Q3-2020 Quarterly perspectivesTavistock Wealth - Investment Outlook
Welcome to the Q3-2020 ‘Quarterly Perspectives’ publication
Despite suffering the worst pandemic in over a century, and the sharpest economic contraction since the second world war, global equity and bond markets staged one of the fastest recoveries of all time in Q2. In many markets, valuations were back near all-time highs – achieved during a period when the economy was performing well and the coronavirus had not yet registered on the hearts and minds of investors. We participated in the recovery but retained our preference for high quality liquid assets. As a result, the portfolios held-up well relative to the benchmark, performing in-line with expectations.
The recovery is predicated on the ability of investors to look through the carnage to the good times that lie ahead. As such, the significant deterioration in economic numbers, such as GDP and corporate earnings, have not mattered. Investors could do so because of the trust they have placed in the large-scale and pre-emptive monetary and fiscal action taken to sure-up the economy. Market sentiment is based on lower for longer interest rates and an understanding that central banks “will not run out of ammunition” and will continue buying securities “for as along as it takes” to drive the market higher. Over time, this confidence morphed into FOMO – the fear of missing out – driving markets to extreme levels.
Liquidity and panic-induced buying has driven prices far in-excess-of underlying fundamentals. Market gains are increasingly concentrated to a small number of stocks such that the top five companies in the S&P 500 now represent over 22% of total market capitalisation. This concentration is not healthy and points to narrowing market breadth. If a vaccine is developed, the coronavirus is defeated and the economy bounces back sharply, those valuations may yet prove justified. But with markets priced for perfection, and little room for error, risk is overtly skewed to the downside.
These risks, which are currently overlooked, include a second wave of the disease and the possibility we cannot develop a vaccine as hoped or that the vaccine proves ineffectual, should the virus mutate. Further concerns include the impact on the recovery if the return to work proves slow or difficult to implement, resulting in longer term damage and the increased likelihood of defaults and bankruptcies. Should these risks materialise we are likely to see a re-test of the prior lows.
Action taken to sure-up the global economy will result in greater deficits and debt and a likely increase in inflation as central banks prioritise employment over price stability objectives. Over the longer term there are risks to sovereign credit ratings and in the US, the reserve status of the dollar. This perspective informs our strategic market outlook and asset allocation which we have implemented across the funds via three key themes: inflation, emerging market equities and commodities. More information on each theme is available on our blog page.
Over the near term we remain cautious and retain our tactical preference for high quality liquid assets. Whilst many markets are priced for V-shaped perfection, there are growing headwinds from tightening liquidity and faltering macroeconomic data. In equities we like ESG, which is an acronym used to describe companies with exposure to environmental, societal and good corporate governance standards.
ESG investments have proven resilient in the downturn and outperformed during the recovery and benefit from both long-term structural tailwinds and government stimulus programs. We also like those countries that have proven most resilient to the virus, such as China, South Korea and Taiwan. We have turned more cautious on the technology sector given extreme valuations. In fixed income, we continue to like assets that are being targeted by central banks, specifically US investment grade debt given its elevated position in the capital structure and improved liquidity profile. Finally, our commodity carve-out is skewed towards precious metals, such as gold and silver, which provide resilience and diversification benefits.
Asset Allocation Outlook
Chart of the Quarter
This chart shows the Fed balance sheet in yellow as a proxy for liquidity. Liquidity is a key driver of markets with prior rounds of quantitative easing driving equity markets higher. QE5 is no exception and the sheer volume of asset purchases has been unparalleled, driving the S&P 500 back towards all-time highs. Recently, liquidity has started to fall. This is consistent with historic bouts of volatility and equity market drawdowns as indicated by the blue circles pointing to the potential for further volatility ahead.
Global markets have been driven by central banks since the market bottom in March. The Fed’s stimulus packages dampened the liquidity-dislocations present in US fixed income markets. However, a lending backstop does not provide the desperately needed demand that poorly capitalised sub-investment grade firms need to sustain their business. High yield corporations have raised a disproportionate amount of debt during this crisis, further leveraging their already debt-laden balance sheets. As a result, we believe solvency risks remain and retain our underweight allocation to high yield debt. Within credit we are overweight US investment grade bonds which should continue to benefit from Fed purchases.
Sub-investment grade issuers have raised a disproportionate amount of debt relative to their investment grade counterparts since the equity market peak on the 19th February. This leverage increases the risk these firms are exposed to.
10 Year US Treasury yields remain suppressed relative to levels typically associated with this level of volatility.
Artificially supressed bond yields relative to volatility-implied levels, despite record debt issuance, has led us to position underweight the longer end of the US Treasury curve, while maintaining a neutral position at the front end. Monetary and fiscal stimulus, yield curve control, supply chain disruptions and our view that commodity prices are due to rise underpins our overweight to US inflation-linked government debt. Both hard currency and local currency emerging market government debt also remain unattractive as weak tourism data, the augmented spread of the virus and poor healthcare systems have disproportionately harmed emerging market economies that are highly weighted in fixed interest indices, such as Brazil. Chinese local currency debt remains our only emerging market overweight.
Global equities marked their largest quarterly gain since 2009, propelled by a plethora of central bank stimulus and optimism for a V-shaped economic recovery. We maintain a cautious approach given how quickly valuations have risen and the disconnect from the underlying economic fundamentals.
Last quarter we initiated a new position in a basket of Chinese internet companies which has been a standout performer. There are several factors that favour this trade such as China’s ongoing shift towards the service sector, internet penetration rates and the sheer size of China’s e-commerce market. Moreover, these corporations exhibit very strong earnings and revenue growth rates with some holdings set to benefit from inclusion in Hong Kong indices later this year.
Chinese internet stocks have outperformed the emerging market benchmark by a significant margin year-to-date and since trade inception.
The upcoming earnings season will reveal the extent of the hardship corporations endured throughout lockdown with the S&P 500 expected to suffer its worst quarterly earnings decline since the great recession. Within developed markets, we maintain positions in the technology and healthcare sectors which are forecast to face the least top and bottom-line pressure.
Within our smart beta allocation, we recently initiated a new position in the MSCI World SRI ETF which provides exposure to corporates with high ESG scores. This position effectively acts as an additional quality screen as well as reducing beta to the broader market, which will add greater resilience to the portfolios going forward.
S&P 500 earnings are on track for their largest quarterly decline in over a decade. Meanwhile the broad equity index is back near record highs, supported by the recent and questionable surge in price earnings multiples.
Our outlook for the wider commodity complex remains bullish. Persistent supply chain disruptions have drawn down global inventories, whilst cautious investor sentiment has supported higher precious metal prices. We continue to hold both gold and silver, which is cheap relative to the yellow metal and should also benefit from its use in real world applications.
This chart highlights the strong current set-up for silver. The metal has been in a bear market since April 2011, with the 50-day moving average struggling to break above the 200-day in any meaningful way until the recent break-out, highlighted by the second yellow circle.
Over the longer term, as demand recovers and the global economy restarts, we expect other sectors within the commodity complex to outperform. Our exposure to copper reflects this theme, as Chinese output has already recovered to pre-virus levels and beyond. Copper prices are up almost 40% since the market bottom on the 23rd of March. This demand is reflected in futures prices, with the near futures spread entering backwardation for the first time in over a year, meaning short-term demand for the metal is increasing, with both refiners and producers demanding immediate delivery. This development is consistent with historical periods of copper outperformance relative to developed market equities. Looking to year-end and elections in the US and elsewhere, record fiscal stimulus will provide further tailwinds for industrial companies and base metal consumption.
The dramatic intervention from the US Fed in late March sparked a strong recovery in risk assets which sent the US dollar notably lower over the subsequent months. This was primarily due to the unprecedented surge in liquidity which helped eased the global dollar shortage. Latterly, dollar weakness is attributable to euro strength following the announcement of a coronavirus recovery plan and clear steps towards eurozone debt mutualisation. On a strategic basis we believe these trends will continue and the dramatic increase in the supply of dollars, and narrowing interest rate differentials, lead to a weaker dollar. This should benefit EM currencies including commodity currencies which coincides with our positive outlook for commodities.
One caveat to the above is how things play out over the near term. Volatility remains elevated across markets and a potential second wave of COVID-19 is a distinct possibility. The US election is only four months away and Trump’s low approval rating raises the possibility that the White House escalates tensions further via higher tariffs. The prospect of a sharp sell-off in risk assets, during the subdued summer months, could see traditional safe-haven currencies, such as the US dollar and the Japanese yen outperform. Sterling may also suffer from elevated volatility as the dark cloud of Brexit looms over its near-term future.
The year-on-year percentage change of the US dollar index, in pink, is highly correlated to the changes in US Federal Excess Reserves which have risen dramatically as a result of the huge stimulus measures taken over the last few months.
ESG, in so much as it differentiates leaders from laggards in the transition to a more sustainable planet, will become increasingly relevant to investors in the second half of the year. Those appreciative of the fact that ‘infectious diseases’ like COVID-19 were just one of thirty risks included in the 2020 Global Risk Perception Survey (organised by the World Economic Forum) will surely shift from a pre-pandemic complacency to a mindset laser-focused on resilience-from and preparedness-against future low-frequency high-impact events.
The relative performance and fund flows of ESG-linked assets in the first half of 2020 suggests the asset class is well positioned to facilitate such a shift. As shown in the chart below, assets invested in the best-in-class iShares SRI range of ETFs increased by 63% so far this year whereas a basket of vanilla equivalents shrank by 9%. Further, the MSCI World SRI index beat the MSCI World index by 335bps, outperforming both during the drawdown to the March-lows and in the rebound-to-date, highlighting similarities between ESG and other factor strategies such as ‘quality’ and ‘minimum volatility.’
Assets invested in the iShares SRI range of ETFs, which provides exposure to companies with high ESG scores and excludes companies whose products have negative social or environmental impact, have increased dramatically this year versus a basket of vanilla equivalents.
We recently increased exposure to ESG-linked assets in our core and satellite allocation, confident that these investments will continue to benefit from superior risk-adjusted returns, healthy fund flows and macroeconomic tailwinds. Policymakers around the world have proposed ‘green-tinted’ pandemic-induced stimuli and these recovery efforts will likely prioritise ESG-friendly investments and catalyse growth in key ‘sustainability sectors’ like renewable energy and electric vehicles.
Whilst global equities have rallied aggressively from the March-lows, a measure of implied equity market volatility, known as the VIX index, remains elevated and well above pre-crisis levels. The VIX index, otherwise known as the ‘fear index’, highlights the fact market jitters never really went away. Concerns remain over a second wave outbreak and the limits of fiscal and monetary stimulus. This dichotomy between equity and equity volatility points to ongoing uncertainty into Q3 and the rest of the year.
At this juncture, the prospect of a V-shaped recovery is losing ground to a slower recovery, be it U or W shaped. With market risk finely balanced our approach is to participate in the market without chasing it higher. As such we retain our cautious bias and strategic exposure to 3 core strategies: inflation, emerging market equities and commodities.
The CBOE volatility index, in yellow, remains elevated and above both the prior range and the 200-day moving average highlighting the fact many investors remain wary at current valuations.
This investment Blog is published and provided for informational purposes only. The information in the Blog constitutes the author’s own opinions. None of the information contained in the Blog constitutes a recommendation that any particular investment strategy is suitable for any specific person. Source of data: Tavistock Wealth Limited, Bloomberg and Refinitiv Datastream. Date of data: 18th July 2020 unless otherwise stated.
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