Q4-2020 Quarterly perspectives

Tavistock Wealth - Investment Outlook

John Leiper, Andrew Pottie, Sekar Indran, Alex Livingstone, Jonah Levy and James Peel

Welcome to the Q4-2020 ‘Quarterly Perspectives’ publication

Q3 Review

Risk assets made further gains in Q3, supported by highly accommodative monetary policy and signs of ongoing economic recovery. Regionally, US and Asian equities outperformed Europe and the UK given the latter’s significant exposure to poorly performing stocks in the oil and financial sectors. Government bond yields were little changed although European yields fell on news the EU had approved a €750 billion fund to help member states recover from the pandemic. Commodities delivered a positive return, led by agriculture and industrial metals, aided by US dollar weakness. The ACUMEN portfolios performed exceptionally well over this period, largely outperforming the market composite benchmark as well as the ARC and IA Sector peer group comparators. We were also delighted to learn that the ACUMEN ESG Protection Portfolio, which we launched in December 2019, won the Innovation Award at the Moneyfacts Investments Life & Pension Awards 2020.

Key Themes

The recent resurgence of COVID-19 infections across the globe has fuelled concerns that a second wave of the virus could dent the fragile economic recovery. Whilst this remains a key risk into Q4 we believe future lockdowns will be localised rather than nationwide efforts employed during the first phase of the virus. Further, it is reassuring to see that despite the pick-up in cases, the number of fatalities remains low, on both an absolute basis and relative to the total number of cases.

The growing prospect for vaccine approval early next year, and recent opinion polls which favour a Biden win and Democratic sweep, have contributed to strong performance across risk assets.

As a result, global equity markets have soared to record highs, surpassing world GDP, which has only happened a handful of times over the last two decades. The stock market capitalisation-to-GDP ratio is typically used to determine whether the overall market is under or overvalued and this metric is now flashing red. Prior such occasions, highlighted in yellow, have typically preceded subsequent bouts of risk aversion.

The recent resurgence of COVID-19 infections across the globe has fuelled concerns that a second wave of the virus could dent the fragile economic recovery. Whilst this remains a key risk into Q4 we believe future lockdowns will be localised rather than nationwide efforts employed during the first phase of the virus. Further, it is reassuring to see that despite the pick-up in cases, the number of fatalities remains low, on both an absolute basis and relative to the total number of cases.

 

The growing prospect for vaccine approval early next year, and recent opinion polls which favour a Biden win and Democratic sweep, have contributed to strong performance across risk assets.

As a result, global equity markets have soared to record highs, surpassing world GDP, which has only happened a handful of times over the last two decades. The stock market capitalisation-to-GDP ratio is typically used to determine whether the overall market is under or overvalued and this metric is now flashing red. Prior such occasions, highlighted in yellow, have typically preceded subsequent bouts of risk aversion.

Chart of the Quarter

What differentiates events today, from those that came before, is the timing and sheer magnitude of fiscal and monetary stimulus deployed to support market prices. As the economy went into free fall, central banks started printing money like there was no tomorrow. This huge increase in the money supply should continue to support markets going forward, so even though market capitalisation-to-GDP is at extreme levels, when compared to the money supply, in blue, valuations are far from prior highs.

There’s room to run, but the risk for disappointment is high, necessitating positive news flow on both the vaccine and ongoing stimulus measures. The key risk here is US fiscal policy, particularly in the run up to the election, with Democrats and Republicans at loggerheads over the size of any subsequent aid package. Meanwhile, central banks have an obligation to keep the show on the road by ensuring financial conditions remain highly accommodative. Ordinarily this might be achieved by cutting short-term interest rates but with yields already close to zero there isn’t much room to fall without going negative. Easing financial conditions via lower longer-term rates is also somewhat problematic as this could undermine banks and their ability to provide credit to the economy. With little room to manoeuvre, and credit spreads relatively tight, we think the best mechanism through which the Fed (the world’s central bank) can ease financial conditions is the US dollar. We think the currency can depreciate 20% over the coming decade, which should benefit the global economy, risk assets, and particularly emerging market bonds and equities.

Financial conditions are an excellent leading indicator for inflation. With that in mind, it is encouraging to note that the outlook for US inflation continues to improve, with easing financial conditions pointing to higher prices over the next few months. This is consistent with the Fed’s stated goal and recent shift to average inflation targeting (AIT) which means the Fed will now allow inflation to overshoot its official 2% target to compensate for prior year where inflation failed to reach that level.

 

Recognising these drivers, our preferred asset classes heading into Q4 are commodities and equities, although for the reasons mentioned above, we are not yet outright bullish. Within equities we prefer to play this theme via quality names: companies with a solid structural growth story, strong balance sheets and elevated cash levels. As a result, we also like ESG investments, which have proven resilient in the downturn and outperformed during the recovery and benefit from both long-term structural tailwinds and government stimulus programs, particularly clean energy.

Moving into 2021, we believe an improving economic outlook, accompanied by rising investor sentiment, will catalyse a cyclical rotation within equities. This rotation would likely favour ‘value’ over ‘growth’ stocks and is consistent with our outlook for rising inflation expectations.

In fixed income, we continue to like investment grade bonds, given their elevated position in the capital structure and improved liquidity profile, and recently switched our existing exposure to EUR corporates into a strategy that meets strict criteria concerning socially responsible investing. We think these companies can outperform over time and the bonds should benefit from future ECB bond buying programs. Within emerging markets, we are overweight Chinese government bonds given attractive yields and plans for large scale inclusion in global bond indices. Finally, rising inflation expectations and lower for longer nominal yields should continue to supress real yields which is a key driver for real assets. We have implemented this theme across the portfolios via a commodity carve-out comprised of precious metals, such as physical gold and silver, as well as a position in copper which provides a cyclical-tilt.

Asset Allocation Outlook

Fixed Income

A regionally polarising quarter leaves the global fixed income landscape full of possibilities. Long-dated European government bond yields continue to trend lower on the back of weaker inflation data, rising COVID cases and other technical factors. We think this trend will continue as ongoing negative sentiment in the region keeps the sovereign term premium muted. We are positioned for this via our overweight exposure to long-dated European government debt. Meanwhile, the US Treasury curve continues to steepen.

German government bonds are not seeing the same steepening as US Treasuries.

Where we do see the opportunity to outperform in US Treasuries is through inflation-protected securities as monetary and fiscal stimulus converge providing a catalyst for ongoing pricing pressure.

Since 1998, US TIPS have typically outperformed US Treasuries when the 10-Year US breakeven inflation rate starts below 1.75%.

In corporate bonds, we continue to favour quality by allocating to ‘Fallen Angels’ rather than the broader high yield debt universe. To compensate we hold overweight positions in both US and sustainably screened European investment grade debt. We forecast that both markets will continue to be supported by their respective central banks.

Within emerging markets quality also plays a key theme. Local currency bonds from economies with stronger current accounts are outperforming those with weaker accounts. Thus, we choose to avoid the broad, global indices and concentrate capital into Chinese local currency government bonds. As well as having a strong current account the projected inflows, as a result of the decision by the FTSE Russell to follow the likes of JP Morgan and Bloomberg Barclays to include these bonds in their indices, provides a further fundamental tailwind to this position.

Equities

Global equities continued their strong momentum from Q2 for the majority of Q3 until coming under some pressure in September as concerns started to grow over a protracted economic recovery.

Our playbook, which involves tilting exposure towards East Asia, has benefited the portfolios with those economies that closely followed China out of lockdown leading the gains last quarter, notably our positions in Korea and Taiwan. As the risk of a second lockdown intensifies, we prefer Taiwanese equities over Korean equities given relative valuations and their lower beta to global trade.

We recently took profit on our position in South Korean equities, rotating some of the proceeds into Taiwan which looks set to outperform on a relative basis.

A basket of gaming and eSports companies were recently added to the portfolios as a thematic trade which has delivered strong returns thus far. Our positive outlook for the ETF is rooted in the rapid growth of the industry, increasing profitability and being well insulated from a second lockdown.

Gaming stocks have proven extremely resilient, outperforming US tech both during and excluding periods of risk aversion.

As alluded to in the key themes section, whilst there have been signs of a rotation into value stocks, we are awaiting stronger conviction that this is more than a short-term phase. We therefore continue to maintain a quality bias, particularly as volatility may spike due to COVID-19 uncertainty and US election risk.

Commodities

We continue to hold a preference for real assets within the portfolios moving into Q4; record low benchmark yields, a weakening dollar, and surging debt levels are a legacy of the coronavirus, thus the ‘opportunity cost’ of holding physical assets is negligible. We wrote in Q3 on the Chinese recovery and our subsequent buying of copper. Since then it has recaptured prior highs amid tightening demand and record Chinese imports. Silver too, outperformed all equity markets by a double-digit margin in Q3. With the US election cycle, renewed Brexit and Sino-US tensions and pandemic induced record monetary easing, diversification continues to be crucial, and our continued allocation to physical gold reflects this. We expect other real assets to begin to outperform in Q4 and beyond; a more constructive base energy complex and a tightening softs environment has prompted us to start broadening our exposure across the portfolios.

As Chinese demand (total copper imports), shown by the vertical grey bars, accelerated out of the pandemic, the LME copper price, in blue has followed suit, rising to a 2-year high. This has impacted LME inventories, with copper stocks being drawn down towards an 18-month low. This tightness, emerging in the copper structure, leads us to remain positive on this barometric commodity.

Foreign Exchange

In currency markets we maintain our bearish long-term outlook for the US dollar against a backdrop of colossal Fed balance sheet expansion, deteriorating interest rate differentials and hopes for a breakthrough in the search for of a vaccine in the global fight against COVID-19.  However, we have since turned short-term bullish, having decided to un-hedge a portion of the developed market US dollar exposure in the latter half of Q3. Looking forward we forecast a rise in volatility which should benefit the US dollar given its safe-haven attributes as the global reserve currency. Seasonal factors, ongoing virus-related uncertainty and lack of clarity surrounding Brexit may also weigh on risk appetite and therefore GBP/USD as negotiations continue. We also remain cautious in the run up to the November US election with polls pointing to a Biden win notwithstanding the possibility of a shock result like we saw in 2016.

In emerging markets, we see potential for selective currency appreciation with specific exposure to the Taiwanese dollar and the Chinese renminbi which have proven relatively resilient to the virus and also benefit from structurally sound monetary policy and promising future growth prospects. Into Q4 and beyond, we think there is considerable scope for EM currencies to catch-up with their developed market peers versus the US dollar.

There is considerable scope for EM currencies to catch-up with their developed market peers versus the US dollar.

ESG Investing

In our Q3 Quarterly Perspectives we suggested that key ‘sustainability sectors’ like renewable energy would benefit from ‘green-tinted’ pandemic-induced stimuli proposed by policymakers around the world. Since then the iShares Global Clean Energy ETF has returned almost 45% and year-to-date the market value of the ETF has increased 7x. Though the basket of underlying holdings has experienced a meaningful rerating, a large portion of the increase in market value can be explained by the surge in volume of shares outstanding – reflecting strong demand from investors. There are several reasons to remain constructive towards this sub-asset class in Q4. First, the obstacles to progress in the transition to renewable energy – political inflexibility and inefficient capital allocation – have abated. To meet ambitious emissions targets set by governments and companies this year will require trillions of dollars of investment throughout the decade ahead. Those determined to slow progress are increasingly trumped by the economic argument in favour of renewable energy over fossil fuels. In its annual capital markets forum BP announced it will (for the second time) pivot away from petroleum as it seeks to achieve net zero emissions by 2050. Second, demand from investors is likely to remain strong. Government support lends ‘anti-fragile’ properties to much of the renewable energy ecosystem, limiting risk to the downside. Armed with ample liquidity and a license to bet on future cash flows, there has been a rush to raise capital for sustainability-themed special purpose acquisition companies (SPACs). If 2020 has been defined by the consequences of not preparing for low frequency, high impact risk events, it is encouraging to see an urgent enthusiasm to meet the challenge of ‘green swan’ risk events ahead.

The significant increase in the iShares Global Clean Energy ETF market capitalisation can be attributed, in part, to strong and growing investor demand, as demonstrated by the dramatic rise in shares outstanding.

Final Thoughts

The next big catalyst for markets is the US election, held on the 3rd November. Trump has repeatedly claimed that mail-in ballots are susceptible to voter fraud and that he may refuse to accept the election result should he lose. That sounds dramatic but if the election is too close to call, and disputed, it could lead to a month or two of elevated uncertainty. As a short-term guide, we can look to the 2000 George Bush/Al Gore election recount which saw safe-haven assets rally, such as Gold and US Treasuries, whilst risk assets sold-off.

The ACUMEN portfolios are positioned for a potential pick-up in volatility with a clear preference for quality assets. Beyond that, our strategic outlook is arguably more skewed towards a Biden clean sweep than the alternative scenarios, given our medium-term forecast for a weaker US dollar, steeper US yield curve and preference for ESG securities and emerging markets. With Biden ahead in the polls our current positioning has delivered strong relative performance thus far. However, there is a big difference between the popular vote and the Electoral College, as Hilary Clinton found to her disadvantage in 2016, and a surprise Trump win remains possible. If Trump does win, it could move markets in the short term but otherwise we see this outcome as a continuation of the status quo. With 13 days to go a lot can still change between now and then. As always, we maintain our disciplined approach to risk management and portfolio construction.

Biden’s lead in the polls exceeds that enjoyed by Hilary Clinton in 2016, but a Trump win remains a distinct possibility and not outside the margin of error. 

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 Lipper for Investment Management. Date of data: October 2020 unless otherwise stated.

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