In just a few short weeks, the narrative has shifted from how bad things will get to how soon we can recover. Yet the economic data is still horrendous, with the potential for worse to come if the US is hit by a second or third wave of infections. When so much is unpredictable, we believe it’s important to remain both cautious and liquid, ready to deploy capital as opportunities arise.
What a difference a month makes. Uncertainty reigned supreme in March as economies around the world were heading into lockdown, unemployment was starting to skyrocket and the full force of the virus was still unknown. March 2020 saw the fastest bear market on record, with the US S&P 500 falling more than 20% in 15 trading sessions (ultimately falling 34% over 22 days). Only 10 days later, April 2020 entered the history books as the fastest bull market since the 1920s and ultimately rallied 29% off the March lows in 18 days. Economies are reopening, the full force of monetary and fiscal policy are on display and we may have ways to treat the virus going forward.
The narrative has now shifted from how bad things will get to how soon we can recover. The economic data for March is horrendous. Just focusing on the US – industrial production is down 5.4% (the worst reading since World War II), retail sales fell 8.7% (the global financial crisis (GFC) only saw a 2% fall), unemployment is expected to hit 20% (compared to 10% in the GFC and 25% in the Great Depression) and GDP is already down 4.8%.
However, this has been countered by extraordinary monetary and fiscal support. The Federal Reserve’s balance sheet has jumped by US$2.5tn in two months (QE1 during the GFC was US$1tn) and the government has approved a fiscal package worth 11% of GDP (a similar size to the combined New Deal). As at the time of writing, policy makers around the world have provided a total of US$7tr of QE, US$6tr of fiscal policy, and US$4tr in loan loss guarantees. This brings hope that we can stimulate our way through the downturn until lockdowns are lifted and the world gets back to work.
V-shaped recovery or bear market rally?
The price action of the S&P 500 would indicate that the market is pricing in a V-shaped recovery. Economic activity is expected to bounce in the second half of the year and the market is looking through any potential hit to corporate profits. This is still seen as a one-to-two quarter event. However, V-shaped recoveries are extremely rare. Based on the last six recessions, it takes on average five years for real GDP to return to its prior peak (it took four years after the GFC). Similarly, looking at the past seven bear markets, it takes typically four years to make new equity market highs. Despite huge stimulus, the GFC took even longer. If we have already seen the equity market low of this recession (22 days in), it would be an historical outlier. On the other hand, strong bear market rallies (where the bounce retraces around 50% of the prior fall), are a fairly common occurrence.
In our view, the recent market rally across most risk assets has been the result of a removal of liquidity risk from the system. Equities were collapsing, credit spreads were widening, and you couldn’t even trade government bonds with ease. Thanks to the swift and dramatic response from central banks globally, this liquidity crisis was averted. It is, however, too early to say whether we have managed to avert a solvency crisis. Corporate debt remains extremely high, but debt serviceability has not been an issue over the past few years. However, the longer economies remain shut, the longer revenues of corporates stay depressed and the more questionable that debt serviceability becomes.
The US and the risk of a second or third wave
While the rest of the world appears to be getting past the worst of their health crisis, the US appears to be lagging. Trump is now favouring re-opening the economy versus flattening the curve. While overall figures in the US appear to be stabilising, this is predominantly due to the tapering of the case count in New York, whose figures dominate the country’s total. Excluding New York, the US case count is still growing exponentially. As Trump looks to ‘liberate’ states from lockdown, there is a growing risk of a second wave of infections. For reference, the Spanish Flu took over a year to pass, with three waves in the US. Similar to the Anti-Mask League protests of 1918, dissatisfaction with government policies seems to have successfully pushed health advice aside in favour of pleasing voters. Ultimately, strict policy was reimplemented in 1918, but only after the devastation of the second wave was upon them. Any second wave now would prolong the economic damage and ultimately increase the risk of corporate defaults.
That said, things look more promising outside the US. Australia, Europe and North Asia have all managed to flatten their curve and look set to start reopening their economies with potentially less risk of a second wave. These markets also refrained from the significant rally seen in the S&P 500. For example, Europe and Australia remain more than 10% below the US since end of February. Even in the US, the rally has mostly revolved around tech stocks, with value stocks underperforming the broader index by 5%.
While we remain cautious about the current, more elevated equity prices, our valuation framework saw significant improvements in expected returns at the end of March. This saw us moving from 20% equities in February to just over 27% equities today, with a bias towards Australian equities, given our concerns over the stretched optimism in the US. Since we expect further weakness, we will be looking to increase our risk allocations if this occurs. While it is a fool’s errand to pick a bottom, we have constructed a roadmap to add to risk on weakness. For now, we remain highly liquid and ready to deploy as opportunities arise. We also used the elevated volatility still on offer at the start of April to sell more out-of-the-money put options to collect a premium.
Regionally, we maintain our preference towards Australia on the back of more favourable valuations and higher expected returns, and it is primarily in the Australian market where we have increased our equity exposure over the last few weeks. While we do see the concentration of the Australian market in banks as posing a degree of risk, the overall containment of Coronavirus has been more effective in Australia compared to other developed markets. In comparison, the US is still in the midst of the crisis while its equity market is effectively trading back at the same levels as Q3 2019, with an elevated forward P/E of over 22 times.
Global bond yields remain anchored to low levels, on the back of weak economic data and central bank QE programs, which have continued to help restore liquidity in bond markets. With further rate cuts in Australia and the US effectively limited by the zero lower bound, balance sheet expansion is now playing its part. The Fed’s balance sheet was sitting at just over US$4tn at the start of March, and in the space of seven weeks this has expanded by roughly US$2.5tn to over US$6.6tn. Similarly in Australia, the RBA’s balance sheet has increased from about $180bn to $260bn.
In credit markets, investors were buoyed by the Federal Reserve effectively acting as a backstop for US corporate debt. Global spreads tightened through the month both in high yield and investment grade credit, while Australian investment grade spreads remained steady. While shorter-term liquidity concerns have somewhat abated, medium-to-long-term solvency issues linger – issues which we do not believe are fully priced into markets.
We have used this as an opportunity to take some profit on our long duration trades. We reduced our duration by 0.25 years to 2.25 years at the fund level.
The Australian Dollar rebounded strongly during April as the rally in defensive currencies such as the USD and JPY stalled out.
While we took some profits on our FX positions in March as the AUD fell below US$0.60, we have since added back some FX exposure following the AUD’s rally back towards fair value. While we initially favoured the USD, we have since switched some of this exposure to JPY. USD remains our largest currency exposure, and we think shorter-term support remains strong, particularly in an environment of global uncertainty, but we also believe the upside over the longer term is limited by the lack of valuation support.
Published by Sebastian Mullins, Portfolio Manager, Multi-Asset, Schroders