Un environnement peu accommodant
The second quarter was disastrous for society and the global economy. The danger on both fronts is passing only slowly. Yet the quarter was great for markets. Barely any asset class delivered a negative return. Trillions of dollars of money was created and central bank balance sheets boomed. It has been a lesson in not underestimating the power of policy. Cheap valuations and rocket-fuel policy drove risk assets. The starting point for Q3 is not quite the same. Where fundamentals go is much more important now.
What an incredible quarter we have just lived through. On a human note it has been tragic. Around the world almost 10 million people have contracted the coronavirus and close to half a million people have died. As we enter a new quarter, infection rates are still increasing. In recent days, according to data from Worldometers, the daily global infection rate has been closing in on 10,000 cases. Medical professionals continue to warn that the virus is not under control and remains a major risk to public health. Yet the focus of policy shifted during the last three months from prioritising health to prioritising economic recovery. The two objectives remain inextricably linked. They will remain the drivers of economic sentiment and market returns in Q3.
The economic consequences have been grave. Over 20 million people became unemployed in the United States in the last three months and millions more will have suffered a similar experience worldwide. Soon we will start to get Q2 GDP estimates. The forecasts are pretty horrendous. The US is estimated to have suffered a 35% annualised contraction in GDP in Q2 according to a Bloomberg survey of forecasters. The Euro Area is estimated to have contracted at a quarterly rate of over 12%. The same survey shows a strong bounce expected in Q3 but the reality of that will only become obvious in the weeks ahead. Mobility and other high-frequency big-data show a recovery in activity but even with these data sets the recovery is by no-means V-shaped. The economy came to an abrupt stop in March. Activity is picking up in Europe, with few signs of a second wave, but in some US states higher cases are associated with some stalling of activity.
There was unprecedented support for financial markets and the real economy put in place by central banks and governments. Trillions of dollars of direct and conditional monetary and fiscal policy has been provided. Without that the social and economic losses would have led to a very different outturn in markets. As it is, the second quarter barely saw any asset class record a negative return. Monetary authorities have provided a relatively open-ended commitment to buy government bonds. They remain the asset where the risk of permanent capital loss is the lowest.
It is on the risk side that returns have been spectacular. High beta credit has recovered strongly from a poor first quarter. High yield became very oversold in the March panic and the 10% index returns over this quarter reflect that many investors saw good value in a market that offered nearly 10% more yield than cash back in March. Equity returns have been even more impressive, driven by lower rates and credit risk premiums and sentiment that has pulled a lot of retail money in to the market, especially in the US. Most equity markets are down year-to-date, as perhaps many would argue they should be. After a strong Q2 performance, where they go now depends on the path of recovery and confidence that higher levels of activity will translate into higher earnings.
Valuation less attractive
Investors faced with this recent history of asset price appreciation and a still very uncertain outlook face a challenge in what to do next. Valuations have got more expensive in absolute terms. Investment grade credit yields are close to their lows of the last 20-years – the exception being European corporate investment grade debt where yields have been low for an extended period already. High yield and emerging debt yields are in the 30%-40% percentiles of their 20-year history but that includes some pretty spectacular spikes (200-2002, 2008-2009 and 2015-2016). Equity valuations are also high, especially in the US, while volatility is still above its long-term average (at least as measured by the VIX).
I have been looking for ways to justify the performance of risk assets in recent weeks. More often than not the conclusion has been the impact of policy through the channel of the bond market and its impact on interest rate and credit risk. A secondary explanation has been sentiment, driven by evidence of activity picking up and expectations of sustained economic recovery. It was easier to see positive sentiment being sustained with a tidal wave of policy announcements and cheap valuations through April and May. Now it is more difficult. The virus is wreaking havoc through the Americas. We can only hope the Pacific Ocean is a big enough barrier to stop the wave making its second trip around the globe in the months ahead. Many investors will surely want to see better news to justify chasing markets that have already priced in a lot. I’m not sure that means turning super defensive but being prepared for less exuberant returns in the next quarter might be prudent.
A V-shaped bounce in Q3 GDP is possible. But behind the headlines will be higher unemployment, lower corporate revenues, caution on investment spending, higher government debt and the consequences of fiscal cliffs when they come. These fundamentals go beyond the superficial recovery signals implied by bounces in purchasing manager indices and retail sales. I read some comments that downplay the remaining health threats, that are very confident in a robust V-shape pick-up and even that monetary policy is too loose. These seem overly optimistic claims. Let’s review in three months’ time just how much of the damage to the global economy has been repaired. Investment portfolios, in my opinion, should be set up to have some protection against a reversal in the dynamics of the last three months. Not all jobs lost will be restored, not all businesses closed will be re-opened, not all debt taken on will be repaid.
Go with safety and what has worked
The valuation and technical support for markets is less strong today relative to three months ago. Sentiment is fragile given what is happening in the US and emerging markets. Looking forward, I think US high yield can still perform but I would hold some duration as well. On the equity side there is always the argument for taking the long-view. My big belief there is that we have not seen the full potential of digitalisation and climate control driven change in products and business models. The FAANGs might be expensive but if anyone saw the queues outside Primark and Nike Town in London when the shops were allowed to re-open then I would put forward the view that the world is still short technology and online retailing has a long way to go. The cyclical rotation of early June is over. Triple-C high yield spreads outperformed for a couple of months, so did value indices in the equity market. It seems that was a brief response to something that should have been entirely expected – the bounce in data starting to come through. My bet would be focussed on better quality high yield and growth sectors.
One consideration for the second half of the year is the US election. I will come back to that over the summer, but it is setting up to be, perhaps, as much of a market event as Donald Trump’s victory in 2016 was. The drama around the race will surely intensify in the coming weeks given coronavirus and 20-million unemployed. I guess it is no surprise that the polls are showing Biden ahead, but these are strange times. When people in Florida argue that defying the guidance to wear face masks is a protest against the “deep state”, who knows how the US electorate will vote. Stay tuned for this one!
I don’t begrudge Liverpool fans celebrating their club winning the Premier League. After all, they’ve had to wait a long time. The points tally speaks for itself and there have been no real challengers for months, if at all during the concluding season. Assuming life returns to some normality, next season will be interesting. Liverpool are one of a handful of clubs that have successfully defended the title in the past, but two others that have – the Manchester clubs – will surely be amongst the challengers. There will be questions – will Pep stay at City? Will Jose be able to turnaround his diminished talent at Spurs? Have Arsenal found someone in Arteta that can guide a necessary rebuilding? Can Chelsea be a consistent force? I have optimism about what is happening at United (I always do I guess). Roll on 2020/21 for a whole host of reasons!
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