A Wall of Worry
Deputy Chief Investment Officer
[Invest. Pro.] Intended for Professional Clients in accordance with MIFID.
Written by Frank Trividic, Deputy Chief Investment Officer at Seeyond, on October, 16th 2020
Watch out for schizophrenia …
This Fall 2020, investors are torn between positive and negative factors.
On the positive side, the global macroeconomic environment is favorable: it is very strong in Asia, solid in the US, and rather mixed in Europe (with a strong dichotomy between the industry and services). In the context of Covid, Central Banks are further willing to support the economy at all costs. As stated by Jerome Powell, Chairman of the FED, their strategy is clear : to help governments finance support-or-stimuli plans so long as pandemic-related uncertainty prevails. Beyond that period though (i.e. at the first signs of inflationary pressures), no guarantee can be given to further exceptional measures from monetary authorities. In fact, Central banks should await a confirmation of inflationary pressures before moving next; which should give time to the economy to return to a favorable path.
On the less favorable side, political risk remains significant, with the American elections and Brexit negotiations coming to an end. Here again, those risks have been identified for a long time and are largely factored in by investors and markets alike. In the United States, the main risk lies in Donald Trump’s behavior in the event of a defeat. As already hinted by him, the current President may indeed refuse to concede victory to his opponent. We believe, however, that his position would quickly become unsustainable as the Republican Party would likely distance itself, as would a significant part of the State apparatus.
Fundamentals have turned positive again
Our equity fundamental models gradually returned positive on the environment over the Summer; first in the United States, then on a larger scale in September and October:
Source: SEEYOND, as of October 2nd, 2020
After the shock over last spring, major equity markets are now supported by the "Earnings Momentum" and "Growth" factors, which clearly improved since the beginning of the summer. Despite high valuations (in absolute terms), extremely low interest rate levels keep the "Market Valuation" factor in positive territory. Conversely, "Earnings Revision" remains the only factor still in decline.
A positive technical environment
The pandemic outbreak in March caused stock markets to crash everywhere, sharply breaking the then positive trend and causing an explosion in risk indicators. Markets rebounded very quickly though - and long before fundamental indicators recovered – thanks to a massive intervention by Central Banks (and governments), and to the inflection of pandemic figures.
Source: SEEYOND, as of October 9th, 2020
From June 2020 onwards, our technical models consequently indicated an upward trend. Also, the recent correction - prompted by imminent US elections together with a necessary consolidation of the swift uptrend - is far from having damaged the favorable market trend.
Bond markets are drained
Government yields have reached levels that no longer leave much value in the Treasury markets, regardless of the region. Valuation factors (real rates, slope of the curve) are at best neutral or negative, while growth and risk aversion factors have become very unfavorable again.
Source: SEEYOND, as of October 9th, 2020
In fact, given long lasting accommodative monetary policies, the risk of yields going significantly off track seems to be ruled out in the short term. But these accommodative strategies are largely factored into Fixed Income market valuation, and we cannot exclude temporary but violent phases of upward adjustment of yields, especially across the longest maturities.
Did you say "rotation"?
US Small Caps have long suffered from investors’ appetite for very Large Cap, where the high-tech sector prevails. The Coronavirus crisis has only exacerbated this trend by accelerating the transition to an increasingly digital economy - and by knocking down long rates.
Without questioning the interest that these Growth stocks bring in a structural way, we however believe that a revaluation period of Small Caps is coming. According to our analysis below, the US Small Cap segment is currently undervalued, owing to a specific risk premium which should gradually disappear.
Source: Bloomberg, SEEYOND, as of October 9th, 2020. RTY: Russell 2000 Index. SPX: S&P 500 index.
In the short term, the environment appears favorable to moderate risk-taking, while maintaining the ability to seize opportunities in the event of a temporary adjustment of risky assets:
- The US elections are a significant factor of uncertainty. Negotiations on a new relief plan are trapped in a particularly complex tri-party game (the Trump administration, the Democratic House, the Republican Senate). We nonetheless believe that, pressured by public opinion, markets and the Federal Reserve, significant additional support programs will finally be released to prevent a dramatic relapse in activity. Besides, polls increasingly favor a Democrats’ victory, be it for White House or for the Senate. Mr. Trump being in power combined with Mr. Biden’s much less divisive personality should also leave little room for surprise, contrary to in 2016.
- The risk associated with Brexit is more difficult to grasp. The diversity of interests and positions in Europe, as well as the British Prime Minister’s negotiation strategy, bars us from ruling out the possibility of a No Deal. The UK would thus have a lot to lose with such an outcome and we believe that even a deal on the surface should be struck by the end of the year. This, combined with the resurgence of the pandemic in Europe, makes us not very optimistic about this part of the world at the moment; but we believe that these uncertainties shouldn’t have repercussions outside of Europe, and are unlikely to change the situation at a global level.
- In China, the recovery, driven until now by real estate, infrastructure and exports, should be fostered by significant improvements in domestic dynamics (consumption, investment). This would consequently be very favorable to economies and markets that are intrinsically connected to China, such as Germany and Japan, for example, and Asia overall.
- From a technical point of view, implied volatility across major equity markets (i.e. the price that investors are willing to pay to protect themselves against an adverse scenario) has remained very high despite the strong recovery in market indices since the last spring. While high implied volatility levels translate a great level of uncertainty for the global economy over the coming months, these also mean, paradoxically, that investors are somehow “protected”, i.e. not that exposed to risk at the moment; should the context turn positive, a massive repositioning of investors could then ensue and fuel a rise in equity markets. And since a number of investors - especially retail investors in the US (one of the main drivers of short-term US equity market flows) - have remained very cautious since last spring, the risk of a significant market correction (that would be triggered by massive capital outflows) seems rather weak.
Over the medium or long term, our analysis mainly relies upon the evolution of the pandemic situation and its medical remedies. In the absence of a robust and durable solution come first half of 2021, investors will likely reassess the risk of a downturn in the global environment, of overly restrictive health measures, and of the impossibility for governments to indefinitely feed economies on life support. Otherwise, a very favorable scenario could emerge, given particularly supportive authorities. A new cycle would thus see the light of day, embodied by a key word: "reflation". But we are not there yet…
This article has been provided for information purposes only to professional clients as defined in the MiFID Directive. It must not be used for retail investors. The provision of this material or reference to specific sectors or markets in his article does not constitute investment advice or a recommendation or an offer to buy or sell any security. Investors should consider the investment objectives, risks, and expenses of any investment carefully before investing. Views expressed in this article as of the date indicated are subject to change and there can be no assurance that developments will transpire as may be forecasted in this article.