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: Stay constructive on riskier assets. Despite the remarkable rally in most equity markets globally, there may be further to run, especially should there be progress in terms of vaccine development. For now, investors seem happy to ignore the widening disparities that are emerging not only within asset classes but also across the real economy. At some stage there may be a greater reckoning. With so much still unknown and many conventional valuation approaches of little use currently, it does however seem prudent for investors to demand some margin of safety. If anything is clear, then the current crisis should mark an inflection point in the active versus passive approach to asset management. High conviction, truly differentiated strategies should continue to prosper in the current environment. 

Asset Allocation: 

• Equities: The rally in most global equity markets which began in late March has continued almost unabated. The MSCI World has now climbed more than 50% from its trough. Despite these gains, the case for equities relative to conventional fixed income remains compelling in our view, underwritten by the fact that the most recent earnings season surpassed expectations. Market gains, however, mask the major differences between winners and losers. Growth as a style has generally outpaced value. This may reverse in time, but not yet. Truly active managers should continue to outperform. 
• Fixed Income/ Credit: It remains very difficult to see how it might be possible to make money through owning government bonds when yields across the developed world remain so low (the 10-year US Treasury yield hit an all-time trough of 0.51% in early August). Yields can, of course, fall further especially if the economic recovery proves uneven. Other segments of the fixed income market (such as high yield) may therefore be more attractive, but necessarily carry higher risk. Default rates remain important to monitor. Remain highly selective with limited exposure to this asset class. 
• FX: A weaker US Dollar has become an increasingly consensual view. However, even with the Euro at a 2-year relative high versus the Dollar, mean reversion can continue for some time longer, particularly in the context of historic Dollar strength. The uncertainty over the US Election may also put additional near-term pressure on the Dollar. 
• Gold: All roads continue to lead to gold, in our view. This was a view we first advocated in late-March and while it is now more widespread, further gains are possible. Negative real yields, dovish Central Banks and a weaker Dollar are all positive for gold. Listed gold miners represent another potential opportunity. 
• 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. 

First despair, then euphoria. Now reality? 

Blink and you may have missed it: the S&P 500 (the world’s largest equity index) made a new all-time nominal high on 21 August, 184 days after having last done so. In between, it recorded a rapid sell-off (losing 34% in just 24 trading days) before marking an astounding recovery, gaining over 50% in value. A similar picture has played out – albeit less dramatically – in most other major global equity markets. Sure, a combination of FOMO (fear of missing out), low volumes and increasing retail participation have all helped. The key question, however, is not to look back but rather forward and consider where equity markets – and more broadly all asset classes – may now head for the remainder of the year. 

A useful starting point may be to compare/ contrast how much has changed over the six-month period between the two recent highs recorded in the US equity market. It would be both platitudinous and facile to state that the COVID-19 pandemic has altered everything right down to how we think, communicate and interact with other humans. More fundamentally though, the data points which follow bear serious contemplation Maybe the correct question to be asking is at what cost has the market recovery been achieved? 

Consider first that the Fed’s balance sheet has swollen over the last six months from $4.2tr to $7.0tr. Most other major Central Banks have seen similar expansions. This is before even considering the explosion in government debt (for the record, the US budget deficit has grown by over 200% from 4.9% to 15.1% of GDP during the same period). The recovery has hence been underwritten by the mantra of authorities ‘doing what it takes.’ It is, of course, both counterfactual and somewhat pointless to contemplate how things might have turned out had authorities not have intervened. Further, as we have discussed elsewhere, the ongoing pursuit of unconventional policies may also be storing up problems (inflation particularly) for another day – not that market participants seem overly concerned at present. 

Perhaps the more important consideration then is to wonder when an elevated stock market became a de facto policy objective (though authorities are unlikely ever to acknowledge it as such). This may be all well and good for investors – higher equity markets, lower bond yields (the yield on the US 10-year has fallen by over 100bp in the last six months) and a higher gold price (up over 25% YTD) – but it is hard to ignore the widening disparities between what are often termed Wall Street and Main Street. 

The following statistics should make for highly sobering reading. In the last six months, continuing jobless claims in the US have risen by over 800% (from 1.7m to 15.5m) and unemployment has moved from 3.6% to 10.2%. Some estimates (for example, from the University of Chicago) suggest that around 40% of these job losses may be permanent. At the same time, mortgage delinquencies have risen from 3.7% to 8.2%. Surely it doesn’t take an investment professional to realise that recoveries are normally contingent on households’ ability and willingness to spend? 

Of course, the other disparity worth exploring is within the equity market. It has recently become popular when seeking a convenient alphabet-based metaphor to describe the current recovery as ‘K-shaped’ (previously the debate had considered V, U, W, L and quite possibly others). What this means most simply is that there is a seemingly ever-widening gap between ‘winners’ and ‘losers.’ The performance of just five stocks (Apple, Microsoft, Amazon, Facebook and NVIDIA) has been responsible for over 25% of the S&P 500’s return year-to-date. Taken together, the market capitalisation of the first four of these businesses plus Alphabet is now more than that of Japan’s TOPIX, the major market index of the world’s third-biggest economy. Meanwhile, some 20% of the S&P 500’s constituents remain at least 50% below their all-time highs (all data per Bloomberg).

A major problem for investors is that the most ‘obvious’ tools used to assess whether assets/markets may be overvalued are of little use at present. The COVID-induced economic slump (Bloomberg consensus now assumes a 5.0% decline in US GDP this year, versus an assumption of 1.8% growth six months ago) has clearly put pressure on earnings forecasts (and hence P/E analysis) even as policymakers have helped to buoy prices. So much remains unknown – and we should not be afraid to admit this – and it would therefore not seem unreasonable for investors perhaps to demand some margin of safety. Many, however, appear almost Panglossian in their outlook; like Voltaire’s famous character, they believe that everything is for the best in the best of all possible worlds. Indeed, investors are currently at their most bullish since February, per the latest Bank of America Merrill Lynch Fund Manager survey. 

What might permit for such a view? Beyond the factors outlined above (policy support, most asset classes outperforming), it is worth wondering what might happen were a successful vaccine for the COVID-19 virus to be identified and/or start becoming available in the coming months. Do not dismiss the possibility. Under such a scenario, economies might start getting more back to normal. From an investment point of view, risk-on would be the order of the day. Bonds might sell off and there could be a broadening equity market rally with rotation into cyclicals (and out of tech). Add into the mix the improved sentiment that might arise should there be a new US administration in the coming months. A Democrat-led America might be more conciliatory and more pro-trade, which would also likely be positive for emerging market assets. 

The above scenario may – almost as plausibly – be a mirage. Colder weather and the return of many children to school in the northern hemisphere may spur a resurgence in the virus. Further, despite clear scientific progress on the vaccination front, a full understanding of the COVID-19 virus (and particularly how it may mutate) remains incomplete. As we have said in previous commentaries, hope is simply not a tenable strategy. Meanwhile, recent previous significant popular votes (e.g. the Brexit Referendum and the 2016 Presidential Election) have made us deeply wary of both attempting to predict outcomes and infer causality. The tensions that have emerged between the US and China, particularly in terms of technological supremacy, can’t and won’t be either simply or quickly resolved. 

With this backdrop in mind, we find ourselves returning to Voltaire. Even if doubt is an “uncomfortable condition”, certainty would be a more “ridiculous” one. Uncertainties undoubtedly remain. From a practical asset allocation view, this therefore implies the need to remain both balanced and nimble. 

It is worth bearing in mind that much of this commentary has focused on the US, perhaps unsurprisingly given that it is the world’s largest economy and the US constitutes some two-thirds of the MSCI World equity index. However, with so much attention focused on America, particularly in the run up to November’s Presidential Election, it may behove investors also to look elsewhere. It would certainly be fair to highlight that Europe has (generally) managed through the COVID-19 crisis better than the United States. The near-term economic outlook for the continent looks relatively less bad versus America and policymakers have shown a surprising degree of recent coherence. Some of this has been reflected already in the recent strength of the Euro relative to the Dollar, but opportunities remain. As we all refocus back on reality – in whatever form it takes – taking an active approach to asset management will increasingly matter. 

Alex Gunz, Fund Manager, Heptagon Capital