The great market detachment from reality
The great market detachment from reality
The great market detachment from reality
The dichotomy between the false market tranquillity and the high level of uncertainty about the length of the crisis and its long-term implications is striking. In our view, we are far from being out of the woods and investors should stay alert as current market levels are still pricing in a ‘too rosy too soon’ endgame. The race between the three cycles will continue. On the pandemic cycle, markets have been relying on the narrative that the worst may be behind us in Europe and the US, with rising expectations of contagion curve- flattening. If these hopes are not realised, market tensions will resurface. On the economic front, the huge fiscal and monetary measures are like an insurance policy for the next six months, but should the recession prove worse than expected, markets will need more and any disappointment will trigger a correction. ‘Credit’ is becoming addicted to CB action; market conditions have improved but not normalised. On the credit default cycle, critical in a world that will see even more debt after the Covid-19 crisis recedes, markets have already priced in a first round of defaults but not a second one for traditionally laggard assets. The battle between liquidity and solvency will continue and US commercial real estate is an area to monitor. The disconnect between market hopes and economic and pandemic reality reinforces our conviction that now is a time to remain cautious: don’t chase the bulls, but gradually and selectively play investment themes better positioned towards a slow road to recovery. Reasons to be vigilant, on top of the uncertainties in the three cycles mentioned above, are: First, a resurgence of the US-China rivalry, amid the ‘blame for the virus’ game, was the main risk that re-escalated in May. Second, the outcome of US elections is uncertain. Third, EM are facing high idiosyncratic risks (Brazil). Finally, the long-term consequences (retreat in global trade, rebalancing of policies in favour of labour, transformation of business models, and acceleration of trends, i.e. smart working) of Covid-19 are complex and remain under scrutiny. During the unprecedented last 3 months, our focus has been: the dual objective of protecting investment capital from any permanent loss and having room to add to emerging investment opportunities. This attitude remains unchanged and investors should focus on the following:
Liquidity: This is precious in managing transition from the deepest phase of the crisis to an uncertain recovery. The crisis has made clear that liquidity should be a key metric of portfolio construction, despite recent signs of improvement. In fact, the depth of liquidity in credit markets remains thinner and more expensive than prior to Covid-19. Investors should keep some liquidity for defensive and aggressive strategies, so they can reposition in some areas of market when opportunities arise.
Positive stance on IG credit: This should benefit from CB actions and the primary market can offer opportunities. However, investors should remain very selective at the sector and company level, focusing on good balance sheets and businesses that can withstand the economic lockdown.
Conservative risk exposure to equities amid further EPS growth revision: Any catalyst for improvement must come from a vaccine or a potential treatment because only these factors could trigger a permanent recovery and positive change in consumer behaviour.
Cautious on EM in light of rising geopolitical risks, with opportunities to watch in credit as well as in Asian and Chinese equities, but the evolution of the China-US relationship is key (recent tensions could derail market sentiment). The credit market is discounting an aggressive rise in defaults, but investors should consider that many of the most troubled stories have already traded down to their distressed recovery levels and some are currently even restructuring. Investors should identify those companies that can successfully draw up a plan to emerge from the distressed status.
Covid-19 is an accelerator of growing importance of ESG: While the E and G will remain high on the priority list, the societal focus towards higher social equality, fair treatment of employees and care for their health will underpin the growing dominance of the S component. There will be greater scrutiny of the ways companies act in the interest of all stakeholders and the community. This will translate into a greater impact on stock prices of some ESG risk factors, which will provide opportunities for active managers, in both the equity and bond space.