View From the Top

Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation.

View from the very top: The second half of 2020 could well herald as many surprises as the first. What matters most though is the direction of travel. From how we see the world currently, things are improving and so the rally in risky assets may endure for some time longer. This is not to say there won’t be pullbacks (especially should a second wave of the virus occur) but consider the sheer amount of stimulus – both monetary and fiscal – that has been thrown at the economy. Add to this, both macro data and earnings revisions appear to be bottoming. Recoveries typically start before recessions end. However, balance, discipline and patience remain the orders of the day. Our strategy is distinctly to favour active over passive and diversification over simplification.

Asset Allocation:

• Equities: Despite the 37% rally in global equities witnessed since the market’s nadir in late-March, we see a continued case for equities, particularly in the context of record-low government bond yields. Consensus earnings estimates appear to have troughed in the near-term and when the Q2 reporting season starts in mid-July, how companies see the outlook will matter more than reported figures. The MSCI World’s current multiple of 22.3x (for calendar 2020) may compare unfavourably to a 10-year average of 18.0x. However, on current estimates – which may now be moving higher – the market trades on just 15.4x two years’ out (all data per Bloomberg). To position appropriately within equities, our mantra remains one of firmly orienting towards managers with truly active, high-conviction and differentiated strategies.
• Fixed Income: Central Bank policy action has put a lid on sovereign yields, which may continue to move lower in the absence of any inflation. At the same time, increasing risk appetite and lower spreads have resulted in massive investment grade and high yield issuance. The Federal Reserve’s decision to start buying corporate bonds has also been supportive. Deteriorating credit quality remains a crucial factor to monitor. This, combined with increasing asymmetries across the credit spectrum, argues for a strongly active credit stance too.
• FX: The Dollar has weakened against most major currencies and may continue to do so. Interest rate differentials are now lower between the US and other developed markets than in the past. The impending US Election is another source of uncertainty for the Dollar. Other currencies (such as the Euro) look undervalued on a relative basis.
• Gold: We remain positive on gold, which continues to outperform, closing in on its 2011 high. Gold acts as a natural portfolio diversifier, carries no credit or political risks and represents a strong hedge against other, more cyclical assets.
• Alternative Assets: We see a clear role for such assets in portfolios. Low yields generally strengthen the case for private assets. Those with strong balance sheets in non-cyclical sectors (e.g. seniors’ housing or logistics REITS) should continue to prosper. We see selected opportunities in infrastructure, real estate and niche private equity.

Reality check

We now stand halfway through 2020 after a six-month period that no one could have predicted; neither the rapid sell-off nor the subsequent recovery. Despite the greatest pandemic in a century and the worst contraction since the Great Depression, the global equity market has seen a record rally from its nadir. Most other risky assets have joined in too. As one Bloomberg headline recently put it, the world has gone ‘from depression to euphoria in less than a hundred days.’

This piece is more about looking forward rather than backwards. Huge uncertainties remain, not least about a virus that is still not fully understood from an epidemiological point of view. Then there is the small matter of the US Presidential Election to come in November, an event that occurs against a backdrop of heightened US-Chinese tensions and a geopolitical order that is trending away from globalisation to one characterised by more belligerent nationalism. Nonetheless, the stance we wish to take – which is certainly not yet the consensus one – is that the current risk-on rally may prove sustainable for some time longer.

Such a view certainly occurs in a high context of high scepticism. Consider recent investor surveys, such as the monthly one conducted by Bank of America Merrill Lynch. In June, a net 78% of investors believed stock markets to be overvalued, the highest figure since its survey began in 1988. Over 50% see the current move simply as a bear market rally. Further, when asked about which letter of the alphabet notionally corresponds best to the shape the eventual economic recovery may take, just 18% called out ‘V’ (versus 64% at ‘U’ or ‘W’ and the remainder not sure).

Against a background of such apparent cynicism, distrust and disbelief our contention is that it’s the direction of travel that matters. Doubters can become believers. The journey will, of course, not be linear. Even if risky assets do appreciate further, corrections can still happen. Indeed, a pullback in the very near-term might even not be that surprising given the staggering recovery since late-March, especially if there is a second wave of the virus.

Sometimes simple explanations are the best. Most readers of this piece will be familiar with the adage ‘don’t fight the Fed.’ Rephrased for current events, never before has so much stimulus been created in such a short period of time. When monetary and fiscal policies are aggregated, announced plans globally total $11tr (per Bloomberg). Combined spend in the US is equivalent to 12.1% of GDP, ~2.5 times the level that the country spent at the time of the Great Financial Crisis. In most other major geographies, stimulus as a percentage of GDP is some ten times higher than the levels committed to in 2008/9 (per McKinsey). The Central Bank (and now de facto Government too) ‘put’ looks to be firmly in place.

‘Doing what it takes’, however platitudinous, has become a highly effective signalling tool. Consider even when there was the slightest wobble in markets at the start of June, the Federal Reserve immediately committed to buying corporate bonds for the first time too. Policymakers seem focused on shoring up investor psychology, even as the punchbowl continues to get bigger. With inflation palpably absent for now (three consecutive monthly declines in the US; at a four-year low in Europe), Central Bank largesse is possible. It’s less a matter of whether you agree with Central Bank (and Government) policy – and we worry about the creation of moral hazard, for example – and more about considering the practical investment ramifications.

The road to recovery will undoubtedly be a long one, hardly a surprise after a generation-defining recession. The IMF forecasts a 4.9% drop in world GDP in 2020 while the OECD is more cautious, suggesting a 6.0% decline (or as much as 7.6% if there is a second wave). Set against these predictions stands not only the announced stimulus packages, but also the consideration that markets typically start to recover before recessions end.

Further, while the loss in output will certainly be significant (the IMF suggests a cumulative $12.5tr globally by the end of 2021), it may not be as bad as the forecasters are currently suggesting. At a big-picture level, the current situation is very different to 2008. Then, the crisis was systematic – a failure of liquidity in the financial system; now, it is exogenous. Meanwhile, already, many high-frequency indicators such as transaction volumes (Mastercard’s data are now pointing to flat volumes year-on-year, versus down over 30% in mid-April), retail footfall and public transport are supportive of recovery.

What if there’s a second wave? This scenario certainly can’t be ruled out, but there is at least now a playbook for policymakers. Investors can perhaps draw confidence from how future lockdowns may be enforced. The public are (hopefully) better informed. And, Central Banks/ Governments are on hand, ready to act. Now that stimulus is available on tap, it’s going to be hard to turn off; the genie is out of the bottle. Withdrawing it will undoubtedly be hard, but history says it is better to be too late in such actions rather than too early. We see this as being a 2021 story, at least. An acute consciousness of wanting to avoid policy errors prevails.

From a valuation point of view, the market is an efficient discounting mechanism; it’s less about the next couple of quarters, and more about what’s implied for 2021, 2022 or even on a 10-year view. Put simply, companies won’t go on haemorrhaging growth and profits for ever. Moreover, as analysts get (more) comfortable with the idea that the worst of the earnings declines are likely now to be in the past, at the same time that economic data are surprising to the upside, such dynamics should drive earnings revisions up and multiples down. There is normally a strong correlation between economic surprise indices (easily accessible via data providers such as Bloomberg) and analyst revisions. Earnings estimates look to have hit a bottom in May/June and may actually see a rise in July.

It is always easier to apply optimistic psychology when things appear to be going well. Such an approach can create dangers in terms of compounding and exaggerating the positives at the expense of risks. Lest we get too complacent, there are several clear factors that will be important to monitor carefully. Many are interlinked and not all are fully discounted at present. Consider when might the cycle move from wealth creation to wealth (re)distribution? Ironically, soaring markets may fuel a further backlash. Regardless of the recovery, someone will ultimately have to pay for current policy generosity. Imagine then a possible scenario that may occur should there be a Democrat victory in November’s Presidential Election. Such an outcome could yield higher taxes (particularly for corporates) and possibly greater regulation. Leaders everywhere will have to manage widening inequalities and social disputes. Civil unrest, as we see it, is part of a wider loss of trust in leaders and institutions; the very fabric of modern society. Don’t forget about the metaphorical elephant in the room. It’s neither debt nor inflation – these issues can be delayed for another day. It’s simply that there is still no vaccine for (or full understanding of) COVID-19. Until there is, the world may not get back fully to normal.

In a world of such uncertainty our counsel is to take a balanced, or barbell approach. Be patient and be measured. For us, the most notable observation from the Bank of America Merrill Lynch survey cited earlier is that 67% of investors believe that the next decade will see 0-5% annualised returns for equities. If this view proves to be the correct, then there is a clear logic in favouring active over passive strategies and diversification over simplification.

Alex Gunz, Fund Manager, Heptagon Capital