Monthly Investment Letter: Not even thinking about thinking

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In this letter, exactly one year ago, I wrote about Nobel Prize-winning economist Robert Shiller’s concept of “narrative economics.” Shiller believes the stories we tell ourselves can drive economies and markets far more than any economic statistics. Today, when investors are left to contend with an invisible virus and distorted data, the story is everything.

Markets are faced with at least three evolving narratives: the “Fed” story, the “second wave” story, and the “US election” story. But which narrative will prove most powerful, stable, and durable? While news headlines can make us think the second-wave and election stories are the biggest drivers for markets, it is the Fed story that will endure over the medium term. Against this backdrop, we think the most important thing an investor can do is to be invested, not sit on the sidelines. We are positive on the outlook for both equities and credit.

The naked truth is that the Federal Reserve has never been more explicit with its intentions. It is not focused on the theoretical, long-term political or economic consequences of its drive to loosen financial conditions. It intends to use its powers to help ordinary workers, fully expecting that it will also benefit owners of capital. Indeed, Fed Chair Jerome Powell may even think that efforts to loosen financial conditions will increase inequality, provided the rising tide lifts all boats. As he told the press last week: “Just the concept that we would hold back because we think asset prices are too high…what would happen to the people we’re actually, legally supposed to be serving? We’re supposed to be pursuing maximum employment and stable prices and that’s what we’re pursuing...We’re not even thinking about thinking about raising rates.”

We are positive on the outlook for both equities and credit.

The two other narratives—centered around a second wave of the virus and the US election—will create volatility as headlines feed investors’ hopes and fears about the speed and strength of the economic recovery. But ultimately we think the Fed’s efforts will continue to support capital in risk assets. To borrow a phrase from Theodore Roosevelt, the Fed “speaks softly but carries a big stick.”

We believe these evolving narratives create opportunities for investors. The Fed story should be supportive of equities and credit such as USD and Asian high yield bonds, hard-currency emerging market sovereign bonds, as well as private credit strategies. Should fears of a second-wave story prove overblown, it will support recovery plays including US mid-caps, the UK and German markets, and stocks geared toward a reopening of the economy. Finally, the US election story is likely to cause volatility leading up to the November vote as markets weigh the prospects of additional fiscal stimulus against the potential for higher taxes and increased regulation. However, the election also provides additional insurance that the Fed won’t hike rates and that both political parties are likely to support further stimulus into the election.

The “Fed” story

The Fed story has never been stated this clearly. At the June FOMC press conference, Chair Powell said: “We’re not thinking about raising rates. We’re not even thinking about thinking about raising rates. What we’re thinking about is providing support for this economy.”

At a minimum, the Fed intends to put financial conditions back to where they were before the coronavirus crisis, and is using a barometer—the National Financial Conditions Index—to track its progress. In starting to loosen conditions again, the Fed has responded with unprecedented scale and speed. It has expanded its balance sheet by nearly 75%, from USD 4tr to USD 7tr, in just three months. On 15 June, it stepped up by announcing that it will begin buying individual corporate bonds under its Secondary Market Corporate Credit Facility, an emergency program previously dedicated to buying exchange-traded funds (ETFs).

We can already see the effects of Fed policy in ETF flows. The Fed has been buying credit ETFs; its total ETF holdings were reported at USD 5.5bn as of 10 June. Yet this has been dwarfed by the broader flows driven by the Fed narrative itself. Investor flows into the same ETFs that the Fed has bought exceed the Fed’s actual purchases by almost 10 times since 23 March, when the Fed first announced unlimited quantitative easing and its credit backstop facilities.

Credit has performed well since the Fed started start buying.

Bond spreads relative to the risk-free rate were at their widest on 23 March. Since then, high yield bond spreads have narrowed, from 1,084 basis points (bps) over US Treasuries to just 585bps today.

Going forward, we believe returns on investment grade bonds are likely to be more muted and will push more investors further out on the risk curve. With central bank support, USD high yield, Asian high yield, USD emerging market sovereign bonds, and equities can generate higher returns. We see potential for further total returns of 6% in USD high yield, 11% in Asian high yield, and 10% in emerging market sovereign bonds over the next year in our central scenario, and even higher returns in our upside scenario. We also think the combination of distressed assets and low borrowing costs could provide a significant opportunity for distressed private credit investors.

Meanwhile, history shows that stock valuation multiples and equity market performance are highly correlated with excess liquidity (defined as year-over-year growth in M1 money supply minus nominal GDP growth). In the US, M1 money supply has grown 34% year-over-year in just three months (March–May, monthly data). Our analysis shows that, if interest rates persist at current levels, global equity risk premiums could fall another 80–100bps over the next six months, supporting further upside for equities. In our central scenario, we expect 6% upside for US stocks, 6% for Swiss stocks, and 11% for emerging market stocks.

The “second wave” story

Fears of a “second wave” have potential to add volatility to markets. Google mobility data shows that US activity continues to increase, but states such as Texas, Arizona, Florida, and California have seen an uptick in new virus cases since reopening. Meanwhile, 33 out of 329 sub-districts in Beijing have imposed new restrictions on movement following the emergence of new virus cases.

But it’s important to remember that

• a) these upticks are still small in relation to the capacity of health systems,
• b) various governments, including the US, have stated that we will not see a renewed national lockdown,
• c) we have not seen any evidence of a negative consumer response to second-wave fears,
• and d) progress on vaccines and therapeutics continues to be made.

As such, while second-wave fears could add to volatility, ultimately, in our central scenario we expect the recovery to gather strength over the coming year.

To position for the normalization story arc in the US, we prefer mid-caps and stocks exposed to the reopening of the economy. We prefer Eurozone industrials and German stocks for their cyclical exposure. We like the UK market for its attractive valuation and high exposure to value sectors. In Asia we recommend stocks exposed to a recovery in consumption. See more in the “Investment Ideas" section below.

The “US election” story

This November’s US presidential election has yet to become a significant story for markets, but we expect it to move closer to the forefront of investors’ minds as the vote approaches. President Donald Trump’s surprise victory in 2016 triggered the so-called “Trump trade” across financial markets. Risk assets rallied, government bonds fell, and the US dollar initially strengthened as investors rushed to price in a combination of lower taxes, looser regulation, and higher fiscal spending.

This year, polls suggest the race will be close, and given the severe economic disruptions caused by the coronavirus, specific policy platforms are yet to be clearly defined. Four months ago, it was President Trump’s election to lose, running on a strong economy and a 50-year low in the unemployment rate. Now, less than four months to the ballot, his approval rating is near the low end of its range during his presidency, and former Vice President Joe Biden is leading in almost every national poll.

The election has the potential to add volatility to markets if investors tell themselves a “fear” story—either that a blue-wave Democratic victory leads to higher taxes, tighter regulation, and antitrust action against big tech, or that President Trump campaigns and wins on a renewed anti-China platform. By our reckoning, increasing the corporate tax rate from 21% to 28% would reduce S&P 500 earnings per share (EPS) by about 5%. But a Biden administration would reallocate these funds into spending on climate, healthcare, infrastructure, and other policy initiatives. Potential new regulation, meanwhile, could be a headwind for energy and financial stocks.

Neither of these fear outcomes is certain, however. The Democratic agenda remains fluid, the US Senate could remain in Republicans’ hands, and President Trump has shown willingness to be opportunistic in support of the economy.

Positioning for a particular election outcome is therefore inadvisable, especially at this stage. What is clear is that the US election story weaves itself into the Fed story. To ward off the impression of political bias, the Fed is not likely to withdraw monetary stimulus this close to the election. Moreover, both the GOP and Democratic parties are likely to support new stimulus efforts to gain voters’ favor. This month, for example, the Trump administration signaled that it wants the next coronavirus relief program to be at least USD 2tr.

Investment ideas

For our upside scenario

1. Select cyclicals: US mid-caps

So far this year, US mid-caps still lag large-caps by roughly 6%, due primarily to the stronger performance of companies exposed to “stay at home” trends. These companies are disproportionately represented in large-cap benchmarks, which also tend to be more defensive. In a recovery, smaller companies tend to outperform because they are more cyclical and typically more leveraged to trends in the broader economy. As lockdowns and social distancing ease, we expect the economic recovery to broaden and gain more traction. This should disproportionately benefit mid-caps relative to largecaps. In addition to US mid-caps, we have assembled a “Reopening America” basket to focus on the recovery.

In the Eurozone, we also like stocks exposed to the reopening of economies, and this cyclical bias supports our preference for the industrials sector and the German market.

2. Select value: UK equities

We see potential for value to recover some ground against growth, but do not see a full reversion to the mean, which would likely need rising bond yields as a precondition. However, UK stocks trade at a large discount to global peers and to their own long-term historical valuation range. This suggests an upward potential over a 12-month horizon. Net EPS revisions—the balance between upward and downward adjustments to analyst forecasts, indicating earnings momentum—are improving on the back of higher oil prices, but stock performance is still lagging. The UK market should benefit from a rotation out of defensive growth stocks into value names, given its large exposure to value sectors such as basic materials, energy, and banks, which account for a combined 40% of the FTSE 100. We also still find opportunities in high quality stocks.

Scenario analysis for COVID-19 recovery

Asia equities should be supported by the ongoing normalization of activity, although higher trade tensions are a risk. Our equity focus is on industries that should benefit from a consumption recovery, like autos, consumer electronics, transportation, beverages, retailers, and select casinos.

3. Weaker dollar

While the greenback enjoyed some flight-to-safety flows during the recent equity market volatility, demand for safe-haven assets is likely to recede as confidence grows that the worst of the COVID-19 crisis is over. The Fed has been the most aggressive of the major central banks in easing monetary policy, and with it, the US’s interest rate premium has eroded. At the start of 2020, the two-year US Treasury yield was 215bps above the equivalent German bond. Now the gap is just 85bps. Meanwhile, the Fed’s balance sheet has grown by USD 3tr over the course of the pandemic, at least twice the growth in the European Central Bank’s balance sheet.

The US political situation, whether related to fears of higher deficits, higher regulations, or higher taxes, should also drive the dollar weaker. Our preferred currency against the US dollar for our upside scenario is the British pound, which we think is heavily undervalued with a purchasing power parity of 1.54.

For our central and upside scenarios

1. Equity

We are positive on global equities. The global economy is starting to show signs of bottoming out, helped by surging money supply and aggressive fiscal stimulus. As earnings are likely to recover in the second half of the year and excess liquidity continues to support risk assets, we see further upside potential in global equities, in particular among sectors that have lagged the rally so far.

2. Credit

A lower-for-longer rate environment and aggressive central bank purchase programs will continue to support credit. Financial conditions are easing and the Fed’s stated intention is to ease them further. Corporate issuers will also continue to take bondholder-friendly action, in our view, fortifying balance sheets and preserving cash flow to avoid downgrades or default.

Within credit we prefer USD high yield, Asian high yield, and USD-denominated emerging market sovereign bonds (those captured by the EMBI Global Diversified Index). We see potential for further total returns of 6%, 11%, and 10% on these bonds, respectively, over the next year in our central scenario and even higher in our upside scenario. Meanwhile, we continue to believe investment grade credit will be well supported, but believe that the bulk of the spread tightening in the asset class has already occured, limiting the potential for future returns.

Private markets offer an alternative source of yield for investors willing to accept less liquidity. For active investment strategies in stressed and distressed assets in the private market and hedge fund universe, there is an opportunity to deploy capital, help companies at a critical time, and potentially generate attractive returns. We expect default rates to rise, but while we believe this is priced into high yield spreads, which focus on large listed companies, much of the distress is focused on small and mid-cap companies, which may not be eligible for or able to access government support programs.

3. Taking advantage of volatility

We believe investors can benefit from current levels of volatility to earn an attractive yield while pre-committing to buying into attractive long-term investments on dips. For investors able to use options, this can be executed through a put-selling strategy. For investors who find themselves sitting on the sidelines but worried about the risk of an ill-timed investment, we recommend using a dollar-cost averaging strategy to build up long-term positions. Averaging into equities can help investors deploy capital while smoothing near-term bumps.

For our downside scenario

1. Active management

One means of insulating portfolios against downside is by including exposure to hedge funds with a strong track record of risk management. As lower yields reduce the ability of bonds to improve portfolio risk-reward, investors can also incorporate dynamic asset allocation strategies to navigate periods of elevated volatility.

2. Gold

Heightened sensitivities to USD weakness, high levels of public debt, financial repression, and geopolitical risks should make gold attractive to investors with an affinity for real assets. In our central scenario, we expect gold prices to rise to USD 1,800/oz over the rest of 2020. We regard the risks to our forecasts as balanced, with gold prices rising to USD 1,900–2,000/oz in the downside scenario and sliding to USD 1,400–1,500/oz in the upside scenario.

3. Swiss franc

The CHF combines safe-haven qualities with a growth-oriented currency that profits from a stronger European economy and rising global trade volumes. The Swiss National Bank has been intervening on a large scale, but we expect it might reduce its efforts and accept a somewhat stronger currency.

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