Crash to recovery – what's next?

COVID-19 has taken a toll on the global economy and markets, creating uncertainty and causing widespread investor panic. But where are we now and what are the investment opportunities in equities, fixed income, hedge funds and multi-asset?

23 Jun 2020

5 min read


Maximilian Anderl

Head of Concentrated Alpha Equity

Jonathan Gregory

Head of Fixed Income, UK

Kevin Russell

Chief Investment Officer, O'Connor

Nicole Goldberger

Head of Growth Portfolios, Investment Solutions


 

Equities

Maximilian Anderl
Head of Concentrated Alpha Equity

While uncertainty regarding the implications of COVID-19 continues, some industries, such as pharmaceuticals, have already seen a bounce back amid strong buying support and increased demand. Currently, we believe pharmaceuticals are fully valued, though over the long term we continue to favor pharmaceuticals given their resilience and valuation support.

In the energy sector, we expect the price of crude oil to rise further but this is already reflected in equity prices. While there are some emerging signs of supply discipline, spare capacity will eventually be added back resulting in higher oil prices. We expect to see a longer-term decline in oil demand but expect the demand support for fossil fuel alternatives, such as renewables, to increase.

With the global pandemic drastically reducing travel and tourism demand and revenues, we don’t expect that to change quickly, so our airline and tourism outlook remains cautious. We believe opportunities exist in quality cyclicals, most notably software companies and healthcare equipment providers, while industrials and semiconductors stocks have some way to go.

For normalization of the market to take place, a vaccine that is both effective and accessible is essential.

Among the winning sectors including cloud, semiconductor equipment and digitalization, there are interesting differences in how medium/smaller companies are perceived vs. larger companies. Smaller companies often struggle to generate profit and in some cases even suffer substantial losses. However, simply because their starting revenue base is small they benefit from enormous sales growth in the range of 30%−100%.

As investors have no alternatives other than sales to value these companies, they resort to using enterprise value-to-sales as a valuation measure. As a result these companies are rewarded with high multiples because their growth is so high. We believe there is too much uncertainty as to whether these smaller companies will ever be able to reach profitability or generate cash flows.

In contrast, innovative large companies like Microsoft and Alphabet are highly profitable industry leaders dominating the market. Their sales growth is moderate in comparison due to the sheer size of their revenue base. These companies trade on profit metrics and tend to have very robust balance sheets. At this stage of the cycle, we find large, innovative companies more attractive on risk vs. reward as their free cash flows give them the flexibility and ability to reward shareholders.

US consumer transaction weekly (YoY) data

US consumer weekly transactions showing trends in online vs in-store for various industries

 

Fixed Income

Jonathan Gregory
Head of Fixed Income, UK

Arguably, the biggest question facing investors is what will happen to inflation? In many countries, structural factors have kept inflation below targets for years. In the short term, these structural factors have now been joined by the deflationary effects of COVID-19 via the dramatic curtailment of private sector spending and investment. But could things be changing?

On the one hand higher savings of ageing workforces and the impact of technology continue to depress inflation. However, the sharp transition now from fiscal austerity to fiscal expansion in many countries or the interruption to the global supply chain through trade and other geopolitical tensions, particularly relating to China, may prove inflationary.

Finally, the balance of power may swing away from capital and towards labor, reversing a trend of the past 20 years. We cannot be certain how these themes will play out but higher inflation remains a risk which investors must now take seriously.

Evolution of 5-year TIPS yield

Ten year history of the 5 year US Treasury Inflation Protected Securities yield

So, we believe holding some form of inflation protection in portfolios makes sense. In the US, five-year inflation protected securities (TIPS) currently yield about -60bp but we think yields could fall even further if the US Federal Reserve continues to keep the policy rate pegged at very low levels, and if inflation expectations start to rise. For example, the yield on 5-year TIPS fell as low as -1.7% in 2013.

We expect to see bond yields remain low and possibly move even lower, for at least the rest of 2020. In the short term it seems very unlikely that a COVID-19 vaccine or effective therapy will be available, which means the economic recovery could be protracted and highly unstable. Monetary and fiscal authorities will likely need to offset the shock to both the supply and demand sides of the global economy.

If bond yields start to rise, this may offset some of the positive effects of fiscal policy and the authorities will want to avoid this. In fact central banks will be buying a lot of the government bond issuance to help keep yields low. It is also likely that some central banks will look to exert more control over the term structure of rates (as we have seen in Japan and Australia) with an approach known as ‘yield curve control’ whereby central banks buy as many bonds as necessary to effectively cap yields along the yield curve.

Monetary and fiscal authorities will likely need to offset the shock to both the supply and demand sides of the global economy.

 

Hedge Funds

Kevin Russell
Chief Investment Officer, O'Connor

In many ways the US corporate credit market has been the epicenter of both risk and opportunity so far this year. Although decisive US Federal Reserve policy intervention enabled a significant gap tightening, investment grade and high yield spread normalization occurred at spread levels roughly two times wider than in January, averaging around 190 bps for investment grade and 750 bps for high yield cash bonds. While the duration of the extreme risk aversion was brief due to the Fed’s comprehensive credit market support and the CARES Act to offset economic contraction, the investment landscape for corporate credit investing has been dramatically altered as the market digests significant issuance and assesses the both the magnitude and duration of the pandemic on corporate business models and the broader economy.

While we are constructive on elements of the corporate credit market on an absolute basis, we are positive on the relative value opportunities arising. The magnitude of issuance in the US investment grade credit market thus far in 2020 is breathtaking at over USD 1.2 trillion as of June 10, which has already outpaced full-year 2018 and 2019 issuance.

We are positive on the relative value opportunities arising.

With the market having to digest such immense supply in just a few months amid market and economic disruption, we expect the credit markets to continue to be fairly choppy for the next 18 months, presenting ample opportunities for active and dynamic investors to capitalize on this volatility as the resumption of economic and business activity dictates relative winners and losers across the markets.

Similarly, the pandemic has opened up relative value and capital structure trades across high yield and convertible debt that allow investors potential to capitalize on mispriced risk between both secured and unsecured debt, as well as debt vs. equity, as companies with more balance sheet leverage struggle to adjust to current conditions.

We expect a high level of dispersion in credit performance and faster-than-normal convergence on relative value trades within credit markets over the next eighteen months.

 

Multi-Asset

Nicole Goldberger
Head of Growth Portfolios, Investment Solutions

Two-sided tail risks loom in this early cycle environment.

On the downside, a second wave of COVID-19, escalating US-China tensions, and concerns around the US election could lead to a more uneven recovery and stoke volatility that roils markets. Conversely, the momentum in risk assets suggests right-tail outcomes could be achieved if policy success begets incremental improvements in activity.

The lofty levels to which equities have already ascended are expensive from an absolute perspective, reflecting expectations for a swift recovery in earnings that seem too optimistic. In our view, this setup leaves little margin for error with stocks vulnerable to downside risk if the virus returns, policy falls short or the economic rebound falters.

Despite volatility moderating from extreme levels reached in March, we believe that the shift to a higher volatility regime is likely here to stay for the next year. We are focused on staying nimble seeking to take advantage of market dislocations and evolving tactical opportunities, while emphasizing diversification in order to deliver a smoother ride.

With interest rates close to the effective lower bound, we seek out other hedging vehicles, such as gold and the Japanese yen that may serve as ballast in our multi-asset portfolios. We think that gold will also likely be a relative winner in the event of unintended consequences stemming from the enormous and powerful stimulus packages.

We are focused on staying nimble seeking to take advantage of market dislocations and evolving tactical opportunities, while emphasizing diversification in order to deliver a smoother ride.

We favor relative value trades rather than taking large directional bets. We prefer to take a barbell approach by selectively adding to early cyclical exposures that we believe have the most room to run in an enduring recovery, while maintaining defensive positions with solid fundamentals looking to protect against a downturn. We prefer US investment grade credit relative to sovereign bonds given Fed support and attractive carry characteristics. Recently, we’ve boosted our exposure to dollar-denominated EMD, which has lagged the degree of recovery enjoyed by other segments in the credit space, providing greater scope for capital appreciation. We favor assets which we believe would benefit from upside surprises to growth and trade at extremely inexpensive valuations (such as selective emerging market currencies).

25 day rolling correlation between equities and bonds

A 25 day rolling correlation between equities and bonds indicating that a well-diversified multi asset portfolio can give investors a higher probability of achieving their financial objectives

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