By Tim Sharp, Hottinger Investment Management
US Federal Reserve President Powell used the post June Federal Open Market Committee meeting press conference to inject an element of reality into the recent equity rally that has seen the NASDAQ top 10,000 and the S&P500 go positive fleetingly for the year. The sobering reality that the Fed will not even be thinking about thinking about raising rates until 2022 and leaving its level of bond buying unchanged, made equity investors finally sit up and take notice. Equity market volatility could be compared to a pendulum that probably overcompensated to the downside to March 23 and has overreacted to the upside with one of the longest and sharpest bear market rallies pushing areas of the market to very stretched valuations. Thursday’s pullback is the beginning of share prices trying to find the right valuation levels based on what we know now. Following the technical bounce Absolute Strategy Research expects a demand shock lasting a couple of quarters and a longer-term supply shock as delicate supply chains are impacted by the pandemic, both pointing to ongoing credit and equity market stress[i].
Over the last 4 weeks the financial markets and real economies have been focused on the gradual reopening of countries following the lockdown periods. A couple of hot spots in South Korea were quickly tracked; New Zealand declared themselves Covid-free and European countries have so far kept their infection rates down. The clear winners have been countries with mass testing capabilities and efficient track and trace technology, such as, Germany and Scandinavia ex Sweden. Unfortunately for the US and the UK neither system has been up to scratch and so far 18 US states including California and Texas have seen a spike in Covid-19 cases and the North West of England has seen its R-rate rise slightly above 1 leaving schools in the area unable to partially open once more.
The rotation from lockdown winners into traditional cyclicals that has taken place over the last fortnight will probably be reversed with the threat of a second wave of the virus, however, as Treasury Secretary Stephen Mnuchin told CNBC on Thursday, June 11, shutting down the economy for a second time is not a viable option. It is our opinion that the financial cost of continued lockdown has been calculated to far outweigh the threat to human life leaving many countries who were hoping to eradicate the virus before the summer tourist season started with little option but to leave the population to make its own decisions regarding participation or risk devastating a major part of their economies.
We suspect investors will focus on the countries that come out of lock down the healthiest and currently that would point to the eurozone, meaning that the lead taken by US equity markets up to this point may well be rivalled by European stock markets. There is no doubt that there are trends within cloud technologies that will be very disruptive and enduring, but opportunities within Europe may show themselves as the global economy continues to reopen despite the consequences. Furthermore, the proposal for a EUR500bn stimulus fund financed by jointly issued government debt is a significant moment for Germany with its resistance to debt mutualisation, and a major fillip for ECB flexibility in the sharing of funding risk, although it is yet to receive full support.
The second observation is that the monetary and fiscal stimulus including the Fed’s reiteration that it will continue to buy bonds, government and corporate, has underpinned the default rates within global credit. High yield has less direct support and has seen most ratings downgrades. The support has restored confidence in corporate credit and with government bond yields so low it allows investors to focus on pure credit spreads particularly investment grade. However, the natural negative correlation between long-dated government bonds and equities can still provide a hedge in multi-asset portfolios. Investors may need to be more flexible in their investments to allow for swift adjustments in duration depending on the climate within equity markets. For example, the pullback in the S&P500 over the past week has been largely offset by the over 15-year US Treasury total return index. Traditional buying of government bonds for yield is no longer effective while interest rates are so low, but in a multi-asset portfolio, they provide capital preservation and a meaningful hedge to equity risk.
Gold has been the best performing asset class this year supported by a flight to quality, falling interest rates and probably most significantly a weakening dollar. The path of the dollar will be crucial to the recovery of the global economy, however, the continued problems in emerging markets will favour dollar strength whereas its relative performance against reopening developed economies may favour the euro and the yen; sterling remains a victim of no-deal uncertainty.
In conclusion, it is unlikely, in our opinion, that the global economy will normalise until a vaccine is found and it is worth remembering that the number of Covid-19 cases globally is still rising with devastating consequences for the populations of the developing world with under-funded and under-prepared health services. The full extent of the effect on the growth potential of the emerging world is yet unknown but it is interesting that countries have become non-collaborative and isolationist during this pandemic unlike the Global Financial Crisis when the power of collective action was very evident.
[i] Absolute Strategy Research – Investment Committee Briefing for June 2020; June 5, 2020