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Mid-year outlook: markets could rise more despite the recession

08/06/2020
Mid-year outlook: markets could rise more despite the recession

Summary

The financial markets reacted to the coronavirus with an unprecedented first-quarter drop, then turned around quickly. This appetite for risk in the face of the deepest recession since the 1930s is quite unusual, but the markets are being driven by optimism about potential economic improvement down the road – so we can’t exclude a further rise in equity prices.

Key takeaways

  • Despite the market’s confidence in a quick rebound from the recession, we think investors should be cautious and maintain a neutral allocation in the medium term – while remaining ready to take advantage of select opportunities
  • We expect bond yields to remain low given the tremendous monetary-policy support from central banks, which represents a “reloading” of the financial repression policies triggered in response to the global financial crisis and subsequent European debt crisis
  • We are neutral to positive on the credit sector overall, as continuing central bank intervention will likely provide substantial support for this sector
  • Over the long term, we prefer equities over low-yielding bonds for investors in search of returns, even though investors seeking a “safe haven” have pushed up equity valuations in the US; valuations are more moderate in Europe and Asia
  • Growth stocks – particularly the tech sector – may benefit from the fact that growth is scarce in this current recession, and from the greater demands being placed on the digital world in times of Covid-19

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For the market rebound to have staying power, four uncertainties must be addressed

During the first quarter of this year, the coronavirus caused the financial markets to drop faster than the average of all 11 bear markets since 1946. But despite unsettling economic fundamentals related to the pandemic, this bear market suddenly turned around far more quickly than its historical counterparts (see chart). Investors seemed reassured by news of a possible peak in coronavirus infections and related deaths, by the prospect of vaccines and therapies, and by massive amounts of fiscal and monetary-policy stimulus.

The coronavirus bear market fell faster – and has so far recovered faster – than the average bear market
(Current bear market vs average of all bear markets from 1946-2009)

The coronavirus bear market fell faster – and has so far recovered faster – than the average bear market

Source: Bloomberg as at 22 May 2020. Bear markets defined as periods in which the S&P Index 500 falls by at least 20%.

This market rebound occurred even as the economic picture deteriorated, highlighting the disconnect between market performance and the wider economic outlook. The question is: will this bounce last? While this recovery in equity prices is fragile, we think it may continue as long as investors embrace a better growth outlook on the back of massive monetary and fiscal stimulus, and they continue to see evidence that infection rates are past their peak. But the rally in equities would be on a much sounder footing if we were to see improvement in at least some of the following four areas.

What should investors do next?

So far this year, the financial markets have shown surprising confidence that the economy would rebound from the virus-triggered recession. Based on all the evidence we have presented, investors should be cautious while remaining ready to take advantage of opportunities. Here are the key ideas investors should keep in mind for the rest of the year.

Amid continued low bond yields, keep up the hunt for income
  • We expect bond yields to remain low given central banks’ tremendous support so far and their commitment to do more if necessary. This is “financial repression reloaded” – a continuation of the policies implemented a decade ago (including low interest rates and increased regulations) to help countries grow their way out of debt.
  • Monetary and fiscal support may generate higher inflation in the medium to long run, but we don’t expect inflation to be a major factor in the pricing of nominal bonds. Still, we are finding value in some inflation-linked bonds.
  • We are neutral to positive on the credit sector overall. While valuations are not overly attractive and global indebtedness is at record levels, central banks are price-insensitive buyers, and they will continue to directly intervene in investment-grade bonds and, to some extent, high-yield bonds. This will likely provide substantial support for this sector.
  • “Fallen angels”, in particular, could be attractive in this environment. Convertible bonds are also interesting, since they have historically performed well in times of volatility and offer potential upside from their equity-like characteristics.
Amid continued low bond yields, keep up the hunt for income
  • We expect bond yields to remain low given central banks’ tremendous support so far and their commitment to do more if necessary. This is “financial repression reloaded” – a continuation of the policies implemented a decade ago (including low interest rates and increased regulations) to help countries grow their way out of debt.
  • Monetary and fiscal support may generate higher inflation in the medium to long run, but we don’t expect inflation to be a major factor in the pricing of nominal bonds. Still, we are finding value in some inflation-linked bonds.
  • We are neutral to positive on the credit sector overall. While valuations are not overly attractive and global indebtedness is at record levels, central banks are price-insensitive buyers, and they will continue to directly intervene in investment-grade bonds and, to some extent, high-yield bonds. This will likely provide substantial support for this sector.
  • “Fallen angels”, in particular, could be attractive in this environment. Convertible bonds are also interesting, since they have historically performed well in times of volatility and offer potential upside from their equity-like characteristics.
Consider growth stocks for the long haul, while staying cautious on equities in the short term
  • Given the impending recession and widespread uncertainty, we think investors should still be somewhat cautious about equities in the short term, at least for now. We recommend a neutral position in equities at this time. We would be ready to change our view and become more constructive when some of the four factors mentioned above – including positive news about containing the virus and robust private-sector growth – show progress. On the other side, we might suggest less exposure to equities if the growth expectations anticipated by the markets turn out to be too optimistic, or if we see signs of a second wave of the virus.
  • Despite our short-term caution, we have a clear preference for equities over bonds for investors with a long-term investment horizon – particularly given that many real (after-inflation) bond yields are negative.
  • Among equities, we still prefer growth stocks at this time – notably those in the tech sector – in part because growth stocks have historically done well in times when growth is scarce. In addition, the coronavirus crisis has shown that there is a structural demand to further build out the digital world. Over the longer term, investors should also consider balancing tech holdings with healthcare and cyclicals. As progress is made towards re-opening and stabilising the global economy, markets may favour areas like pharmaceuticals, biotechnology, and even parts of energy, financials and industrials. These areas may offer compelling risk-reward opportunities.
  • Emerging-market equities could also be an attractive source of growth potential for long-term investors. China A-shares (companies listed on stock exchanges in Shanghai or Shenzhen) are one such example. These securities give foreign investors a direct way to participate in China’s long-term growth story -- which we believe is still compelling despite US-China tensions.
Use sustainability as a lens to spot weaknesses and strengths
  • The coronavirus pandemic has exposed shared vulnerabilities in our economies and the systems on which we all rely. Amid so much interconnectivity, investors will increasingly need to be selective among sectors and individual names, rather than rely on broad market performance. Environmental, social and governance (ESG) factors can be a helpful lens for highlighting major global risks and test the resilience of businesses and systems. Look for partners with experience conducting in-depth research into sustainability issues and engaging with management teams to improve practices.
  • Corporate governance will be critical as the private sector navigates a deep recession. We expect more attention to be paid to how companies allocate capital overall – particularly on share buybacks and dividends. But these practices need to be addressed on a case-by-case basis, since retail investors and pension savers also benefit from higher stock prices and dividend payments. We also expect to see growing interest in aligning the performance and remuneration of management with the interests of all the companies’ stakeholders.
  • The coronavirus will likely result in people demanding sound healthcare systems and better access to high-quality care, which could have positive implications for the healthcare sector. And over the long term, we expect to see a trend towards simpler, more “local” supply chains that are easier for firms to control.
Stay active to help distinguish winners from losers in this environment
  • Financial markets during times of crisis lend themselves better to active strategies, in our view, and this pandemic is no exception. Active investing can help add a layer of risk management to portfolios by seeking to mitigate declines when markets fall, and aiming for the most attractive opportunities when markets rise.
  • Markets today are being driven by sector-specific performance rather than the broad market returns (beta) that passive investors relied on in recent years. There will certainly be winners and losers during this crisis, even within sectors, and the divergences could be quite pronounced; some companies may not survive. Passive and index investments – which can be useful in certain environments – could expose investors to potential underperformers or even defaults.

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Active is: Seizing the China opportunity

Growth in China set to outlast the pandemic and trade wars

by Anthony Wong | 17/06/2020
Growth in China set to outlast the pandemic and trade wars

Summary

Despite the impact of the coronavirus pandemic, and continuing tensions with the US, China remains on course to become the world’s largest economy by 2030. This could represent the coming decade’s most transformative development in global financial markets – and a major opportunity for investors.

Key takeaways

  • While it has been a challenging year so far, we expect China to resume its growth trajectory and become the world’s largest economy by 2030
  • The previously export-led Chinese economy is shifting its focus to higher-value, tech-driven sectors, with growth fuelled by the country’s burgeoning middle class
  • Improved accessibility, governance and transparency have increased the appeal of Chinese A-shares to foreign investors
  • Many indices underplay China’s growth story; a lack of exposure to China could mean benchmark investors miss out
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