River FOURcast: September 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.
- Equity markets continued to move higher this month, although the recovery continues to be uneven. Credit spreads tightened modestly.
- Eurozone inflation turned negative in August, raising chances that the European Central Bank will intervene.
- The Federal Reserve announced that it will allow inflation to exceed the 2% target for periods of time before reacting; equity markets reacted positively to this “lower for longer” posture, while interest rates rose modestly at the back end of the yield curve.
- The inflow of positive economic data continued; business sentiment improved while consumer spending also rose, albeit off a low base.
Most major equity markets rose over August, with the US in particular up approximately 7%, pushing valuations into very expensive territory. The UK and Europe continued to lag, rising only about 2% over the month.
Credit conditions continue to be supported by ultra-loose monetary policy including direct lending backstops for many companies, while economic expectations remain mixed. With valuations across most major asset classes very expensive, we believe we are still in the Downturn phase of the cycle. Although headline economic growth numbers are likely to improve in the near term, we believe consensus expectations for a full economic recovery may still be optimistic. That said, policy support continues to be the dominant factor for markets, effectively encouraging investors to look past weak data towards a future recovery. This supports higher return seeking allocations than the headline data would suggest, but argues for a bias to higher quality where possible and for assets with in-built downside protection.
- Economic expectations remain mixed. Near term economic data will likely continue to improve, but the true extent of longer-term damage is yet to be seen.
- Credit conditions are unusually strong given the economic backdrop, with borrowing costs generally at record lows owing to central bank policy.
- Valuations are very expensive across most major asset classes. While there are reasons that expensive valuations make sense given policy actions, they remain a risk and argue against building meaningfully into risk assets without downside protection.
An Uneven Market Recovery
Quality companies such as Microsoft, Amazon and Apple continued to be favored by institutional investors. Crowding (a high concentration of investors in the same trades) is high, but there is good reason for this. With interest rates close to zero, corporate earnings under pressure and defaults remaining elevated, the macroeconomic environment favors growth-oriented firms with robust balance sheets and strong earnings.
That being said, extremes in crowdedness are often associated with higher volatility, and can precede short-term market pullbacks. The current environment underlines the importance of taking high-quality, risk-managed exposure as we navigate the long and uneven recovery ahead.
Central Banks Faced with Low Inflation
Weak demand, distorted supply and low wage growth could mean that inflation remains subdued for longer than initially expected, prompting further intervention from central banks around the world.
The inflation rate in Europe came in at -0.2% for August, despite the ECB’s pledge to keep borrowing costs low. In the US, there was a modest pickup in inflation, yet it is considerably lower than the Fed’s 2% target. Low inflation expectations tend to feed off themselves and can cause policy problems. The Fed, in a historic move, announced this month that it will allow inflation to run modestly higher than the stated target for periods of time, boosting equity valuations.
Data in the manufacturing and service sectors has recovered from March lows and risen steadily over the past few months. Manufacturing output in Europe expanded at the fastest pace in the past two years, although order book growth slowed as firms prepare for a near-term weakening in demand.
In the US, disposable personal income edged higher this month, supported by fiscal stimulus. Consumer spending also rose, aiding the current economic rebound. The savings rate remains at elevated levels (17.8%), which is an important cushion for spending and growth moving forward. Savings rates and disposable income will likely be impacted without a replacement for the $600 a week enhancement to unemployment benefits via the Cares Act (which expired on July 31,2020).
Implications for Portfolios
It is important to acknowledge the powerful yet competing forces of 1) significant policy support and 2) economic uncertainty. At an overall level we support a neutral to modestly overweight position in some risk assets (such as credit), but believe this exposure should be very selective and have downside protection where possible.
We advocate the use of structured equity, for example, which allows us to participate in equity markets on the upside to a certain extent, while capping the level of downside we are exposed to.
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