River FOURcast: June 2020
Welcome to our monthly macro update, giving greater insight into our outlook for investment markets and the investment ideas that currently interest us.
We make our internal views more accessible using our four-phase framework, the River FOURcast. Much like a weather forecast, it provides a guide to what we think may be coming, and how we should position portfolios to prepare for the climate to come.
- Most global equity and credit markets delivered low single digit returns over the month of May. Large US companies continue to lead the way.
- Measures to contain COVID-19 are being eased in many developed countries. But there is a long road to recovery ahead for most businesses. The success of significant policy support in preventing permanent economic damage remains unclear.
- Having taken a back seat since last year, US-China trade talks are back in focus.
- Given the sharp shock to growth, spike in unemployment, and fall in oil prices, we expect inflation expectations to remain subdued. Significant stimulus may provide modest inflationary pressure when demand picks up.
- With strong competing forces acting on markets at present, we continue to advocate a selective approach to adding to return seeking assets. We favor high quality assets and areas of the market with targeted policy support.
Despite economic data pointing to the worst economic downturn since the Great Depression, equity and credit markets continued their path higher over May. These markets delivered returns of 3% to 7% buoyed by further monetary and fiscal stimulus (now 27% of global GDP) and gradual reopening of the global economy.
We believe we are still in the Downturn phase, but vigilance is required using this framework in these unprecedented times. Current economic damage is likely to have a material, lasting impact, as unemployment climbs and corporate restructuring becomes commonplace. But the significant policy response is a positive force on markets and cannot be overlooked. We see opportunities in certain markets, albeit on a very selective basis. Focusing on high quality assets is key, as well as areas of the market supported by policy.
- Credit conditions remain weak. Central bank support has helped reduce the cost of borrowing for many companies from the peak in March. This provides a floor for the price of corporate bonds, limiting the likelihood of indiscriminate selling. But it can’t protect vulnerable companies (i.e. those with weak balance sheets and cash flow problems) from defaulting.
- Short-term economic expectations are undoubtedly weak. Q2 forecasts point to a deep global recession. Yet, there are signs of improving consumer confidence as certain economies reopen. We expect this to be a slow process, albeit one supported by substantial amounts of fiscal and monetary stimulus.
- Global equity valuations appear broadly fair. Some areas of the market may look attractive on the surface (e.g. cyclicals, low quality, high beta) but this is often not the case in the context of the current economic environment. On an economically adjusted basis, we continue to favor higher quality assets.
Trade Tensions Re-Emerging
After months of overshadowing by COVID-19, the US-China trade deal is causing market jitters once again. Throughout May, President Trump threatened to terminate the “phase one” trade deal – punishment initially for China’s handling of the coronavirus situation and more recently for its actions against Hong Kong.
With an election on the horizon, Trump will likely make criticizing China a key theme in his campaign. Though Trump may stop short of abandoning the trade deal, having painted it as a major victory. While both countries have less to lose given the economic downturn, China’s position has strengthened because of the US’s reliance on medical supplies manufactured there. Any material escalation in trade tensions is likely to add to market volatility and threaten the recent market rally.
Continued Policy Support
Recent economic data has re-emphasized the need for significant, targeted policy action. The Eurozone and Japan are the latest to step up their efforts. The EU’s executive arm proposed a new fiscal stimulus package worth $826bn, while Japan added $1tn of measures. Japanese stimulus increased from 30% of GDP to 60% over May – now the largest in the world as a proportion of GDP.
While increased stimulus has been interpreted almost universally as a positive, there is still a risk that it will not have the desired economic effect. For instance, consumers appear to be hoarding cash rather than spending. The US savings rate reached 33% in April, beating the prior record of 17% set in 1975. While the crisis has undoubtedly caused “forced saving” a more structural change in savings habits would have meaningful implications for any recovery.
Inflation Will Take Time to Emerge
When such significant stimulus is introduced, the inevitable question is whether it will create inflation. But, with deflationary forces at play, we think it will take time before any significant inflationary trend emerges. Headline inflation expectations have already fallen off the back of sharp falls in growth, employment, and oil prices. Unemployment, in particular, is likely to take time to fall back to pre-crisis levels. High unemployment will knock consumer spending and confidence, keeping inflation in check.
As lockdown measures lift, consumer demand will return. Demand will likely be uneven across different parts of the economy, and the economy might take time to adjust. Some supply chains still need to be resolved and many suppliers may not recover at all. Weak supply may offset deflationary pressures, particularly if stimulus measures are left in place, but we expect inflation to take time to emerge.
Implications For Portfolios
With strong competing forces acting on markets, we continue to take a very selective approach to adding risk to portfolios. Within equity and credit, we favor high quality assets and areas of the market which will benefit from policy support, such as investment grade credit and the TALF 2.0 program.
We are also finding opportunities because of short-term market volatility, such as structured equity. These alternative structures provide for flexibility in terms of how much risk to take and upside potential to cap.
Please speak to your usual River and Mercantile contact if you would like further information on these opportunities.
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