What our House View means for asset allocation and portfolio construction.
10 minute read
- Adding risk selectively
- Underweight in global equities to reduce the economic sensitivity of portfolios
- Overweight in more defensive risk assets, such as global investment grade credit and Italian government bonds
- Neutral view on the US dollar
Risky assets have delivered a striking recovery from their March lows, in some cases reversing much of the historic decline seen in February and early March. Many equity indices are not far from where they began the year, and while credit spreads remain more elevated than in recent years, they have tightened significantly. Meanwhile currencies that traditionally have been negatively correlated to global growth have embarked on a weakening path. The vast amount of monetary and fiscal policy support, alongside the rebound in economic activity that has followed the easing of lockdowns, has seen risky assets de-couple from fundamentals.
It appears that most risky assets are pricing a relatively rapid return to pre-COVID levels of activity, with the hope that a combination of fiscal stimulus and central banks being assumed to keep policy rates at the effective lower bound for many years to come, provide sufficient support. However, our central economic scenario is somewhat less optimistic than what appears to be priced in. Moreover, valuations, which – even in the absence of further price gains and following consensus’ more positive stance on the earnings trajectory – are screening as unattractive. Finally, the jury is still out on whether the COVID-19 crisis will merge into a corporate solvency crisis. With this backdrop, we prefer to be underweight global equities.
However, acknowledging that the global economy has entered an economic recovery phase and taking advantage of a number of themes that have emerged in response to the COVID-19 crisis, we prefer to be overweight more defensive risk assets, such as global investment grade credit and Italian government bonds. Equity market valuations across a range of regions are on course to approach previous peaks as earnings continue to deteriorate (Figure 1).
Figure 1. US forward multiples have expanded rapidly
While price/earnings multiples typically start rising at some point during recessions, as the market starts to price a recovery well ahead of an eventual turn in earnings, the current dynamics concern us for several reasons. First, the de-rating going into this recession has been shallow relative to the magnitude of the economic and earnings downturn, i.e. the starting point from which multiples have recovered has been comparably high (Figure 1).
Secondly, the earnings trajectory envisioned by consensus would be atypical for those normally experienced during recessions and recoveries, particularly for one of this magnitude: the decline understates the drop in GDP while the recovery would be very swift and strong, implying a return to end 2019 earnings by end 2021 (Figure 2). Lastly, incorporating even these optimistic earnings expectations, an adjustment towards longer term average valuations, assuming unchanged index levels, would only occur several years from now. To summarize, already high valuations that are prone to rise further and are built upon an optimistic outlook for earnings, do suggest that sensitivity to any potential negative news is high.
Figure 2. Expectations for an EPS recovery by end 2021
Consensus' EPS expectations for the S&P 500
While we are cautious on global equities at this juncture, there is an upside risk to our assessment. It is possible that valuations could remain elevated – and even rise further – compared to the past, on the back of monetary policy expectations having raised net present values by lowering the risk-free rate. Another upside risk would be a stronger cyclical recovery than currently anticipated, with activity following closer to our Scenario A (outlined in the executive summary), while central banks continue to keep rates at historically low levels.
However, there are also downside risks. Some of the longer-term consequences of the COVID-19 crisis tilt the outlook for equities to the downside. Corporates are likely to leave the crisis with a much higher level of indebtedness (Figure 3), curtailing both the potential to engage in growth opportunities and to maintain, let alone raise, payouts. Holding ample inventory in case supply chains fail and pressure to attain self-sufficiency in producing critical goods will require companies to spend on capex and to run less efficient and optimized production, leading to margin pressure. Moreover, it is not yet decided how governments are going to restore public balance sheets but raising taxes on corporates or individuals remains an option and would lead to pressure on bottom- and top-line, respectively.
Figure 3. Corporate indebtedness is on the rise
At the other end of the risk spectrum, we prefer to be overweight government bonds. Yields have been well anchored at low levels, not least owed to significant central bank purchases. We expect duration to remain attractive and term premia to stay compressed given ever growing monetary and fiscal cooperation considering the need to finance government deficits. Should the macroeconomic environment turn more adverse again and/or should the Fed decide to introduce Yield Curve Control later in the year, bonds could still offer decent returns despite low yield levels currently. There is little doubt that central banks will continue to support the economy during this uncertain recovery phase via the existing toolkit, and possibly by doing more should the necessity arise. The Fed has implicitly announced a floor to its QE purchases and does have the flexibility to ratchet up purchases if need be. The ECB has recently increased the firepower of the Pandemic Emergency Purchase Programme (PEPP) to a total of €1,350 billion, extended the programme’s horizon and added re-investments. The Bank of Japan has strengthened its monetary policy to support the government’s actions and the BoE has added to its programmes as well. With central banks showing the willingness to absorb public and private debt issuance, we regard lower for longer as a valid ongoing theme.
After having experienced tremendous dislocations on the back of very poor liquidity in March, credit market conditions have improved, as evidenced by significant spread compression (Figure 4). The retracement of approximately 70 per cent of previous spread widening can largely be attributed to technical factors, predominantly direct central bank purchases of credit instruments.
Figure 4. Credit spreads supported by policy backup
US & EU credit - OAS
Credit fundamentals outside of financing costs, however, have deteriorated significantly in response to the COVID-19 crisis. Consequently, rating agencies have pushed through large amounts of rating downgrades. Selecting quality names is even more important in a context where nearly 50 per cent of global investment grade (IG) indices are now BBB-rated (Figure 5). Further, the Fed’s decision to include fallen angels and high-yield ETFs in its programme has also contributed to an increase of US issuance in the BB-rated sector.
Figure 5. Deterioration of quality in IG credit
Quality of IG universe
As such, we prefer to be selectively overweight credit. US investment grade credit is our preferred choice, but we also have a preference for Italian government bonds (BTPs). The latter follows positive developments for European political risk, namely the potential for a Next Generation EU plan. We regard BTPs as the most direct beneficiary of further steps towards European fiscal integration. In addition, ECB support and lighter supply pressure over the summer may induce further spread tightening. Over the medium term, however, we think the usual risks to a common European policy framework remain in place and the beginning of the budget process may start to lay bare fault lines. Moreover, rating risk might become an important factor once again in the latter part of the year.
Within FX, we have a relatively neutral view on the US dollar at this time. Absent independent shocks to risk sentiment, the dollar tends to perform inversely with global growth (Figure 6). Given the recovery expected in Q3, the dollar’s relationship to growth would suggest limited appreciation potential from here. Among other factors, politics and the outcome of the US election in November could potentially affect performance negatively over the coming months. Across other currencies, we have a preference to be underweight sterling and overweight the euro. The latter is currently better positioned in terms of political risk and is experiencing a quicker exit from lockdown economics than the UK.