US mega-cap tech stocks ended their stellar run in September, with nervous investors spooked both by rising COVID-19 cases in Europe and by the ongoing political deadlock in the US. That saw value stocks and global bond yields gain ground – yet the reversal may be short-lived. We continue to be cautious on risk assets over the long-term, while taking advantage of short-term weakness to add measured exposures to the portfolio.
It’s easy to get distracted in the current environment. Covid-19 case counts globally ebb and flow as does the political rhetoric around vaccinations and cures, the US political “circus” rolls on and will only intensify in the lead up to the November poll, the delivery and appropriateness of the various fiscal support packages (including the Australian budget) are under scrutiny and geo-political tensions remain elevated.
Behind this list lie some extremely important bigger picture issues that will materially impact the path forward for markets.
With economic Armageddon averted through rapid and aggressive fiscal and monetary policy responses as the pandemic unfolded earlier in the year, the focus has shifted to the realities of recovery and both credit and equity markets have responded reflecting a more optimistic future in prices. The optimistic view is that 2021 will bring a successful vaccine and vaccination roll-out, and against a backdrop of significant and ongoing fiscal and monetary support, economies will roar back to life in the “new” normal economy. However, despite the proclamations of President Trump, this is far from assured and the outlook for 2021 remains uncertain. The optimistic scenario may play out, but it’s entirely possible that despite the ongoing support from policymakers, the private sector does not match up, or that the stop-start characteristics of 2020 carry forward.
While few would argue that the fiscal and monetary life support for the economy is not welcome and/or needed, it is a double-edged sword from an investor’s point of view.
Firstly, record-low interest rates are helpful for borrowers both in terms of “encouraging” credit growth and reducing the cost of debt, but for savers, interest rates and returns from interest bearing investments have collapsed. Increasing capital values as interest rates have declined simply reflects a pull-forward of future returns but returns from these investments going forward will be very low for some time.
Secondly, while government debt levels in Australia are low by global standards it’s the burgeoning global debt load that effectively keep rates low for an extended period (supply and demand doesn’t really work in the sovereign debt market). This means that we need to get accustomed to negligible returns from cash and shorter dated low risk debt investments for an extended period. More variability at the longer end of curves is possible given the combined stimulus could trigger some inflation (particularly if the economy gains some underlying momentum in 2021) but this won’t help those with money in the bank.
The implications for equities are mixed. The bullish argument for equities is two-fold. Stimulus measures have and will continue to inject liquidity into the economy and while private demand remains subdued this is flowing into financial markets and asset prices (not goods prices). With rates so low, equities generally offer higher yields (income) and the potential (indeed the assumption) of growth. At what point this argument collapses is difficult to tell but with risk free rates close to 0% it could run for a while.
The more bearish (although I’d suggest “balanced”) argument is that absolute valuations particularly in certain sectors like technology in the US are very extended suggesting that much of the potential recovery is now discounted and the onus has shifted back to corporates to deliver even better earnings growth to drive further gains. The alternative is a broader rotation away from these “growth” sectors towards the parts of the market that are fundamentally more solid but at much better valuations. At present, markets are grappling with these competing perspectives (as are we).
The key idea behind a diversified investment portfolio is to avoid the need to bet on a particular outcome but to balance risks to align with investor objectives under uncertainty. We have no better insight to the likelihood of a Covid-19 vaccine than the average punter.
To this end, I’d summarise our key positions as follows:
- we are cautious but not bearish on risk position, largely due to liquidity and policy support and the fact that in equities the extremes of valuation are concentrated and not uniform;
- within equities, we are biasing toward the more attractive segments of the market like Australian equities and value to growth as a style bias;
- where possible we aim to find high quality “carry” in preference to cash – albeit they are becoming scarcer;
- we are looking for and making investments in areas where there is a structural and underinvested risk premia (like Commercial Real Estate lending) and other selective alternative investments;
- we are diversifying away from broader corporate risk in developed economies and into markets like Asian credit and US securitized debt which provide high quality exposure to the US consumer; and
- we have a preference for safe-haven currencies (USD and JPY) as risk hedges, albeit maintaining some sovereign duration exposure despite very low yields.
Equities weakened during September, with investor sentiment affected by a resurgence of COVID-19 cases in Europe and the inability of Democrats and Republicans in the US to come to an agreement on a fiscal package. With Biden’s chances of winning the US election increasing over the last few weeks according to betting markets, investors are weighing up a what a potential Biden victory may imply for equity markets. While the proposed tax hikes will be a drag on corporate earnings, this will at least be partially offset by increased fiscal expenditure, should it pass through congress.
The other factor that will impact markets is the upcoming US Q3 earnings season which kicks off from mid-October, with consensus expectations for a continued recovery in earnings per share (EPS), albeit still down almost 20% from 2019 levels in absolute terms.
With the pullback in equity markets bringing the recent run in mega-cap US tech stocks to a halt, global value stocks outperformed growth stocks during the month. However, over the 12 months to September, value stocks have still underperformed growth stocks by over 38%.
While we remain cautious on equity markets, given the extended valuations and uncertainty around the upcoming US selection, we have used the pullback in September to add about 2% to our equities exposure, taking our overall allocation to 27.5%. We also sold some out-of-the-money S&P 500 put options, allowing us to collect a premium while the CBOE Volatility Index (VIX) is still trading at a relatively high level of around 30. This, should enable us to effectively buy back into the market should the S&P 500 fall to the 3000 mark.
Australian bonds were one of the standout performers during September, as both shorter and long-end yields moved lower on the back of a speech by RBA deputy governor Guy Debelle, flagging the potential for the RBA to provide further easing. Bond markets are now anticipating a further rate cut to 10 bps and potentially further quantitative easing. Global bond yields also rallied through September, albeit to a smaller extent than in Australia. Credit and emerging market debt spreads widened over the month in conjunction with the pullback in equity markets.
Over the month we made a few changes to our fixed income positions, though overall portfolio duration remains at 1.75 years. We added moderately to our credit exposure, distributed across investment grade, high yield and securitised credit, in order to seek some additional yield. We also added a US 5s30s steepener, given the concerns around a steeper US rate curve.
The USD recovered some of its losses over the last few months, as a broader sell-off in risk assets resulted in safe haven currencies like the USD and JPY outperforming. While we had flagged that a possible rebound in the USD was possible, given the accumulation of short speculative positions, our medium term view is still that the USD will continue to weaken as it remains overvalued against other developed market currencies (with the exception of the AUD), while the Fed’s accommodative stance is also likely to be supportive of a weaker dollar.
Published by Simon Doyle, Schroders