After an unprecedented selloff in March, April was characterized by optimism, as equity markets recuperated more than 50% of their losses and many indices were in new bull markets (up 20%) as of April 30. While plenty of questions – and risks – remain, markets have focused more on massive monetary and fiscal stimulus, looking beyond the current crisis. With valuations back to pre-crisis levels, we believe that markets are currently underestimating the hurdles still ahead.
Reasons for Caution
Tentative reopening plans across many European countries and US states starting in May are encouraging developments, but the recovery is likely to be slow and staggered across regions, countries, and industries – suggesting a U shape with a more gradual lineup. In addition, while markets appear to be looking through poor data and focusing on 2021, we still do not know the extent of the damage, nor the scars we might be left with from this crisis. This suggests that risks of bankruptcies and longer-term unemployment persist.
Finally, as we reopen, risks of a second wave of contagion are non-negligible, as seen in Asia, and could further slow or halt the ramp up in economic activity. In this context, we choose to remain prudent as downside risks remain given the reality of fundamentals. The starting point, the damage, and the speed with which the quarantine ends still matter for the recovery. Indeed, data has been worse than expected, and estimates for Q2 – which will be even worse given the timing of confinement measures – continue to be revised down. The US market gave up 10 years of job creation in a few weeks, consumption already dropped sharply during the first quarter, and Purchasing Manager Indexes (PMIs) reached record lows in April. In addition, earnings releases are showing the high level of uncertainty for businesses, as guidance for Q2 and for 2020 is being withdrawn and dividends are being slashed at a rate not seen since 2009. We therefore remain slightly underweight on equities, with a preference for more defensive allocations or “first in, first out” regions.
Opportunities in Credit?
Conversely, the scale and depth of central bank support has brought relative calm to bond markets, as the Federal Reserve (and others) are seen as the ultimate backstop to the worst case scenarios. As such, we maintain a neutral position in sovereign debt that can act as a hedge in the case of another leg down in equities. We believe that credit offers attractive entry points for the longer term, as spreads remain much wider than earlier in the year. We highlight a preference for investment grade (IG) over high yield (HY), as central banks will provide more support to the former and risks to the latter are likely to persist. We feel more confident buying what the central banks are (or could be) buying. While we see risks in the short term, we maintain a more constructive outlook over the medium term. We will make it through this crisis, even if it might be a bumpy ride. As such, we look to gradually build positions over the coming months as entry points should improve again. In the short term, though, we maintain some hedges such as gold.
After March’s unprecedented collapse in equities, April saw markets stage a strong rally, in some cases recovering more than 50% of losses. In our view, today’s levels and valuations are now underestimating the risks that remain. As such, we believe that another leg down, even if we do not re-test the lows, is likely, and we remain prudent, maintaining a slight underweight.
We believe that more defensive regions, such as the Nordics and Switzerland, should continue to benefit from the current environment. We believe that sectors most impacted by the outbreak and ensuing containment measures will remain at risk – including travel, entertainment, and energy – while technology and healthcare should remain well-bid. While we believe the next few months will be complicated, we maintain our more constructive medium-term view and look to more attractive entry points to gradually build longer-term positions.
Sovereign yields have remained within a broad range in recent weeks, as central bank support has helped bring some calm back to bond markets. Liquidity and funding markets stress has eased somewhat, though financial conditions tightened in April. We expect yields to remain low for some time, and we maintain a neutral allocation to the segment, with a preference for the US. We have added back to IG credit, where we have a preference over HY. Indeed, default risk remains elevated in HY, and the exposure in US HY to the energy sector suggests further volatility ahead. Moreover, central banks are more focused on protecting the IG segment even if they can support HY if spreads widened in an unorderly fashion. We believe that spreads can remain wide for some time, but valuations are now much more attractive than they have been for some time, and the central bank backstop suggests interesting entry points.
Major currencies have entered a broad range, though the US dollar remains underpinned thanks to its safe haven status. We believe these ranges will hold for now, as EUR and GBP have found new levels and central banks in Switzerland and Japan will try to keep their currencies from appreciating too much. Emerging market currencies are likely to remain at risk of a dollar squeeze, though they can offer selective opportunities for the medium term.
The oil collapse continues, as concerns over storage and the lack of demand continue to weigh on prices. Despite production cuts, prices are likely to stay low for some time given both a demand and supply shock. We later expect a recovery, though medium-term supply is expected to remain ample, which should cap prices. Gold should continue to see underlying demand as a safe haven, given inflation expectations and central bank quantitative easing programs.
We continue to see a place for alternatives in portfolios, as we look for de-correlating and diversifying strategies to complement traditional asset classes, particularly with liquid alternatives. We believe that real assets can also help provide income in a “lower for longer” world.