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abril 08, 2020

Coronavirus: Markets’ excessive optimism

abril 08, 2020

Coronavirus: Markets’ excessive optimism

PATH

Coronavirus: Markets’ excessive optimism

abril 08, 2020

The unprecedented stimulus provided in many regions may not be a panacea. As a public health crisis, credible efforts to contain COVID-19 are also crucial. This has some serious economic ramifications, many of which have not yet materialised and which we believe markets are not pricing in. We are wary of what we see as excessive market optimism and this is the focus of this week’s update.

US equity ETFs had outflows of $1.98bn in February, followed by substantial inflows of $23.1bn in March¹, suggesting many investors were buying the dip. We believe this is likely a temporary recovery. Whilst the risk-reward potential has improved over the long-term, we expect markets to retest previous lows in the short-term, which appears to already be happening for sectors with the weakest fundamentals such as European Banks².

Some investors are predicting a very sharp hit to growth in Q2 followed by a V-shaped recovery in Q3. Many are now assuming a ~30% hit to EPS, and an EPS recovery of ~+50% in 2021, which is even sharper than the 40% seen in 2010³. This bullish scenario assumes that when lockdown measures are lifted, business will resume as usual. We believe this is unrealistic and will lead to markets being disappointed. We have outlined some of the key factors which markets may not be fully reflecting:

Early data indicate severe recession

Global Services PMIs⁴ have plummeted. Companies have already cut dividends, buybacks, staff, unnecessary costs and capex, but this may not be enough. If bankruptcies increase, unemployment will spike, impacting consumption. Last week’s US jobless report showed an immediate impact with 6.6mn claims⁵, doubling the record 3.3mn from the week before and suggests millions in the US are likely in need of funds.

Bureaucratic hurdles

Despite the US government’s promise of support, large bureaucratic hurdles mean funds may not be received by households and businesses in time. The small business loan or “Paycheck Protection Program”⁶, is experiencing issues. It is administratively tough for the federally-insured banks issuing the loans to process the vast number of applications, including verification of eligibility. Consequently some applicants have been refused loans due to lack of a prior relationship with the bank. Moreover, these measures aim to keep businesses and households afloat for a certain period. If the state of emergency is prolonged, even more stimulus may be required and this is already being proposed in Congress.

Protracted period of isolation and border restrictions

Even once a country is in recovery from COVID-19, some isolation is still likely for the remainder of 2020. For example, Singapore was initially praised for its management of the virus, but a second wave of imported cases has led to stricter lockdown measures. When a country eventually recovers and lifts its lockdown measures, business may not resume as usual, as other countries may not have recovered and re-opened borders. Given the travel sector represents approximately 10% of global GDP, this factor alone could have a great impact.

By the time the lockdown measures are lifted, the damage to the economy may already be irrevocable. This suggests further downside and that the current market optimism is premature. We believe that a V-shaped recovery is unlikely and see a U-shaped recovery as the most optimistic case.

Our list of indicators to re-invest in risk assets

In the next several weeks the US economy will approach an inflection point, as we see whether virus-affected businesses receive stimulus approved by Congress before they go bankrupt. We continue to focus on the following factors to help determine the right time to increase exposure to risk assets globally, including equities. We still see little improvement in the status of these indicators:

1. Credible steps to contain the virus and flattening of the infection rate curve:Whilst many European countries have taken credible steps, the US is far behind. The infection rate may be slowing in Europe generally, but in the US there is a risk of outbreaks intensifying outside New York City, the current epicentre. There does not appear to be a credible, coordinated nationwide virus containment or suppression plan.

2. Extreme valuations: Current developed market valuations, while more attractive by historical standards, are not at levels that we believe generally characterise a positive turning point in market direction.

3. Extreme positioning: ETF flows indicate that equity positioning is increasing and many investors appear positive about the future market direction, driven by “fear of missing out”. However, overall fear has not yet replaced greed. We believe that at a market bottom, investor sentiment generally reflects “fear” not “greed” and equity positioning would be falling not rising.

Effective monetary and fiscal policy: The policies appear to be largely in place and it has been made clear that more fiscal stimulus may come, if required. However, the implementation, especially in the US, is encountering many bureaucratic delays and segments of the economy are not yet eligible, yet require funding. Speed is essential to prevent bankruptcies, which could trigger a downward spiral, tipping the economy into deeper recession than is already likely.

Tactical Asset Allocation Changes

Below we have provided an overview of our latest, key tactical asset allocation change:

Emerging Market Local Currency Debt: Moving from Neutral to Underweight

Emerging market economies are likely to weaken further given the triple shock of a global recession, weakness in oil prices and a pandemic. Compared with 2008, emerging market economic fundamentals such as current account balances, FX reserves and fiscal balances are in a weaker position to weather this downturn. Furthermore, the number of COVID-19 cases in emerging markets has also started to escalate. Populations in these countries tend to be heavily undertested and medical resources are constrained relative to developed markets, so are less equipped to tackle the virus or provide effective containment measures. Finally, many emerging market central banks and governments have not provided swift and effective monetary and fiscal stimulus. Consequently we expect the asset class to remain volatile with further downside risk.

¹ Bloomberg data, BI ETF.

² Based on the Euro STOXX Banks Price (EUR) Index.

³ Based on S&P 500 12-month trailing EPSg. Source: Datastream, IBES, 2 April 2020. EPSg is earnings per share growth.

⁴ Source: Datastream. March 2020 IHS Markit Services Purchasing Managers’ Index (PMI).

⁵ U.S. Department of Labor. 2 April 2020 and 26 March 2020. ”The previous high was 695,000 in October 1982.” www.dol.gov/ui/data.pdf

^⁶ This is a government-backed loan for businesses with fewer than 500 employees.

RISK CONSIDERATIONS

There is no assurance that the Strategy will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Accordingly, you can lose money investing in this portfolio. Please be aware that this strategy may be subject to certain additional risks. There is the risk that the Adviser’s asset allocation methodology and assumptions regarding the Underlying Portfolios may be incorrect in light of actual market conditions and the Portfolio may not achieve its investment objective. Share prices also tend to be volatile and there is a significant possibility of loss. The portfolio’s investments in commodity-linked notes involve substantial risks, including risk of loss of a significant portion of their principal value. In addition to commodity risk, they may be subject to additional special risks, such as risk of loss of interest and principal, lack of secondary market and risk of greater volatility, that do not affect traditional equity and debt securities. Currency fluctuations could erase investment gains or add to investment losses. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes.Equity and foreign securities are generally more volatile than fixed income securities and are subject to currency, political, economic and market risks. Equity values fluctuate in response to activities specific to a company. Stocks of small-capitalization companies carry special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed markets. Exchange traded funds (ETFs) shares have many of the same risks as direct investments in common stocks or bonds and their market value will fluctuate as the value of the underlying index does. By investing in exchange traded funds ETFs and other Investment Funds, the portfolio absorbs both its own expenses and those of the ETFs and Investment Funds it invests in. Supply and demand for ETFs and Investment Funds may not be correlated to that of the underlying securities. Derivative instruments can be illiquid, may disproportionately increase losses and may have a potentially large negative impact on the portfolio’s performance. A currency forward is a hedging tool that does not involve any upfront payment. The use of leverage may increase volatility in the Portfolio. Diversification does not protect you against a loss in a particular market; however, it allows you to spread that risk across various asset classes.

Andrew Harmstone

Managing Director

Global Balanced Risk Control Team

Manfred Hui

Managing Director

Global Balanced Risk Control Team

Christian Goldsmith

Executive Director

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