The second quarter of 2020 saw the largest quarterly gain for equities since the doldrums of the Global Financial Crisis in 2009. Global equities rallied by close to 20% in US dollar terms. This despite the economy being in tatters. According to the New York Federal Reserve’s Weekly Economic Index, the US economy will contract by 8.4% in the second quarter compared to last year. Industrial production is still 15.9% below its pre-pandemic high and the US unemployment rate stands at 16.4%. A similar trend reverberates through most of the other global economies – developed and emerging economies alike.
Financial markets are forward-looking and the collapse of equity and property prices (“risk assets”) in March forewarned of an economic calamity. Record stimulus, liquidity conditions and an eventual economic recovery are creating strong tailwinds for risk assets. However, demanding valuations, rising political risks and overbought short-term technical argue for a correction. These forces will probably balance each other out over the coming months – we hence believe that markets will churn over the Northern hemisphere summer with little direction.
In addition to these risks, the overhanging threat to risk assets is the evolution of Covid-19 and its impact on the global economy. The second wave of infection has started in many countries and it will only continue to escalate as economies re-open, loosen social distancing rules and the testing of more potential cases. Investors will be rattled by headlines such as the resumption of lockdowns in Beijing and mounting new cases in Southern US. Having said that, a significant portion of this risk is probably already priced in. This is especially true when one considers the disparity between the top and bottom performing global equity sectors since the market bottom on March 23 2020.
What are investors to do? Investors must be nimble. Merely buying market exposure (via index-tracking instruments like ETFs) is not enough. By making an active decision to invest in index tracking instruments, an investor is exposed to significant concentration risk to the above-mentioned outperforming sectors identified as being inflated and disconnected from economic reality. The best approach would be finding cheap assets levered to the nascent recovery, which will be a source of excess returns.
A strategy most likely to generate the highest reward-to-risk ratio will be to focus on assets and sectors that have not yet fully priced in the upcoming global economic recovery, unlike largest constituents of the broad equity market. In this context, global bonds remain extremely expensive and unattractive. The FX market offers reasonably priced opportunities to bet on the burgeoning global cyclical upswing. This is especially true with various macro forces combining to drive the US dollar lower. The largest opportunity, however, lies within equities as deep cyclical, economically sensitive companies remain attractive relative to defensive ones. One option to capitalise on these trends and opportunities to invest in global, asset allocation portfolios. These portfolios provide portfolio managers (and thus clients) with the maximum leeway to identify and capitalise on these opportunities, whilst remaining cognizant of the risks.
Let’s see what the third quarter has in store for us.