Stocks adjust to Fed outlook

CIO Alert published at 11 June 2020, 10:06PM UTC

What happened?

A sober assessment of economic recovery prospects from Federal Reserve Chair Jerome Powell and concerns over rising coronavirus infections in some US states weighed on equity markets on Thursday. The S&P 500 closed 5.89% lower and the Stoxx Europe 600 finished 4.53% weaker. The combination of "lower for longer" rate expectations and concerns about the recovery also saw some of the recent growth-to-value rotation reverse course, with the tech-heavy Nasdaq (which hit an all-time high on Wednesday) outperforming the Russell Value Index by 3.72% over the past two days. Although Thursday’s sell-off is large, it does need to be put in the context of a persistent recent rally. Markets are now broadly back to levels they were trading at less than two weeks ago.

Rising numbers of new coronavirus cases in some US states that have reopened also prompted news headlines about the potential for a broad “second wave” of infections.

At Wednesday’s FOMC meeting, the Fed refocused investor attention on economic risks, predicting a 6.5% decline in US output for this year, with unemployment expected to close out 2020 at 9.3%. Powell’s comments highlighted the extent of economic uncertainty and suggested that the economy might not fully recover until people believe the risks from COVID-19 have disappeared (implying not until a vaccine is available). The Fed’s forecasts pointed to policy rates remaining on hold until the end of 2022, supporting the view that rates will remain lower for longer.

Rising numbers of new coronavirus cases in some US states that have reopened also prompted news headlines about the potential for a broad “second wave” of infections. On Wednesday, 2,504 new cases were reported in Texas, the state’s highest daily total since the start of the pandemic. Weekly new cases reached 8,553 in Florida, its largest seven-day total since the pandemic started. Meanwhile, in California, the number of hospitalizations has risen for nine of the last 10 days.

In addition, while biotech firm Moderna announced that Phase 3 trials for its vaccine remained on track for July, the company confirmed that the recommended dose was at the higher end of the expected range (100mcg dose), which suggests that production capacity could be close to 500 million doses per year rather than 1 billion.

?What is the outlook?

We are still confident that with positive medical developments and supportive stimulus measures, economies will be able to reopen sustainably without a second wave of infection overwhelming healthcare systems.

At present, we do not see the latest US virus developments leading to a reimposition of national, or even statewide, lockdowns. It is important to note that the increase in number of new infections is not broad-based, and in some cases is a continuation of the first wave that has yet to peak, rather than a second wave. In Georgia, for example, new cases have reached a plateau, despite being six weeks into reopening. Overall, US infection rates continue to fall. In the US states where infections have risen, they remain low relative to hospital capacity.

It is important to note that the increase in number of new infections is not broad-based, and in some cases is a continuation of the first wave that has yet to peak, rather than a second wave.

Furthermore, while news headlines may focus on fears of a second wave, markets are more likely to focus on the consumer response. So far, mobility data shows that consumers have remained active in spite of "second wave" headlines, even in those states where infections are rising. Google mobility data for retail and recreation as of 5 June showed an improvement to –36% relative to the baseline, compared with –46% four weeks earlier. The equivalent figures for Florida were –23% compared with –33%, and for Texas –14%, up from –23%. Meanwhile, in Europe, mobility has picked up yet the number of new infections has remained subdued. For example, the numbers of daily new cases in Austria and Denmark, which reopened their economies early, remain in single digits.

What should investors do?

Global stocks are now 7.1% below their prior record high reached in February. We think there is still room for equities to move higher in both our central and upside scenarios. While the Fed highlighted the risk that the economic recovery may not be V-shaped, it also reaffirmed a commitment to loosening financial conditions. Over the medium term, this will continue to be supportive of risk assets. Credit also still has policy support and looks attractive as a means of income generation in a low-yield environment. That said, Thursday’s risk-off move highlights the importance of a selective approach to stocks after the recent sharp rally.

We highlight four areas of opportunity:

1. Be selective in stocks.

Rate-sensitive value stocks such as banks and cyclical companies took a hit on 10–11 June after the Fed flagged a weak growth outlook and that the low-rate environment would persist for years. Investors turned back to secular growth areas such as tech, which outperformed during the crisis sell-off. As economies reopen, against a backdrop of unprecedented fiscal and monetary support, we expect select cyclical and value stocks to close the gap with growth stocks. We think US mid-caps and Eurozone industrials as well as German stocks are well positioned, especially if we enter our upside recovery scenario. Given that the upside scenario is not guaranteed, we also see an attractive risk-reward profile in more defensive stocks in two primary areas—healthcare and quality stocks—that should hold up relatively well in any scenario.

2. Protect against the downside.

Thursday’s sell-off highlights that we are still in a volatile environment, and investors should consider downside protection, particularly given outstanding uncertainties surrounding the virus, the growth outlook, US-China tensions, and the US election. Aside from being diversified across asset classes and regions, investors should consider options strategies and alternative diversifiers such as gold and active management strategies including hedge funds. More here.

3. Add income to portfolios.

The Fed’s comments highlight that we are in a new era of lower-for-longer rates. This means investors are likely to be pushed to hunt for yield. We continue to recommend exposure to credit, in particular US high yield and US dollar-denominated emerging market sovereign bonds (EMBIGD). Although we think the bulk of spread tightening has probably already taken place, these asset classes still offer an attractive yield, especially against the backdrop of lower-for-longer policy rates and aggressive central bank asset purchases. More here.

4. Dislocation opportunities.

As an alternative way to generate yield in a world after COVID-19, we also see opportunities arising from the credit dislocations that the pandemic has caused. We expect a long and lasting downturn across liquid and illiquid debt instruments, with a material pickup in default rates. For active investment strategies in stressed and distressed assets in the private market and hedge fund universe, this presents a unique opportunity to deploy capital, help companies at a critical time, and potentially generate attractive returns. More here.

Visit our website for more UBS CIO investment views.

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