Virus volatility creates opportunity as well as risk

Equities fell and safe haven assets rallied last week as a number of US states paused the phased reopening of their economies amid a continued rise in coronavirus cases.

The S&P 500 fell 2.9% on the week (2.4% on Friday) and the Stoxx Europe 600 shed 2%. Gold gained 1.6% to reach its highest level since October 2012 and the yield on 10-year US Treasuries fell by 5.5 basis points over the week.

On Friday Texas governor Greg Abbott ordered bars to close down again and restaurants to limit their indoor capacity to 50% from a previous 75% after new coronavirus cases rose by more than 5,000 for the fourth consecutive day on Thursday. Other state governors have announced they will halt the next phase of their reopening, including Arizona, Arkansas, Delaware, Idaho, Louisiana, Maine, Nevada, New Mexico and North Carolina. At the national level, the US recorded a record high in new cases on Saturday of more than 45,400.

Adding to negative sentiment, on Friday the S&P 500 banking sector sub-index dropped by 4.5% after the Federal Reserve announced new restrictions on the banking sector following its annual stress tests. The Fed warned that some banks had employed “more optimistic than appropriate” economic scenarios in their capital planning and could come close to minimum capital levels if the economic situation were to deteriorate. Big banks will now have to cap 3Q dividends at their current 2Q level and will have to suspend share buybacks in 3Q.

What is the outlook?

These latest virus developments, in our view, may slow the recovery, but are unlikely to derail it. With virus cases still rising in a number of US states, a more volatile trial-and-error approach to reopening now appears more likely, but we expect any new restrictions to be localized. In Germany last week, for example, the state of North Rhine Westphalia reimposed two “light” local lockdowns after an outbreak at a meat factory. There appears no political appetite for renewed lockdowns at a national level. Mobility data and business sentiment surveys point to a trend toward normalization, and last Thursday US air passenger traffic reached a new high since the pandemic began. So far there is little sign that rising infection rates are causing widespread fear that could impact consumption, although it is a risk if the daily case count continues to increase.

Our view remains that it is this central bank liquidity narrative that will prove most important for risk assets over the medium term.

While the Fed’s restrictions on big banks’ dividends and share buybacks hit sector share prices on Friday, it has to be seen in a wider context. The Fed’s overall assessment of the financial sector was positive. Fed Vice Chair Randal Quarles characterized the sector as a “source of strength during this crisis.” In addition to the financial stability issues, at a time when the Fed is supporting the banking system with liquidity, it is logical that it doesn’t want that support to be used for share buybacks.

The more important Fed story is the unprecedented scope and scale of the monetary policy support that the central bank is providing. Our view remains that it is this central bank liquidity narrative that will prove most important for risk assets over the medium term.

What should investors do?

We believe it is important to stay invested, and we see further upside in equities, although the ride could be a bumpy one as the “second wave” story creates volatility. A disciplined financial strategy can help investors avoid panic selling, or costly periods on the sidelines in cash. But volatility is also an opportunity. We recommend a dollar-cost-averaging approach to build long-term exposure. Investors who can use options can employ put-writing strategies to earn a higher yield at times of higher implied volatility (the VIX is currently 36, almost twice its long-term average) or consider other structured strategies to ensure leveraged upside participation.

With rates set to stay very low for a long time, we also recommend looking at ways to earn income from credit exposure. We like US investment grade and high yield, Eurozone crossover bonds, and USD-denominated emerging market sovereign bonds.

Given our view that the economic recovery will gather momentum over the coming year, we think the focus when building equity positions should be on select cyclical and value stocks. We prefer US mid-caps as they tend to be more leveraged to trends in the broader economy. We like Germany and European industrials for similar reasons. We also see opportunities in the US, Asia, and Europe in stocks that are likely to be beneficiaries of reopening economies.

Finally, with uncertainty remaining high, we acknowledge that more risk-averse investors may want to protect against downside risks. Here we recommend several strategies including exposure to select hedge funds, gold, and global quality stocks.

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