July Investment Committee: The performance of risk assets and economic scarring

By Tim Sharp, Hottinger Investment Management

The continuing rally in risk assets continues to feel out of step with our view that growth and earnings have been fundamentally impaired by the pandemic lockdown. There have been a lot of theories for this phenomenon including lower summer trading volumes and an increase in retail day traders missing the opportunity to bet on sports. It is interesting that retail names such as Tesla and Amazon continue to lead US equity markets with Tesla becoming the world’s largest carmaker by market capitalization, overtaking Toyota despite only creating 500,00 cars a year! It is difficult to justify such lofty valuations even with the significant dispersion between winners and losers, or growth and value.

Absolute Strategy Research (ASR) points out the relative expensive state of US equities in general; US equities are on a 60% PE premium to the rest of the world and are trading on a price-to-book ratio that is also 2.3 times higher. Over the last week the Nasdaq 100 which is heavily laden with technology stocks has seen a significant outflow of funds which may indicate that short term investors are also considering the technology leaders to be looking expensive. Current data would indicate that the US is seeing a significant spike in new virus cases, particularly in the more populated states. Although fatality rates are not rising in step due to the younger demographic that is contracting the virus through poor social distancing, this will have an inevitable effect on economic activity just when the economy seemed to be recovering quickly.

ASR use Technology vs. Banking as the proxy for Growth and Value and it is not often that stock markets can undertake a prolonged rally without carrying the banking bedrock of the real economy with it. This is more noticeable in Europe where the banking sector is still the main conduit for corporate funding and the introduction of government support. The European economies seem to have opened more successfully than other developed economies, seeing consumer activity bounce back quickly and safely, suggesting that a more prolonged recovery may be possible in Europe at this time. We expect investment opportunities to present themselves in Europe and ASR argue that it is difficult to like European stock markets without supporting the banks. The set of fiscal policies including the latest EU Recovery Fund would have been unlikely pre-pandemic, but these developments will likely change the eurozone approach to stimulating demand and improve collective risk sharing between nations.

The Chinese economy has bounced back sharply with manufacturing and service sectors once more in expansion territory and the property market activity also strong. China has benefitted from the global demand for medical supplies and IT equipment but is likely to see economic activity sustained as the developed world begins to re-open. Over the last month Chinese stock markets have been strong emulating the optimism in the real economy, however, tensions with the US and UK remain leaving an underlying anxiety among investors.

The underperformance of the UK stock market due to the ongoing uncertainty of trade negotiations with Europe has been a theme this year but there is a fear in certain quarters of the Japanification of the UK economy. However, the convergence of nominal rates at the long end of the government yield curve under-estimates the ability of the UK economy to create inflation unlike Japan, so real rates are actually diverging approaching -3% in the UK. Furthermore, the UK is running a current account deficit of 3.3% of GDP, second only to Brazil, while Japan has a 3.6% surplus. This suggests that sterling, which has been held down by Brexit since 2016, is unlikely to strengthen in the near term when interest rates are anchored close to zero.

ASR research monitors growth in money supply as a signal of a potential rebound in economic growth and the surge in money supply over the last quarter has been held up by some as a sign that there will be a strong rebound in economic activity. However, this may also be the result of central bank accommodation of government fiscal policy and companies using credit lines to drawdown cash rather than proof of a strong recovery.

The rally in gold has not gone unnoticed with the price in US dollars now above $1800/oz approaching levels last seen in 2010 / 11. There is a possibility that this may provoke some profit-taking especially with discussions regarding future inflation back on the agenda but within a multi-asset portfolio precious metals still offer a hedge to equity volatility and any perceived weakening in the US dollar.

There is a possibility that the default rate is being underestimated by markets thanks to central bank intervention and that insolvency will become a problem during the second half of the year as that support falls away but lockdown scarring affects the return of economic activity. We remain cautious on low rated companies but believe there is value in the yield pick-up of medium duration, investment grade corporate bonds over government bonds.