Second wave or second wind?

We outline ideas for positioning for the upside, protecting against the downside

After a strong rally from the March lows, equity markets have been range-bound. Investors are weighing hopes of a recovery against fears of a “second wave” of virus cases, high valuations, and US-China trade tensions. In this letter, we offer some perspective on these worries and why changing sentiment could revive and broaden the advance in equity markets.

In our view, for markets to catch a “second wind,” investors need greater confidence that a “second wave” of virus infections will not lead to renewed lockdowns.
Even if current economic conditions are weak, markets are forward-looking and would likely trade higher if investors gain confidence that a robust recovery will take hold.

Where could this confidence come from? As we have seen in recent days, news about faster-than-expected vaccine or antiviral development has the power to reduce investor anxiety. We are confident that more medical progress will be announced. Yet we are also looking closely at the way that hospitalization rates
respond to looser lockdown measures.

The weak correlation between the severity of lockdowns and the spread of the virus across different societies suggests that reductions in movement have been neither fully effective nor the only factor at play in determining transmission. If lockdowns have been as ineffective as some of the data shows, yet hospitalization rates have fallen anyway, that could mean opening up societies more rapidly may not produce a major second wave or require renewed shutdowns.

The rally from the lows during this pandemic has been notable for the significant outperformance of already-highly-valued growth sectors such as technology, consumer staples, and healthcare. This has left major equity indexes fully valued on some measures. Still, rising confidence that a second wave either can be managed or won’t materialize would lead to a reassessment of the speed at which economic functioning can normalize and help unlock further upside for market segments that have lagged behind and remain under-owned, such as value, mid-caps, and cyclicals. Greater comfort that heightened US-China tensions need not lead to a new trade conflict could offer a secondary boost.

We think it is important to consider this non-consensus view about a second wave of the virus based on our analysis of the data, because it could be the key to further upside for markets. However, we also know that an unprecedented mix of scientific, political, fiscal, and monetary policy choices are being made daily with some unpredictable consequences. So while the probability of our downside scenario has reduced over recent weeks, it is prudent to acknowledge that a wide range of outcomes remains possible.

As we await more evidence that points to a rapid return to normality, credit remains the asset class with the best risk-reward overall in our view. Credit should participate in a bull scenario, but is better supported than broad equity indexes in our central and downside scenarios. We like US high yield and investment grade credit, and USD-denominated emerging market sovereign bonds. Within equities, we continue to focus on sectors more resilient to virus uncertainties, like global consumer brands and healthcare. We also continue to seek opportunities in elevated equity volatility to earn additional portfolio yield. To protect against our downside scenario, investors should consider adding assets like gold, select hedge funds, and Treasury Inflation Protected Securities (TIPS) to portfolios, as well as considering dynamic asset allocation approaches.

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