Andrew Pease

GLOBAL HEAD OF INVESTMENT STRATEGY

Well, that was historic. The fastest 30% drawdown in the history of global equities in the first quarter was followed by the largest 50-day advance in market history in the second quarter. The S&P 500® was back above 3,100 on June 3 and the Nasdaq hit a record high on June 10. Meanwhile, commentators have been lining up to claim that markets are detached from fundamentals.

We’re not so certain that investors have it wrong. For sure, markets seem to be priced for an optimistic outcome of no meaningful second wave of infections as lockdowns are lifted. But record levels of fiscal stimulus, sustained low interest rates and ongoing low inflation create a supportive environment for risk-asset outperformance.

Our previous quarterly report in late March laid out a cautiously optimistic case for riskier assets, such as equities and credit, to outperform defensive assets like cash and bonds. This was based on our cycle, value and sentiment (CVS) investment decision-making process. Value had improved following the market crash, the cycle outlook was turning positive with central banks and governments in “whatever it takes” mode and, most importantly, our composite contrarian indicator of market sentiment was providing one of its most extreme buy signals. Oversold conditions imply that investors are cautious and worried about downside risks. These conditions provided a springboard for risk assets to rebound as the economic impact of the lockdowns turned out less bad than feared and as a possible second wave of infections failed to materialize by mid-June.

The market rebound means that value is no longer compelling for global equities or credit. On the other hand, the cycle outlook has improved as fiscal and monetary stimulus announcements continue and economies start to emerge from lockdown. The bottom of a major recession when stimulus is flowing is one of the few times it is possible to have a relatively confident view on the cycle. Sentiment, unsurprisingly, is no longer as supportive. Our composite contrarian indicator, as of mid-June, is providing a neutral signal. This means that the support from oversold conditions is waning and markets are at greater risk of pulling back on negative news.

Neutral value, neutral sentiment and a supportive cycle give us a more balanced view on the investment outlook. Looking near-term, markets are vulnerable to negative news after a 40% rebound and with sentiment on the verge of triggering our overbought signal. Over the medium-term, the supportive cycle outlook should allow equities to outperform bonds.

The main risks come from a second wave of virus infections and the approaching U.S. federal elections in November.

• There is little evidence so far in mid-June of a meaningful second wave of virus infections following the easing of lockdowns across Asia and Europe. COVID-19, however, is highly contagious and has only been contained through the imposition of severe lockdowns. We should know in the next couple of months whether a second wave is underway. On the plus side, most countries are now better placed to manage a second wave in terms of healthcare capacity and treatment. Also, the news on vaccine development is promising, although 2021 is the most optimistic timeline.
• The U.S. federal elections are too close to call. They will become a bigger focus for markets if the Democrat nominee, Joe Biden, takes a decisive lead. Biden plans to at least partially reverse President Donald Trump’s 2017 corporate tax cuts. This could deliver a hit to earnings per share in 2021. One of the key watchpoints will be the election outcome of the Republican-led U.S. Senate. Democrat control of the White House, Senate and House of Representatives would make a corporate tax hike more likely. It would also create the risk of more corporate regulation.
• The other election risk is a re-escalation of the U.S./China trade war. A recovery in the stock market and the economy provide President Trump with his best chance of re-election. We expect he will not endanger this by re-starting trade hostilities. This calculus could change if Trump’s poll ratings show him in a losing position a couple of months from the election. He may conclude that nationalism and China-bashing increase his chance for victory.

Here are five likely longer-term impacts of the pandemic.

1. Low interest rates for longer. The global economy has taken a huge hit from the pandemic and interest rates are zero or lower at all the major central banks. There is a lot of economic spare capacity which will keep inflation low for the next couple of years at least. This means central banks will keep rates low, which will keep bond yields low. Furthermore, after experiencing zero rates, central banks are likely to keep rates low once inflation rises. They will be reluctant to tighten too quickly.
2. Less globalization. Globalization was already in reverse before COVID-19. The 2008 financial crisis undermined the trust of western voters in the free market capitalist model. The backlash continued with Brexit, the rise of Trump and the U.S./China trade war. The virus is accelerating the anti-globalization trend. Global supply chains are being unwound and the pandemic has created fears about food security and pressure for domestic production of medical supplies.
3. More government debt and a bigger share of government in the economy. The lockdowns are leading to the largest rise in government debt levels since World War II and higher levels of government support for industries. Eventually, the political debate will turn to how to pay for the lockdown support measures and how to address the inequalities that have been worsened by the pandemic. Well-paid white-collar workers have been able to isolate at home while lower paid workers have been laid off or had to work in less-safe conditions.
4. Higher inflation, eventually. Inflation shouldn’t be a problem for the next couple of years due to economic spare capacity caused by the recession. Longer-term, inflation could rise by more than expected. Globalization was deflationary and its reversal will be inflationary. On the supply side, it would be inflationary from higher input costs, less cheap foreign labor and rising tariffs and protectionism. On the demand side, central banks likely would take a lax approach to rising inflation and governments would see higher inflation as a way of reducing debt burdens.
5. Pressure on profit margins. Slower trend economic growth, less efficient capital allocation, just-in-case instead of just-in-time inventory management, higher taxes and higher labor costs will place profit margins under pressure. One potential offset is that the increased use of technology encouraged by the lockdowns will generate cost savings and productivity improvements.

These trends should favor domestic stocks over those exposed to global revenues and supply chains. Mid- and small-cap stocks should do better than large-cap stocks, in a reversal of the trend of the last decade. Developed markets should benefit relative to emerging markets as there will be less technology transfer and less export-led growth. The unwinding of globalization is a headwind for emerging markets. Ongoing low interest rates favor higher yielding assets such as stocks, property and infrastructure over government bonds and cash.

Our cycle, value and sentiment investment decision-making process has a moderately positive medium-term view on global equities. Value is neutral, with the expensive U.S. offset by reasonable value in the rest of the world. Sentiment is also neutral as of mid-June after being strongly oversold in late March. We see the cycle as supportive of risk assets for the medium-term. The recovery from the recession in our view means a long period of low-inflationary growth supported by monetary and fiscal stimulus. Sentiment is no longer overbought, and supportive following the market rebound. Our near-term view on equities is more cautious with the risks around a second wave of infections and U.S. politics heading into the federal elections in November.

• We prefer non-U.S. equities to U.S. equities. This is partly driven by expensive relative valuation. It also reflects that the second stage of the post-coronavirus economic recovery will see corporate profits recover. This should favor cyclical and value stocks over defensive and growth stocks. The rest of the world is overweight these stocks relative to the U.S.
• We like the value in emerging markets (EM) equities. China’s early exit from the lockdown and stimulus measures should benefit EM more broadly.
• High yield and investment grade credit were very attractive in late March when spreads were wide. Spreads have since narrowed and as of mid-June only adequately compensate for the likely rise in default rates following the recession. We have a neutral view.
• Government bonds are universally expensive. Low inflation and dovish central banks should limit the rise in bond yields during the recovery from lockdowns.
• Real assets: Real Estate Investment Trusts (REITs) sold off heavily in March, with investors concerned about the implications of social distancing and online shopping for shopping malls and office buildings. Sentiment appears overly bearish, while value is very positive. By contrast, Global Listed Infrastructure (GLI) is expensive, which leads us to prefer REITs to GLI.
• The U.S. dollar should weaken into the global economic recovery given its counter-cyclical behavior. The dollar typically gains during global downturns and declines in the recovery phase. The main beneficiaries should be the economically sensitive “commodity currencies”, such as the Australian, New Zealand and Canadian dollars. The euro and British sterling are undervalued at mid-year 2020. The euro should gain if a second wave of the virus is avoided and a recovery is sustained. Sterling, however, is likely to be volatile around uncertain Brexit negotiations.