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Defying gravity

INVESTMENT STRATEGY

SEPTEMBER 2020

 

Laurent Denize

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

Given the many uncertainties, it makes sense to hedge portfolios.

Equities had a good summer. After heavy losses in spring, they recovered surprisingly quickly, too quick for the many investors who have been cautious since the crisis began. At the end of summer, the question now arises if it is still the right time to invest in risky assets. But as there are also beautiful days in autumn, this gravity defying rally may not be over right now. First, valuations are high, but they reflect some facts on the ground that are positive for risky assets. Compared to the financial crisis of 2008/09, the Covid 19 recession this year will be more severe, more global, but also shorter. Against more pessimistic forecasts the economy is recovering quicker than expected. With huge differences across sectors business is back in expansion mode, even if in the coming months there could be more mixed news from companies. The current consensus now forecasts a global GDP growth for 2020/21 that would leave GDP 5% below its precrisis trend. This output gap implies that inflation pressure will remain muted.

Several factors will particularly shape the coming months, first and foremost the further development of the Covid 19 pandemic. The infection numbers are rising again, but with less severe disease courses occurring we expect no overburdening of the health system and no strict lockdown measures. Tailwind for the economy and the capital markets will come from monetary and fiscal policy. Central banks are committed to keep interest rates low, which is good for the recovery but increases the danger of some valuations moving away from fundamentals. In the longer term the planned EU reconstruction plan could provide a boost especially to European equities. Politically, a chaotic US election and to a lesser extent a disorderly Brexit could cause some turbulence on the stock markets, but we don’t expect these factors to be decisive. To summarize: 2020 may not be as bad as expected and even as momentum may slow down in the coming months, positive factors should prevail.

Europe is the place to be

Regionally we prefer Europe to the USA. While valuations for global equities are at an all-time high, those for European ones are comparatively more attractive. The European recovery plan will offer an additional boost to European equities especially to small caps and in areas such as technology, health care and energy transition which will benefit from targeted European programs. For instance, out of 100bn € in France, 35bn € will be allocated to the energy transition. Due to the EU's ambitious sustainability targets, the stocks preferred by ESG funds will also be in favor. As the weight of growth stocks in European indices has increased in recent years these indices should offer lots of opportunities for stock pickers searching for long-term performance.

Our convictions at a glance

Stocks: Despite high valuations, we favor stocks over bonds. The recovery of the last few months was not only due to the massive liquidity injections by central banks, but also to improved economic data overall. In this environment, equities have stable and still attractive risk premiums compared to government bonds. Low interest rates support growth stocks, while for the resurgence of value we would have to see a massive, inflationary rebound of the economy.

Bonds: In the bond segment, we prefer European high-yield bonds, which offer more value potential than investment-grade securities. Even if spreads are not narrowing further, with no refinancing wall expected before 2024, there’s still some carry to capture. Short maturities offer an appropriate risk/return profile.

Diversification: In both asset classes a way to minimize risk is to avoid companies with negative future cash flows, weak growth, high debt levels and ESG controversies. Given the many uncertainties, it makes sense to hedge portfolios. While the massive inflows into gold recommend caution, buying volatility can efficiently diversify the portfolio.

 

 

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