What our House View means for asset allocation and portfolio construction.
6 minute read
Equities and credit: driven by recovery hopes and government intervention
The global economy improved rapidly from its partial paralysis in early Q2, when lockdowns meant that activity in certain sectors dropped to almost zero. The fast recovery meant that recent monthly changes are huge, and prospects for continued advances are enhanced by optimism that mass vaccinations will make normal activity possible once again. The extreme pessimism in H1 has abated, and expectations for earnings have begun to improve, albeit from depressed levels (Figure 1). In normal times, such “fundamental” changes would justify gains in risk assets, but the level of earnings and the trajectory of expectations matter too. This is why we think there has been a “decoupling” of equity prices from their short-term earnings fundamentals: even with forward (2021) earnings dropping 20 per cent in the US and more elsewhere, equity index levels have fallen much less, or even gained year-to-date in China and the US, leaving traditional valuation multiples elevated (Figure 2).
Figure 1. US earnings have been upgraded faster than other regions
Figure 2. Equity indices’ multiples are very elevated
This does not make equity prices irrationally exuberant, because a more powerful force than fundamentals has intervened: governments have come to the rescue of firms and workers, allowing consumer spending to avoid a crash, and central banks have also come to the rescue of banks and markets, lowering the term structure of yield curves (more on fixed income below). This upside was highlighted in our last quarterly, and as we do not expect either of these two main themes of our house view to let up, risk assets such as equities and credit will remain supported, as long as downside possibilities such as fiscal cliffs are avoided and assuming that the global economy is, however erratically, continuing to heal into 2021.
The uncertainty around the economic outlook and risks to our House View will cause two-way equity volatility
This also means that, to a large degree, risks to the outlook and how they feed into earnings and capital flows do matter, and we have seen that impact in the past few months: the US Congress’s incapacity to agree on a Phase Four fiscal deal, potential vaccine delays, and above all a COVID-19 second wave slowing down the re-opening of economies have meant that the ebullience of equity markets in July and August took a serious knock when these reality checks manifested themselves. Valuations outside the US, Japan and China are more supportive and arguably provide some cushion; moreover, in several markets the earnings outlook for 2021 has bottomed out and begun to improve.
In credit markets, the blow to earnings has been too much for many leveraged companies, with bankruptcies and downgrades rife across retail, energy, travel and leisure. Those defaults and credit deterioration were accompanied by spread widening and forced selling, but what was expected in Q1 was worse than what transpired in Q2 and Q3, and is now mostly in the rearview mirror. Banks will be affected but benefit from regulatory forbearance and central bank largesse mentioned above, while corporates are benefitting from low interest rates and in many cases direct purchases as their bonds are included in asset purchase programmes. Valuations have compressed – from a spread of 1087bps at their peak for US High Yield and 401bps for US Investment Grade, to 547bps and 139bps respectively – but these are still 40-60 per cent higher than where they were pre-crisis. Despite record issuance, these asset classes remain attractive and we prefer the risk/reward they offer compared to equities. EM Hard Currency debt, where and we prefer the risk/reward they offer compared to equities. EM Hard Currency debt, where the spread of 410bps is comprised of IG and HY both well wide of corporate counterparts, has likewise already suffered from defaults of some of the weakest credits, and remains an overweight, though landmines must still be avoided.
COVID-19 shock led central banks to cut rates to lower bound, where they will remain for an extended period
As the significant economic impact of COVID-19 became apparent, central banks around the world eased monetary policy, cutting rates and initiating or expanding quantitative easing (QE) programmes to support their economies and aid the functioning of global banking and financial systems. With developed market central banks having used significant firepower and unlikely to do dramatically more, additional policy support will need to come via the fiscal channel, while policy rates remain at the lower bound for an extended period.
This has led to a significant yield compression of front-end rates such that the dispersion in rates across economies has contracted (Figure 3). Unsurprisingly yield compression has been largest in economies where rates were high on a relative basis going into the crisis. Most impactful for the market was the reaction function of the Federal Reserve, which cut rates by 150bps and restarted QE, and recently altered its framework to accommodate the new average inflation targeting (AIT) mandate. This shift in goalposts implies front-end rates will remain pinned at the effective lower bound for even longer and has brought rates across the curve to historic lows. At current levels, the ability of US government bonds to offer risk-reducing diversification in multi asset portfolios is more limited.
Figure 3. G10 two-year swap rate compression year-to-date
While the ability of nominal rates to rally from here looks constrained, real yields look comparatively more attractive (TIPS and other inflation-linked bonds), even at record lows of around -1 per cent for the US year bond. Since the GFC, inflation has struggled to reach central bank targets; going forward the combination of loose monetary policy and fiscal support provides more scope for upside inflation pressures. Additionally, the AIT framework means that when inflation does rise above target the economy will be allowed to run “hot” for a period to compensate for consistent undershooting. Longer-term inflation risk premia could rise to accommodate both recession risk and subsequent boom phase, but in any case, higher expected future inflation implies even lower real yields now.
AIT framework could lead to more volatile swings in economic cycles and feed into measures of risk premium
With central banks less likely to look through exogenous shocks, more dramatic swings in economic outlooks and subsequent monetary reaction functions, higher volatility in fundamentals could feed through into market volatility and broader measures of risk premium. As such, taking views on governments’ curve structure will likely provide opportunities over our investment horizon.
Large fiscal deficits across the world might normally mean higher and steeper yield curves, and/or bond yields widening to swaps, but for now central banks are keeping rate volatility subdued.
USD depreciation trend has scope to extend so long as the growth trajectory remains positive
US dollar depreciation has been a significant trend in markets over the last few months. Looking ahead the key question will be to what extent this trend can continue. Historically, changes in USD have had a countercyclical relationship to global growth, with USD appreciating as growth falls and vice versa (Figure 4). It is unsurprising, therefore, that USD would depreciate once growth bottomed and we moved into a more risk-friendly environment. But there are several other longer-term factors that could continue to support the recent decline. The yield compression and equity outperformance discussed above has considerably weakened the relative attractiveness of USD assets and generates questions over the sustainability of US exceptionalism. Yield compression has also meaningfully reduced the cost of hedging for foreign holdings of USD assets (Figure 5).
Figure 4. MSCI EMFX YoY vs global growth nowcast
Figure 5. Cost of selling USD fwd (3m fwd points, annualised rate)
As economies recover from the shock of COVID-19, differences in fiscal policy response and the easing of restrictions could open up relative value opportunities, particularly where market pricing does not reflect divergent paths. In Europe, the coronavirus crisis has accelerated progress towards fiscal integration with the development of the European Recovery Fund. The combination of more bearish USD drivers described above with a more positive outlook for Europe supported the rally in EURUSD. The theme of European Unity in our House View points to scope for further upside should the outlook for growth improve and the investment in the European project bears fruit.
Emerging market assets have struggled; we remain selective on opportunities
While the USD has been the dominant driver of trends in G10 FX, emerging market (EM) currencies’ appreciation vs USD has been more mixed. A weaker flow picture for emerging market assets has hampered EM FX performance. Typically, the DM / EM growth differential has been a good indicator of capital flows into EM. Current forecasts suggest a weaker relative backdrop for EM (both including and excluding China) for the second half of 2020 and the first half of 2021, before improving in EM’s favour in the second half of 2021. The market is likely to seek confirmation of this improving growth backdrop – especially the impact on exports to China as it embarks on its next Five Year Plan – and diminishing risks for the global economy before it is willing to allocate significant resources to this asset class. Because of the record low yields in EM FX and EM Local Governments overall (Figure 6), we are therefore selective in EM f ixed income markets, even with the weak dollar backdrop. We are choosing exposure based on high-carry, steep-yield curves, or valuations that scan as attractive relative to stable or improving fundamentals, such as Mexico, but generally prefer hard currency exposure.
Figure 6. Emerging market dollar bond yields have remained relatively high
In terms of our asset allocation (Figure 7), credit remains a preferred growth asset with increased appetite for high yield. We have become less bearish on equities; defensive positioning has begun to pay off recently but there is a recognition that from here positive news around a vaccine could generate upside momentum. We retain our small positive bias for government bonds. With rates globally pinned near the lower bound, we look for relative value opportunities that exploit divergences between expected recovery paths and market pricing. Our conviction in Italian government bond spreads has increased given positive political developments and gradual progress on Eurozone integration. In FX we prefer to be overall short USD.