By Tim Sharp, Hottinger Investment Management
An extreme deterioration of fundamentals amid the COVID-19 pandemic would suggest that the global economy is currently in recession. A strong rally in equities over the course of the last 6 weeks has seen investors ignore the current environment and focus on the ability of companies to hit 2021 / 22 earnings projections. We remain defensive reflecting the on-going fundamental outlook for growth and earnings as well as the concentration in technology stocks once more leading the market. It may be true that these companies have benefitted from the lockdown environment and the take-up of cloud services has accelerated, but valuations are now looking stretched.
The difference between winners and losers is extended and although equity investors are eternally optimistic some of the comments in the financial media justifying the full valuations of technology companies is very reminiscent of the 1999 / 2000 technology rally in our opinion. It is true that growth stocks tend to have lower debt so are less likely to suffer from credit defaults and offer protection from a slow return to normality, however, it is going to be difficult for equity markets to push higher when many traditional sectors, most significantly financials, have not participated.
Many countries are focusing on the reduction in new cases and deaths due to Covid-19 and the move towards re-opening economies. As most European and Asian countries relax stay-at-home protocols and many US states re-open, some despite seeing no flattening of the infection curve, attention moves to tracking signs that lockdowns have been lifted too soon through a resurgence of the virus. Morgan Stanley make the point that once governments have lifted restrictions it is going to be very difficult to go back to full lockdown from both a country and individual perspective[i]. Therefore, many are looking at the Swedish experience to social distancing as perhaps the model for the future having remained partially open throughout the pandemic.
To us, this sounds like a gradual move forwards, containing virus hotspots as they appear, as well as increased testing, leading to a U-shaped recovery rather than the more optimistic V-shaped recovery that has fueled the equity rally. The strength and depth of government support has led many to believe in a shallower recession, but it may also make governments slow to react to a second wave. There remains a risk that should there be a second wave of the virus caused by the early lifting of lockdowns, the global economy suffers a W- shaped, double dip recession. ASR further write that this bear market is a multi-factor crisis bringing together a biological shock, an oil shock, a credit shock and an economic shock and as such, may well see a multi-phase recovery with economic uncertainty that is currently underestimated[ii].
At the time of writing equity markets seem to have stalled as the realization that the economic recovery is going to be gradual and the risk to future earnings estimates is real. Market technicals also point to a major resistance level on the S&P500 at 2950-3020 and the index has backed away from that level over the last couple of days pointing to potential weakness in stock markets in the very short term. A potential catalyst to push markets higher may come from a rotation into deep value sectors such as Energy, Materials and Banks, but, many traditional sectors have not experienced such moves as investors continue to shy away from areas of the economy that have been substantially affected by the pandemic.
Major companies have been a significant support for stock markets through buybacks, and signs that programmes have been halted or scaled back, due to falling earnings, will remove a major buyer from the market. ASR believe that corporate earnings will take longer to recover than markets expect having seen earnings take two years to recover after the global financial crisis in 2008 and, therefore, 2021 earnings estimates remain unrealistic[iii].
In terms of asset allocation, we continue to believe we are seeing a strong bear market rally with insufficient fundamental information to establish a growth or earnings trajectory. Therefore, we remain mindful of a second equity drawdown that may re-test the lows depending on the signs that economies have opened too early. Positioning remains defensive with underweights in equities and corporate bonds in favour of cash. Finally, the poor starting point for government bonds, with yields so low, means investors do not receive a real return but this should not detract from the natural hedge that ten-year government bonds offer against equity weakness for multi-asset investors. Actively managing duration may be a better strategy than ignoring the negative correlation this relationship offers.
[i] Morgan Stanley Sunday Start – U is for Unicorn; May 10, 2020
[ii] ASR Investment Committee Briefing for May 2020.
[iii] ASR’s Ian Hartnett, CNBC’s Squawk Box Europe, May 14, 2020