As we write, 2020 shows a strong start for financial markets, after, and despite, the outstanding returns of 2019. With the only exception of Emerging Market stocks, down 2.6%, all major asset classes are positive year-to-date. At the same time, COVID-19 continues to spread, taking a growing toll on activity, as February economic surveys unambiguously confirm. Markets themselves are sending divergent messages: risk aversion drives Gold at a seven-year high and pushes US 10-year yields below 1.5%, but at the same time equity indices have recently printed all-time highs in the US and Europe. Who is right, and should we prepare for a correction in stocks?
Let’s start with our conclusion. We were fully invested in 2019 and in the first weeks of 2020, and we have started to trim down risk by reducing our allocation to Developed Market equities in mid-February. We don’t pretend to be able to predict the short-term. But what we know, for sure, is that the valuation of DM stocks fully price-in our 2020 scenario, which justifies taking profits.
Back to the virus, and the resilience of markets: dealing with unexpected events is a constant challenge for investment professionals. The first reaction is always to look at what happened before. Indeed, “this time is different” has proven to be a dangerous statement when it comes to investment decisions. Yes, history tends to repeat itself, and past occurrences of viral infections indicate a severe but brief impact, leading to a V-shaped pattern in markets. This anticipation explains why risk assets are currently steady, especially as it combines with other supportive factors: the Fed balance-sheet is expanding, Q4 earnings season is good, and the probability of Mr. Trump being re-elected in November is significant.
Whether this time is actually “different” or not is certainly a crucial question, but it is impossible at this stage to answer with anything else than a guess. Investment decisions should not be based on guesses, but on a disciplined assessment of risks and rewards, analyzing three key market drivers: the backdrop, the valuations, and behavioral factors.
Let’s start with the backdrop, i.e. economy and policies. Our scenario for 2020 is for a marginally improving global growth, with more monetary stimulus from emerging regions than from the West. To that extent, the virus poses a downside risk: all indicators in China, from energy consumption to manufacturing activity, are pointing to a substantial shock in Q1 -at least. The disruption is extending geographically, through tensions in the supply-chain and pressure on international trade and tourism. The reopening of China’s factories is critical to the world, and we’re not there yet. As we write, we acknowledge downside risk to our scenario but also note that the policy response is strong. It is too early to exclude history to repeat, i.e. seeing a severe but limited impact on the economy.
The second key driver is asset valuations, and this is an area of facts, not guesses. The message is unambiguous in Developed Markets: both equities and fixed income are expensive, at the top decile of their historical ranges. Rates are not far from pricing-in a recession, which is not our scenario. We are thus underweight on DM government bonds, high yield and even global real estate. With regards to equities, DM indices have reached in February the fair values we had calculated for the end of 2020. There is no upside anymore, which is the key reason why we recommend to take profits. Emerging Markets’ valuations tell a different story: bond yields are higher for the same level of risk, and the equity valuation discount to their DM counterparts have simply never been that high.
The third market driver is not fundamental, but behavioral: investors’ positioning and sentiment. This is where our fundamental preference for Emerging Markets is vulnerable in the short-term. Any worsening of the epidemics would pressure EM assets, but given their fundamental long-term picture and their valuations, this could be another opportunity to add.
As a conclusion, it is important to remember that it is impossible to time the markets, which makes any radical directional view extremely perilous. Wealth Management is about aligning your risk level to your investment horizon, through a robust strategic asset allocation, and implement measured tactical deviations to adapt to opportunities and risks. We believe in the long-term potential of Emerging Markets but recommend to reduce exposure to Developed Markets, as their valuations create vulnerability, and raise the levels of cash. Its flexibility might prove precious down the road, as 2020 will undoubtedly be an eventful year.
* Any opinions expressed in this article are the author’s own
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