-year bond yield offers only 1.32%. On the commodity side, we have seen oil and industrial metal prices mirror the bond yield picture whereas gold rallied with equities. The divergence in the markets have left investors perplexed.
Despite the second quarter rally, the world equity market is still down since the start of the year. More importantly is to realize that the market rebound has been driven mostly by large technology stocks. A number of large banks, industrial and energy stocks are still down 35% or more from their February levels.
We navigate the choppy waters by considering the main trends at play. In general, bond and industrial commodity markets tend to reflect the outlook of the real economy whereas stocks reflect the outlook for corporate earnings.
A Second Wave is Gaining Momentum
Countries all around the globe are on the path of relaxing lockdown measures. Governments are gradually permitting larger group gatherings and the opening of restaurants, bars and non-essential shops. This opening of the economy takes place against the backdrop of limited success in virus containment.
Although some countries have accomplished lower case and death rates, others still face increasing infection rates. These countries, however, continue down the path of relaxing measures, fearing the prospect of being left behind in the economic recovery.
Predicting the effect of a second wave on markets is difficult plagued by unknown factors. The public appetite for lockdown measures is clearly fading with a growing number of people choosing to flout or protest remaining lockdown measures in place. It is also unlikely that governments will impose the same lockdown measures as seen in the first wave, choosing instead to prioritize the economy by following the “Swedish model” which markets will favor.
Also, developments in technology have given governments the ability to create tracing systems which are better equipped to contain small breakout clusters. Furthermore, treatment options have improved since the onset of the first wave with medical professionals learning more about the virus.
Concerning equity markets, if a more deadly second wave occurs, we would expect to see some severe short-term weakness in the equity market as many sectors would reel from a second punch.
Another risk factor is the increasing animosity between China and the rest of the world. The implementation of a new National Security Law in Hong Kong triggered a reaction from countries like the U.S. and the U.K., while clashes at the China-India border created tensions with India, which prompted India to basically block many popular Chinese Apps.
Hong Kong is at risk of losing several legal and trade agreements with western countries. However, we feel Hong Kong as a financial center is not at risk in the short-term, as its capital market is too important to both China and the western world. Hong Kong also has more than enough monetary reserves to maintain the HKD-peg to the US dollar.
The positive news is that the increased tensions have spurred China to provide large economic stimulus packages to its domestic economy and start new infrastructure spending programs. This will be positive for Asian economies and indirectly for the world.
Although equity markets will face an uncertain period, there are plenty of positive drivers which will likely keep the bull market pushing on higher. As economic data continues to improve equity markets should pull higher.
Although we may see a slowdown in growth during the second peak it is likely governments will not halt economic activity altogether in the same way. Typically recoveries from external market shocks tend to be more rapid than those created by internal problems. The pandemic would qualify as an exogenous (external) shock and, therefore, equity markets should see a more rapid recovery than for example after the 2008 global financial crisis.
The amount of government spending to protect people’s incomes is extraordinary. Although the CARES Act will expire by the end of July, and the 18 million Americans who are unemployed could lose the $600USD/week in extra unemployment benefits.
Both Congress and the White House agree that more fiscal support is needed, but they differ on how the next package will be structured. The Trump administration, worried about unemployment benefits being too generous, favors a “back to work” bonus. The House democrats want to simply extend the extra $600USD/week to January 2021, send another round of $1,200 cheques to each family and increase infrastructure spending.
Will ideological differences between the Republicans and Democrats lead to a blockage of the second stimulus bill? Not likely, as both parties understand that the stakes are too high. Especially now with the flare up of the virus in the southern states. Therefore, we can expect to see additional economic stimulus on top of the huge amount of fiscal spending we have already seen. This explains why the economy remains in reasonable shape despite the pandemic.
The same is happening in Europe, where it is likely that Angela Merkel will manage to get a new EU backed economic stimulus fund of 750 billion Euro approved in the short-term. Which comes on top of an earlier package of 540 billion Euro plus all the individual government spending programs.
The upcoming US elections have the potential to cause a stir in markets. If Biden ousts Trump and the democrats take control of the Senate, corporations will shudder at the prospect of Trump’s corporate tax cuts being rolled back. However, given that the current forecast is now expecting a democratic win, this risk is likely already priced into the market.
Furthermore, a Biden win would likely lead to improved relations with China which would be welcomed by global markets. Anyway, four months is still a long time in Presidential politics, and anything can still happen.
Bond yields will remain depressed until inflation picks up, which we do not expect to happen any time soon. The unemployment rates have jumped so rapidly it will take likely 1-2 years to return to the levels before the pandemic and even then, it will still be another year or more before a tight labour market would lead to higher inflation.
Central banks would likely let inflation levels run up before stepping in to increase rates. Furthermore, highly indebted governments will prefer a higher inflation environment so that the real value of debt is eroded.
Bond yields could see some recovery alongside global economic growth. We will likely begin to see long term yields rising more than short-term rates. However, yields will remain low in absolute terms.
The Fed has been actively buying fixed income Exchange Traded Funds (ETFs) in the past two months to provide liquidity to the (high yield) credit market. This means the credit market does not offer particularly attractive opportunities at the moment. Given our outlook for the world we would prefer to add credit risk in emerging market debt or, for clients who can accept low liquidity, opportunities in private credit.
Since March the trade weighted US dollar has fallen by 4%. Last year, the dollar held the benefit of higher interest rates and stronger economic growth which benefit the dollar.
The dollar usually behaves as a countercyclical currency. Therefore, it tends to display an inverse relationship with the global business cycle. If global growth continues to recover, as we expect, the dollar could continue to weaken further.
During the past quarter we made multiple changes to client portfolios. In April, after the initial rebound we de-risked the portfolio slightly which we intend to hold until we see opportunities in the market which would warrant an increased appetite for risk. For the majority of managed portfolios, we either reduced equity exposure by increasing short-term treasury or cash holdings.
In single stock portfolios we focused on adjusting allocations to incorporate large cap global quality stocks to provide some downward protection. These companies usually exhibit high profitability, strong balance sheets and high revenue protection.
We have been managing sustainable portfolios for a number of years and we decided to include sustainability as a key investment criterion in all our portfolios going forward. Combining traditional investing with Environmental, Social, and Governance-related (ESG) insights to improve long-term investment outcomes. In other words, companies with strong sustainability ratings have potential to outperform those with poor ratings.
In particular, we believe companies managed with a focus on sustainability should be better positioned versus their less sustainable peers to weather adverse conditions while still benefitting from positive market environments.
This period of market turbulence and economic uncertainty has further reinforced our conviction that companies with strong ESG characteristics show more resilience during market downturns. The recent downturn was a key test of this conviction. In the first quarter of 2020, Morningstar reported 51 out of 57 of their sustainable indices outperformed their broad market counterparts, and Morgan Stanley Capital International (MSCI) reported 15 of 17 of their sustainable indices outperformed broad market counterparts. While this short time period is not determinative, it aligns with the resilience we have seen in sustainable strategies during prior downturns in 2015-2016 and 2018.
For investors, the most important question is why? What explains the resilience? Research by BlackRock has established a correlation between sustainability and traditional factors such as quality and low volatility factors which tend to provide downside protection in market sell-offs. As a result, we would expect sustainable companies to be more resilient during downturns.
Another key piece of the resilience story has been increasing investor preference for sustainable assets during the crisis. As investors have sought to rebalance their portfolios during market turmoil, they are increasingly preferring sustainable funds over more traditional ones.
In the first quarter of 2020, global sustainable mutual funds and ETFs attracted USD 40.5bn in new assets, a 41% increase year-over-year. That means that sustainable investing as a trend is gaining traction, which could become self-fulfilling as it risks leaving companies with low sustainability ratings behind.
As well as introducing quality bias in the single stock portfolios and through the integration of ESG principles in our core portfolios we also chose to switch the value bias to quality for the core portfolios at the end of May and early June. This decision was rewarded as quality outperformed value in June. We may continue to make switches to our factor bias in portfolios as we see opportunities pick up in the markets in the coming months.
A final approach we took in portfolios is to incorporate more thematic trends where we see an opportunity for outperformance. For the core ETFs based portfolios we incorporated themes into the portfolios by adding tactical ETF positions.
One area that we are interested in at present are health care innovation and biotechnology companies as we feel the pandemic crisis will lead to even more investment in healthcare and especially in health technology.
Secondly, we invested in renewable energy as this has been a major trend for several years, but we believe the recent turmoil in the oil market will only lead to more investments in renewable energy.
Our final tactical decision was to overweight our exposure to China with particular focus on technology and healthcare.
In our single stock portfolios, we included more companies focused on health care, technology and consumer sectors than before as we feel these sectors might ultimately profit from the current crisis.