Multi-asset allocation views: Changing seasons, changing dynamics

Despite the strong performance of the US equity market over the summer, the concentration of gains in a handful of stocks was a concern. The S&P 500 rose seven per cent in August, but the S&P 500 Equal Weighted index gained only about four per cent over the same period.¹ A small number of the largest tech companies were disproportionately responsible for performance.

September saw a correction, initially led by some of those highly valued Nasdaq-listed shares.²

Interestingly, the current market narrative is that technology companies’ recent weakness is an opportunity for undervalued parts of the market to perform better – such as the industrial sector, banks or commodities.

This is not borne out by history, however. The dotcom bubble offers a good example. When outlandish tech valuations began to fall, the broader market remained relatively flat for a long period before falling in turn. Undervalued stocks did not begin to deliver meaningful gains until the growth sector had stabilised (Figure 1). It is much harder to imagine appreciation in value stocks without continued resilience in the growth segment of the market.

Figure 1: S&P tech vs. S&P ex-tech during the dotcom crash

A time for caution?

We remain cautious overall, particularly on two markets whose relatively good performance over August and September may not be entirely warranted given the broader risks: Japanese equities and US mid-cap companies.

For some time, we have highlighted Japanese companies’ sensitivity to capital spending from international companies. Ongoing uncertainty around households and companies’ willingness to spend and further changes in policies to limit the spread of coronavirus make it difficult for businesses to make capital spending decisions. The Japanese market is somewhat vulnerable to this perpetual delay.

In terms of domestic politics, while new prime minister Yoshihide Suga appears to be a continuity candidate, he does not belong to a political faction within the LDP and will have to negotiate hard to develop a support base. There is a possibility he will call an early general election to shore up this base, which makes a policy step-change uncertain. Suga’s ascension seems unlikely to unlock a great deal of value in Japan in the near term. In this context, we see the recent resilience of Japanese equities as a cause for alertness rather than reassurance.

The US mid-cap market has also been resilient, performing better than the broader US market, but its companies do not have the low debt and strong cashflow generation of large-cap and big tech firms.

Figure 2: US mid-caps versus broader market – March to September 2020

Smaller companies are likely to be more challenged than big tech by the delay in US stimulus rollover, or if the economic recovery is weaker than anticipated over the next few quarters. Almost 80 per cent of revenues for the Russell 2000 small and mid-cap index are generated domestically.³ These companies’ earnings are also typically more volatile than those of the main S&P 500 index, having posted outright losses in the second quarter – a fate avoided by the large caps.⁴ Rather than shun the US equity market in its entirety, our caution is focused on small and mid-caps, where balance sheets and cashflow generation are more at risk.

Figure 3: Russell 2000 companies’ revenue exposure by country

Brexit and the pandemic

We also remain cautious on the UK. As December 31 looms closer, Brexit negotiations (and the Internal Market Bill in particular) have returned to the headlines and investors’ concerns, alongside ongoing uncertainty around the UK’s path through the pandemic.

We see the Internal Market Bill as a calculated risk. On the one hand, it raises the stakes in negotiations and focuses attention; on the other hand, the UK government is breaking some trust with its negotiating partners on its willingness to stand by any subsequent agreement.

Our base case is the bill won’t by itself derail the chances of a deal, which we still see as the government’s preferred outcome. The core issues of fishing and state-aid policy still stand, but in practice these are negotiable unless either side finds itself hostage to particularly inflexible factions.

Despite much talk of firm deadlines, negotiations may also stretch out into November, but we do not think these delays will pose an additional risk to the chances of reaching a deal in the medium term.

In fact, the UK’s response to the pandemic is of greater immediate concern. One of the lessons the British government has taken from March and April is the need to get ahead of the pandemic by moving earlier and faster. For instance, restrictions on the public appear to be tighter than in many other European countries.

These are effective but they do have economic consequences, particularly given the UK’s size. Severe regional lockdowns are more likely to affect national economic activity than in a large country such as the US.

There is also a question of balance between the severity of restrictions and the level of stimulus put in place. Compared to countries like Germany, the UK’s combination of tighter restrictions and less generous fiscal measures suggests economic activity and the labour market may be more challenged than elsewhere as we head into winter. This is one of the reasons we currently prefer the euro to sterling.

Big is more beautiful

We are also more cautious on UK mid-caps than larger British companies, firstly because a weaker currency would benefit big international businesses. Secondly, a slowdown in the domestic economy is likely to hurt a larger share of the mid-cap sector than the FTSE 100, especially as some sectors of the latter are benefitting from relative tailwinds. For example, there is a large energy component in the FTSE 100, and our analysis on reported earnings suggests these companies may be slightly lagging the recent oil-price recovery.

Since the start of the year, the FTSE 100 in sterling terms has also underperformed the MSCI World Index in dollar terms by 20.9 per cent.⁵

The FTSE 100 does remain sensitive to a potential slowdown in the domestic economy, for instance through banks or major retailers. However, the combination of price weakness, companies’ international exposure and possible sector tailwinds mean current valuations seem to offer some margin of safety over UK small caps.

Themes where we are constructive

In terms of areas of opportunity, we remain constructive on global credit markets, albeit with some changes to our views. Earlier in the recovery, central bank support for the investment-grade market provided some upside, but spreads have since tightened. The average credit spread on the Bloomberg Barclays US Corporate Bond Index went from a high of 373 basis points (bps) over Treasuries on March 23 to a low of 124bps on August 11, and back up to 128bps as of October 7.

On balance, opportunities remain in investment-grade bonds, particularly if spreads were to continue widening, but the risk-reward is not as attractive as earlier in the year. The strong rally means improvements in corporate health may now be less important to total returns than government bond yields.

Elsewhere, the spread on the Bloomberg Barclays US Corporate High-Yield Index, which was 471bps on September 2, had widened to 533bps by September 24 due to a deterioration in risk appetite.

At face value, such spreads look attractive in a zero-interest-rate world. However, the high-yield market’s continued resilience is predicated on economic activity maintaining some degree of momentum and avoiding further national lockdowns. In that respect, we see reasons for optimism, both in that the odds of nationwide lockdowns are much lower than they were in March, as expressed in our House View, and in that we expect more information on the prospects for a successful vaccine in late October.⁶

The end, or reduction, of stimulus is likely to have a negative impact on investor sentiment and one of the reasons we remain cautious overall. Sell-side analysts have begun to upgrade some profit expectations in 2021 in the US. However, we question whether this would persist if there were an extended period without stimulus that could put the brakes on US household income growth in the fourth quarter.

We are trying to achieve a balance in our portfolios between caution where we feel there is excessive optimism, and having some exposure to areas where there is clear potential upside. In that sense, we currently prefer global high-yield to investment-grade credit and equities.

European recovery

Meanwhile, Europe could be the source of attractive opportunities, especially in light of the €750 billion European recovery fund, which could lead to major structural change for region’s economies over the medium term.

However, the second wave of COVID-19 has come through somewhat more quickly and aggressively than expected. While many countries in the region have explicitly ruled out nationwide lockdowns, the resurgence in the number of cases is likely to diminish the chances of major earnings upgrades in European companies.^7,8,9

We continue to see opportunities in the currency and peripheral government bond markets like Italy, whereas the European equity market looks likely to be more volatile in the short term. We see it as a longer-term story where validation may come in 2021 through better economic and earnings prospects.