What a difference, again, a month makes. 2020 so far has seen both the worst sell-off since 1929, and the best 15 days for US stocks in four decades. Our latest monthly column was close to the bottom of this kind of pattern. At this time, we were scared by the backdrop and by the markets’ technicals, but at least, valuations were reasonable. It helped us take the decision of buying back the stocks we had previously sold in mid-February close to their top. Alas, let’s face it, the valuation criteria is not favourable anymore, leaving us in a state of unstable equilibrium with more questions than answers, more risks than bargains, but as always, good principles to apply in your portfolios to deal with the situation.
Let’s start with an updated take on the three pillars of all our investment decisions: what happened, what is priced-in, and how do investors behave?
The backdrop is characterised by two opposite forces, equally powerful at play, especially in the West. The economy is cratering - the annualised contraction in Q1 alone should reach double digits in both the US and Eurozone and we should receive the numbers this week. As evidenced by the flash PMI numbers, Q1 was bad, but April is far worse,. For example, the Euro area PMI is at 14, compared to 36 at the worst of the global financial crisis a decade ago, with 50 being the base level from which there is an expansion. In view of this economic apocalypse, policy responses are of unprecedented magnitude. Central banks, are all firing their most powerful monetary bazookas at the same time, cancelling any notion of interest rate and boosting their balance-sheets (i.e. printing money) at a much faster pace than in 2009. This provides governments with the unlimited funding they need to prevent irreversible job losses, at a time when in the US alone, 22 million people have applied for unemployment benefits in just 3 weeks (it took almost a year to reach this cumulated number in 2009). This is why the US, for example, released a first $500 bn programme to protect the paychecks of small businesses – it was entirely tapped in 2 weeks, and a second one of comparable size was approved last Friday. The equation has become relatively simple: should the economies reopen soon, the policy response would have been big enough to preserve our ability to rebound. If not, we may face a depression rather than a transitory recession. Time is more than ever, money – time is GDP, and this is why many restrictions have started to be lifted, especially in Europe, and elsewhere are planned soon, especially in the US. Emerging Asia, by comparison, appears to be much better placed. China’s recovery has indeed started in March, and China’s factory PMIs, due next Tuesday, could hold above 50. Having said that, there are limits to divergence: Asia cannot prosper with the rest of the world collapsing, so all eyes remain on the West.
The second driver is valuation, and the issue here is that markets seems to have decided to look through the crisis. Equity multiples not only suggest, but implicitly demand, that the economy comes back to normality in the second half of 2020. Of course, massive liquidity injections by central banks, also supporting targeted segments of the corporate bonds markets, have an impact on multiples, which are also inflated by depressed denominators, i.e. earnings. But simple common sense says: how come that with the worst economic disruption in almost a century, global equities are only down 15% and a (well run) balanced multi asset portfolio only down 6%? This is right only if the implicit scenario is right. It should hopefully eventually happen, but there are many uncertainties in the meantime. What if lockdowns are not lifted globally? And in a more subtle way, are valuations integrating the fact that lifting restrictions will mechanically trigger a resurgence of infections? Elevated valuations are an issue because they create vulnerability.
Finally, markets’ behavioural factors add their layer of instability. It is impossible not to mention the absolute dislocation of the oil futures markets which crystallised last week with the WTI May contract trading below zero. Fundamentally, demand has evaporated and storage capacity is saturated. Adding speculation to the cocktail led to the insane situation where so called “investors” would have to pay to get rid of their commitment to take delivery of oil. It shows the magnitude of the fundamental issue we face: as I write, more than 10% of the supertankers in the world are currently used to store oil rather than transporting it. In view of this, speculating on futures is not advised. It also illustrates Warren Buffet’s statement that derivatives are financial weapons of mass destruction, as several banks are reporting heavy losses on their books because of the extreme levels of volatility.
Let’s sum it up: there is reasonable hope that the economy will restart in H2, but as markets are already priced for it, the system is vulnerable, and unstable. We expect large swings around our fair values, which are not far from the current levels, as news evolves on the only fundamental catalyst: the economic recovery.
In such a context, we have taken a simple action in our recommended tactical asset allocation. We have aligned the major categories, i.e. cash, fixed income, equity and alternatives, on their long-term optimal weights which is our Strategic Asset Allocation (SAA). We have entirely re-designed them in late 2018 with the latest models and the most realistic assumptions – they are extremely robust and built to deliver the best possible return while protecting your capital in 3, 5 and 7 years respectively. Having an updated SAA is priceless in times of uncertainty.
We express our preferences not between, but within these four categories of assets, with an overall “quality at a reasonable price” bias. Within Fixed Income, we favor investment grade corporate and Emerging Market (EM) sovereigns. EM, with faster growth and cheaper valuations, are an overweight in equities, with secular growth sectors such as Healthcare and Technology also over represented. Finally, in alternatives, we have a very clear preference for Gold, which is simply the currency you cannot print. It works in the short and medium term, adding resilience to the portfolio and benefitting from very low real rates. In the long-term, it could also be an answer to the trillion-dollar question: can we print infinite amounts of currencies without impact on their purchasing power?
This could be a topic for another monthly column, and perhaps the opportunity to start considering alternate assets from an investment perspective. In the meantime, we wish you all the best for the Holy Month of Ramadan. Stay safe, and invest wisely for the long-term.
* Any opinions expressed in this article are the author’s own
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