Paul O’Connor, Head of the UK-based Multi-Asset Team, gauges the potential for a sustained cross-asset recovery as the world adapts to a new paradigm, one where COVID-19 remains a persistent risk factor for investors.
- The scale of policy response in the first half of 2020 helped investors to look past the spread of the coronavirus, and some hair-raisingly bad economic data.
- Consensus forecasts project a strong global economic recovery into next year, but the depth of this year’s slump means that economic activity is expected to stagnate – or even contract.
- Decisions on asset allocation should be extended to include a widening range of new alternative data that incorporates the now-essential analysis of the coronavirus pandemic.
The second half of 2020 could be a truly memorable period in financial markets if it ends up being more dramatic than the first six months of the year. The worst-ever first quarter (Q1) for global equity markets has been followed by the best quarter since 2009 and a broad-based rally in all the major asset classes. Multi-asset investors who held their nerve during the March meltdown will have reached the middle of the year having likely recovered most of the hefty mark-to-market losses they were facing back then.
Focus shifting back to fundamentals
The Q1 sell-off was all about the coronavirus outbreak — the Q2 market recovery was all about the policy response. The breadth, size and coordination of policies unveiled by central banks and governments was truly impressive. For example, the US Federal Reserve alone bought over US$3 trillion of assets, including taking its first steps into the corporate bond market. The scale of the policy response helped to give investors the confidence to look through both the continued spread of COVID-19 and some hair-raisingly bad economic data. With policy innovations beginning to slow down after a frantic few months, market sentiment is shifting back to fundamentals. These days this means looking at developments on the coronavirus front as much as the usual focus on corporate results and economic data.
At the mid-year stage, the global economy seems to be making its widely anticipated transition from a Q2 collapse to a Q3 recovery. While coronavirus-related complications are going to keep that recovery uneven and unpredictable, it would be a great surprise if economic data did not continue to improve over the next few months as major economies ease lockdown restrictions. However, this view is fairly consensual and is probably already well priced into financial markets, which means that the big challenge facing investors in Q3 will be evaluating the nature of the economic expansion beyond the initial reopening rebound.
Three lost years
At face value, consensus forecasts project a strong recovery in the global economy into next year, with major developed economies looking set to enjoy growth rates in 2021 that would be the strongest seen in decades. However, the depth of this year’s slump means that economic activity in most of these economies is expected to stagnate or even to contract over the three-year period spanning 2020 to 2022 (see Exhibit 1). Even by the end of 2022, unemployment rates in most of the major economies are expected to be significantly higher than where they were at the start of this year.
Exhibit 1: consensus forecasts for real GDP growth (%)
Source: Bloomberg, Janus Henderson Investors, 2 July 2020.
Of course, making economic predictions through the fog of COVID-19 is even more challenging than usual. While it is encouraging that the global recovery now appears to be underway, the risks to forecasts still seem to be skewed to the downside. It is easier to think of ways in which the difficulties of living in the coronavirus era could hamper the recovery than it is to imagine such concerns quickly disappearing.
Social distancing requirements are an obstacle to activity across many sectors of the economy and consumer confidence might be hard to revive amid the prevailing health concerns, barring a surprisingly quick development of an effective vaccine. While governments are likely to deliver further fiscal stimulus programmes later in the year, there is a risk of a negative jolt to consumer and business confidence before then as temporary support initiatives, such as job furlough schemes, are wound down. The ongoing negotiations about a summer fiscal package in the US will be an important test of this theme.
The COVID-19 era
Although monetary and fiscal policy interventions have effectively cushioned the market and economic impact of the coronavirus so far, central banks and governments are unlikely to be able to alter the fact that the evolution of the pandemic will probably define the shape of the economic recovery from here on. As Q3 begins, headline indicators remain troublesome (see Exhibit 2). The number of total global cases has doubled since mid-May, as the virus continues to surge though Africa, Latin America, the Middle East and some parts of Asia and the US.
Exhibit 2: global infection rates continue to rise
Source:OurWorldInData.org, 31 December to 2 July 2020. https://slides.ourworldindata.org/2020_pandemic/2020_pandemic#/25
Right now, we see a wide range of outcomes for the coronavirus pandemic and its economic impact. Optimistic scenarios focus on the extent to which the virus has been brought under control in former hotspots such as China, other developed Asian countries, Europe and the New York tri-state area. A constructive interpretation of these developments would be that the virus can be relatively well controlled through social distancing, sheltering of the vulnerable and the introduction of ‘test-and-trace’ programmes. Optimists will also highlight that in many developed economies, the spread of COVID-19 is becoming increasingly concentrated among socially mobile young people, which should mean that each case of infection is less dangerous than a few months ago.
While many of these themes have plenty of support in the scientific community, none yet have widespread endorsement. There is still a broad range of opinion among epidemiologists about many of the key characteristics of the coronavirus and plenty of support for more ominous theories as well. More pessimistic views focus on the stubbornness of the spread of COVID-19 in poorly-resourced emerging economies, the speed at which the virus has flared up as the US has re-opened its economy and the general challenge of getting people to maintain the behavioural changes required to keep the virus in check. Even more troubling themes surround questions about the persistence of any acquired antibody immunity, which raise doubts about the concept of herd immunity and the potential for a COVID-19 vaccine.
A long war seems inevitable
The situation remains very fluid and views, including our own, are continually evolving as the data flow in. At this stage, we are swayed by the evidence that greater public awareness and social distancing can be effective in containing the spread of the virus, as experienced in many countries so far. However, the evidence also suggests that the virus spreads very effectively when the appropriate measures are not in place. Some countries seem to have won the battle with the first wave of COVID-19, but given that less than 10% of people across the developed world appear to have contracted the virus, and a vaccine is unlikely to be widely available within a year, a long war against the coronavirus seems a reasonable central scenario.
So, we enter the second half of the year facing a fairly complicated market backdrop, expecting a strong but transient rebound in growth, followed by months or even years in which health issues will be a major driver of economic and market outcomes. In this unfamiliar environment, traditional market metrics and cyclical rules of thumb will be less useful than usual. Decisions on asset allocation should be extended to include a widening range of new alternative data that incorporates the now-essential analysis of the coronavirus pandemic.
Expensive and crowded versus cheap and volatile
In broad terms, investors now seem to face the difficult choice between expensive and crowded assets or cheap and volatile ones. The first group includes: government bonds, investment grade corporate bonds, gold and equities that have either defensive or secular growth characteristics. The unifying characteristics of this group are that they are typically very sensitive to interest rates and usually perform well in an environment of slowing growth and inflation. These assets have enjoyed strong inflows in recent months, reflecting investor confidence in central bank dovishness and distrust of the economic recovery. While coronavirus concerns persist, we still see an important role for these assets in multi-asset portfolios, but our enthusiasm is somewhat tempered by the fact that the risk-return outlook is less attractive than it was a few months ago, after a period of strong performance.
The other group includes assets that are typically more sensitive to the economic cycle, such as cyclical commodities, emerging market equities, shares in smaller companies and ‘value’ stocks. These assets have generally underperformed in 2020 and have typically been the most volatile areas of the market in the coronavirus era. We see scope for bouts of outperformance from these sorts of assets in the months ahead as the recovery becomes more visible. However, a sustained upswing in consensus growth or inflation expectations should be needed to support a more enduring rotation of market leadership in this direction. To that extent, these assets remain highly sensitive to investor opinion on the outlook for COVID-19.
While we hope that the second half of 2020 will not be as wild a ride as the first half for financial markets, we nevertheless expect it to remain bumpy. Investors are likely to be edgy and reactive in a financial landscape for which they have no roadmap and little confidence about what lies around the next corner. As market participants struggle to evaluate potentially conflicting signals on both the coronavirus and the economic outlook, we expect to see occasional big swings in sentiment and market leadership. While buy-and-hold investing can be an efficient strategy in low volatility and trending markets, we believe that high volatility regimes like this will both demand and reward a more active approach to asset allocation.