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MONTHLY INVESTMENT BRIEF

MAY 2020

 

Laurent Denize

Laurent Denize,
GLOBAL CO-CIO &
GLOBAL HEAD OF FIXED INCOME


Tactically, we have trimmed our equity exposure a little further but reiterate our posi-tive long-term view of the credit markets

Share prices have soared recently as central banks and governments delivered a rapid and unlimited re-sponse to the crisis, but the equity markets might now face another setback albeit probably without falling back to their March lows. Investor behaviour should soon stop being governed by emotion -for lack of data and a clear outlook- and instead adopt a more pragmatic attitude as the economy reopens.

We are not of the view that the global economy is heading for another Great Depression or prolonged period of forced debt reduction. However, the shock created by Covid-19 is on such a scale that it will prevent economic activity from bouncing back to pre-crisis levels any time soon. This might seem somewhat disappointing in the short term as the surge in share prices (which followed a bout of panic selling) could soon give way to a more ra-tional analysis of the profile and degree of the recovery in economic activity and corporate earnings over the coming year. We are concerned that the market has once again jumped too far ahead of the fundamentals. Investors ap-pear to be very confident that economic activity will suc-cessfully get going again in an orderly manner.

Many countries are attempting to reopen their economies. But in order to do so safely and resume previous produc-tion levels, the world will need a series of medical break-throughs and the widespread application of a treatment that is far more convincing than the initial results achieved with existing Covid-19 treatments applied so far.

In addition, the S&P 500 benchmark index has bounced back into its mid-2019 trading range (although non-US global stocks are still well below these levels). And yet the global economy (the USA included) is on a much weaker footing than it was a year ago. Earnings have shrivelled while forecasts are hardly upbeat and offer little visibility on the long term. Prices have been propped up by share buybacks in recent years, but this support has evaporated. It is also worth noting that a bearish phase on the equity markets generally draws to an end when the performances of sectors or investment styles that drove the previous bullish phase begin to turn around. But this has not yet happened. Quite the contrary, in fact, as tech stocks and secular growth stocks have continued to dominate, thereby enabling the US markets to continue outperforming. US investors are factoring in just a 20% drop in earnings per share in 2020 and above all a 25% rebound in 2021, and they therefore strike us as being particularly complacent. We certainly do not doubt that the central banks will contin-ue to provide unlimited support, but the fact is that compa-nies are going to emerge from the crisis carrying even heavier debt burdens than before and will not be able to increase their investment capacity. So there is little chance of unemployment being absorbed at all rapidly in the USA, and this will take a toll on consumer spending which is a key growth driver of the US economy. In this respect we can learn a lot from consumer behaviour in China. Alt-hough the consumption of staples has indeed caught up there, the same cannot be said of durable goods. Equity investors in the euro zone expect earnings to fall more steeply (-35%) but also to bounce back and find them-selves at end-2021 just 20% below their 2019 levels. Un-less governments coordinate their action more closely, this scenario seems unrealistic to us, especially as Europe’s potential growth was and still is much weaker than the USA’s.

So what strategy to adopt?

Tactically, we have trimmed our equity exposure a little further (we were neutral with a defensive slant) but reiter-ate our positive long-term view of the credit markets which are benefiting from the unfailing support of the central banks. Here too, there is some cause for caution as spreads have recently tightened significantly, and we do not advise investors to increase their positions at these levels. However, the credit markets do have one major advantage in today’s zero interest rate world and that is very high positive yields (about 5%-7% depending on the maturity) which, thanks to considerable carry gains, make it possible to purchase hedging. In what form? A reduction in direct exposure and a build-up of the cash component, but also the construction of convex profiles by buying put options with volatility now at far more reasonable levels. Paying a put option premium enables an investor to continue bene-fiting from the rally, if indeed there is a rally. Because any core scenario needs to be set against an alternative sce-nario, such as significant progress on tackling the pandem-ic (vaccines, treatments, elimination of the virus, etc.) or simply confirmation of the saying “Don‘t fight the central banks”.

To conclude... for the sake of caution and in light of the recent rebound, we believe the best approach is to “wear a mask when venturing outside”. Not to shy away from cur-rent circumstances but to protect ourselves and strive to overcome our vulnerability to this disease and its effects, most of which are out of our control. The aim, laid bare this time, is to pay lower prices for quality assets that will sur-vive this unprecedented crisis. And here again, we cannot afford to get it wrong.

 

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