July 17, 2020
A trillion-dollar patchwork of global policy efforts has thus far been effective at bridging the demand gap, banishing the spectre of deflation, and helping businesses of all sizes to stay afloat in the wake of the pandemic. With economies opening up and mobility tentatively normalizing, the data tells a story of stabilisation. As seen in China, activity in the western world is picking up, albeit with manufacturing remaining stickier than services. If one data point was the centrepiece of this crisis that we will remember for years to come, it was skyrocketing jobless claims in the US, where over 40 million Americans lost their jobs in the blink of an eye. Now, employment data is surpassing expectations, and, after peaking at 14.7% in April, the unemployment rate eased further in June to 11.1%. In the euro area, furlough schemes have kept the unemployment rate relatively close to March’s record low of 7.1% (May’s reading, the latest available at the time of print, was 7.4%). Employment is crucial. Prior to the crisis, consumers were the key driver for the global economy and it is therefore pertinent that they do not lose their purchasing power or their willingness to consume if we are to see a recovery take hold. The good news is that confidence has not evaporated. In the US, for example, the Conference Board Consumer Confidence Index for June saw its largest increase since 2011 (of course from a very low base). Looking ahead, consumers are less pessimistic about the short-term outlook, but remain pragmatic and are not banking on a huge pickup in economic activity. Of course, this could all be undone by a second wave of the virus, which for the time being seems limited to outbreaks of manageable clusters.
Despite promising data, the investment terrain remains fraught with uncertainty. The pandemic (over which we have not yet declared medical victory) has dented confidence, challenged income generation, and called the long-term viability of key global sectors and industries into question.
At the same time, lower yields mean that investors have to take on more risk to generate income. Since the nadir in March, equity markets have embarked on a relentless rally. This was initially supported by central bank liquidity injections, and subsequently backed up by high-growth companies demonstrating their ability to generate profits during lockdown. Evidence of the global economy returning to work is now behind much of the momentum and optimism about the months ahead has left global equity markets at their most expensive levels (in terms of the P/E ratio) since the tech bubble in the early 2000s.
Our exposure to equities remains neutral, with a focus on quality names and growth companies which we believe will continue to prevail in the long term. In the near-term, indeed value, cyclicals and small caps (which enjoy better relative valuations) could gain some traction, especially if the global reopening goes to plan, but, caveat emptor: when value falls out of vogue, it does so suddenly and violently. Dividends will become more important with the persistence of low yields.
ESG-focused companies have been outperforming, and we expect this trend to continue with the pandemic propelling sustainability to the fore. Already, Christine Lagarde has suggested the ECB could use its asset purchase scheme to pursue its green objectives, by selling so-called “brown” bonds issued by carbon-intensive companies in favour of those issued by greener industries. ESG companies tend to be higher quality, and we have a particular focus on those able to withstand regulatory scrutiny.
The pandemic has also ushered in a digitalized economy quicker than anyone could have expected. According to Gartner and IDC, the personal computer market grew 3% in the second quarter versus the same period in 2019, with over 64 million PCs shipped worldwide as distributors and retailers restocked. Sales of mobile computers have risen strongly as a large proportion of work and learning has moved online. To remain relevant, companies are having to reinvent themselves – and they are having to do so quickly. Looking ahead, we believe certain industries will experience notable long-term changes, both for the better and for the worse (e.g., disruption and the “sharing economy” could render some business models obsolete), which will have significant investment implications. We are focusing on companies that could benefit over the long term from an increasing shift to digital and online consumption. This naturally drives a US bias in the portfolios given that most of the pioneers of the Fourth Industrial Revolution are concentrated there, with Europe still generally an “old world” economy.
Banks face an uphill struggle from here, having financed vulnerable looking assets such as cars, planes and vessels, while the ultra-low interest rate environment is toxic for their business models. At the same time, certain compartments of the broader “Financials” category, such as insurers and financial data companies which are pursuing digitalization should not be disregarded.
During previous recovery phases, long-term interest rates initially rose quickly in anticipation of growth and inflation. This time, rates looks set to remain at historic lows: the Fed seems set to hold rates near zero for the foreseeable future (we don’t expect any detour into negative territory), while the ECB’s rate remains frozen below zero. While government bonds make no yield contribution (even peripheral spreads have tightened), they offer effective diversification against equity risk and for this reason they remain a fixture of our portfolios.
In the current context, any quest for higher income does entail increased portfolio risk. Diversifying the sources of risk, whether it be liquidity, credit or interest rate risk, is essential. In the investment grade space, there is still room for spread tightening and we curate an exposure to this asset class, made up of high-quality names with high free cash flows and robust balance sheets. Now more than ever, it is essential for investors to perform proper due diligence before buying credits. Many firms that have spent years in the twilight zone, with the weight of their own debt blocking out the sun, have been kept alive by government support – for now. In some segments, such as the US high-yield area, where the Fed is providing less direct support, defaults are already starting to creep up (rising to 6% over the past month).
While holding some dry powder could prove useful for opportunistic buying, investors should aim to be fully invested. Indeed, it is tempting to wait for more clarity (epidemiologically and economically speaking), but this could hinder the pursuit of long-term goals. Rather, we believe investors should gradually rebalance their portfolios to achieve a diversified allocation with a prudent approach to risk. After the recent run in equities, this could mean crystallising some gains and putting the money back to work – potentially in companies benefitting from the long-term structural shifts towards sustainability and digitalization that we mention above.
Author: Group Investment Office