Brooks Macdonald Asset Allocation Overview - July 2020
The health and economic effects of the Coronavirus pandemic (also referred to as COVID-19) are already immense but investors need to assess how long they will last. Will the economy bounce back quickly, or will the damage last for a longer period of time?
As many economies take their first steps towards reopening, there has been considerable debate on recovery paths, from V shaped to U-shaped and more in between. With a V-shaped recovery, the economy will bounce back quickly to its baseline before the crisis. This is one of the most optimistic recovery patterns because it suggests that the downturn did not cause any lasting damage to the economy. Under a U-shaped scenario, the economic damage lasts for a longer period of time before eventually reaching the baseline level of growth again.
In thinking about the likely shapes for both an economic recovery and a financial market recovery, in the first quarter of 2020, we said that it was possible we could see both a U and a V at the same time. That is to say, while the underlying economy might take a longer time to see a recovery come through, we felt that financial markets could see a much faster improvement in risk appetite, turbo-charged by the unprecedented pace and scale of monetary and fiscal policy accommodation. The second quarter was an opportunity for this story to play out, with weaker economic data coming through as expected on the one hand, but with a stronger appetite for market risk on the other.
In June, the US National Bureau of Economic Research provided data showing that the longest-running US economic expansion in history (from June 2009 to February 2020) had come to an abrupt end. While economic and market fundamentals had on the whole been supportive prior to the Coronavirus, the global pandemic was enough to curtail continued growth. At the same time, policy makers around the world have pledged unprecedented levels of monetary and fiscal stimulus, with both central banks and governments encouraging markets to look further out along their investment horizons. With interest rates close to zero, the ‘opportunity cost’ of forgoing near-term earnings in favour of longer-term growth falls. So far in 2020, this has benefitted companies in ‘growth’ sectors such as technology and healthcare.
As was the case before the Coronavirus pandemic, we continue to observe a significant difference between the expected earnings yields available on equities compared to that available on government bonds. There has been a sharp rise to over $5 trillion in US money market funds as at the end of May1, around a quarter of US GDP in 2019, some of which represents investors keeping cash on the sidelines. However, the question remains, if those investors in this position choose to move back into risk assets, will they choose to buy US Treasuries where ten year benchmark bonds are yielding less than 1%, or will they be tempted to look at equities where, for example, the expected 12-month forward earnings yield (the inverse of the price to earnings ratio) for US equities is over 4%. While this earnings yield gap between equities and government bonds does not determine the near-term direction of markets, it offers a longer-term roadmap as to how we might continue to position our asset allocation.
Our top investment risks
The COVID-19 pandemic continues to dominate our list of top investment risks. We stay alert to any rise in daily new case growth numbers, as well as the risk of a secondary infection wave, as economies attempt to emerge from their virus-induced lockdowns.
US-China relations and US domestic politics are becoming more closely intertwined as we approach the US Presidential elections on 3 November. The progress following the Phase One agreement is at risk should US politicians see China as an easy target for votes and a cynical distraction from domestic issues.
As the shock and awe from the huge monetary and fiscal policy accommodation is likely to outlast the virus, inflation expectations will be closely watched. Any rise in expectations for medium-term inflation could curtail central banks’ room for manoeuvre.
Eurozone tensions between a coordinated monetary and fiscal policy response to COVID-19 has exposed the region’s structural weaknesses. As EU leaders continue to debate a region-wide solution, this risks a rise in political tensions between northern and southern member states.
As the UK-EU transition clock continues to count down to its unchanged 31 December 2020 deadline, tail-risks remain of talks failing, which could lead to an increased risk of the UK and EU moving to adopt World Trade Organisation (WTO) rules on trade.
OPEC+* in April put in place a hard-fought production cut of close to 10 million barrels per day, equal to around a tenth of daily global supply in 2019. While this cut is expected to gradually ease in the coming months, should member compliance fray, it could leave the oil price vulnerable in the months ahead.
*Past performance is not a reliable indicator of future results. Investors may not get back the same amount invested.
1. US Office of Financial Research (OFR), US Department of the Treasury. Data to 31 May 2020.
* OPEC+ = group of oil-producing nations made up of the members of the Organization of the Petroleum Exporting Countries (OPEC) as well as certain non-OPEC countries including Russia.
| Outlook |
|---|
| + Positive Outlook | = Neutral Outlook | - Negative Outlook |
| Change |
|---|
| ↑ Raised Outlook | ↓ Lowered Outlook |
| Asset Class | Outlook | Change | Rationale |
|---|---|---|---|
| Equities | |||
| UK | = | Post EU-secession, we continue to see political risks around the transition period and future trading-relationship. The focus on COVID-19 has shortened the remaining time left for the UK and EU to secure a deal by the current deadline of 31 December 2020, providing for an uncertain sterling currency outlook. Relative valuation attractions remain alongside an accommodative fiscal and monetary backdrop. This has supported the reduction in the scale of our underweight position earlier in the year. | |
| US | + | With Joe Biden the only remaining Democrat Presidential nominee, voters have coalesced around a centrist candidate rather than risk a lurch to the left of the party which had been feared by markets. Despite COVID-19 upsetting the narrative of a resilient domestic economy, markets have nonetheless been encouraged to look through the current pandemic given the scale of the policy response. While equity valuations have recovered, the US continues to offer exposure towards our preferred technology and healthcare themes. | |
| Developed Europe (ex UK) | - | The COVID-19 pandemic has exposed the structural tensions in achieving joined-up EU monetary and fiscal policy responses. Despite the risks to the Eurozone economy, the more fiscally prudent Northern countries continue to frustrate Southern members’ hopes for a mutualisation of EU member debt. While a solution may ultimately be found, any disappointment in pace and scale could hamper the speed of the economic recovery that the region might otherwise see, and risk underperforming other regions globally. | |
| Japan | = | Despite the challenges that COVID-19 presents, policy makers are judged to have limited room for monetary and fiscal policy manoeuvre, with Japan’s public debt to GDP estimated by the IMF this year to exceed 250%. Against the stimulus provided to support the economy from COVID-19, this followed a tightening in fiscal policy with the increase in sales tax last year. However, these concerns are already reflected in relatively low valuations. Further, when it comes, the recovery in global growth expectations and trade should be a support to Japan’s export economy. | |
| Far East | + | China has laid an ambitious roadmap for restarting its economy after COVID-19, supported by the National People’s Congress in May, where policy makers delivered a carefully choreographed fiscal and monetary policy coordination. Markets will hope that the quicker than expected restarting of China’s economy, supporting neighbouring Asian countries in turn, can be a blueprint for others globally. Far East equity valuations continue to be attractive relative to other regions and countries globally. | |
| Emerging Markets | = | Emerging-market equity valuations are attractive relative to their developed-world counterparts, but while some emerging countries are able to support their economies through COVID-19 with stimulus, other countries are seeing less success in containing the virus. While expectations have started to focus on the potential for global stimulus to in turn support a possible reflationary narrative, the evidence of a sustained improvement in this regard is not yet clear. We consider an active investment approach essential. | |
| Equity Themes | |||
| Technology | + | The current economic backdrop continues to be supportive of growth assets. Post the pandemic, as before, we see long-term growth from technology’s ability to identify, enter and disrupt new markets, creating new revenue streams and barriers to entry. We also see the after-effects of the COVID-19 pandemic creating opportunities for the technology sector’s continued constructive performance, as economies seek to build and improve their resilience to future economic and societal shocks. | |
| Healthcare | + | ↑ | With Joe Biden as the presumptive Democratic Presidential candidate, the risks for wholesale reform of US drug pricing that had been feared under other more radical Democratic contenders has softened. In addition, as economies emerge from the COVID-19 pandemic, the challenge to western health-care systems geared toward elective care procedures also improves. Healthcare assets are beneficiaries of long-term structural demographic trends, and with sector valuations at a modest discount to the wider market, this supports a positive outlook. |
| Fixed Income | |||
| UK Sovereign | = | Gilts will continue to benefit from episodes of politically-driven risk aversion, or bouts of economic weakness such as COVID-19. However, yields are low reflecting the current policy accommodation backdrop. | |
| UK Credit | = | With the support that the Bank of England, alongside central banks globally, are providing to the corporate credit market, we have a preference for investment grade corporate credit within UK fixed income exposures. | |
| International Sovereign | = | International sovereign bonds are benefitting from the global co-ordinated shift towards more supportive monetary policy. However, yields are low relative to equities. | |
| International Credit | = | As policy makers, including notably the US Federal Reserve (Fed), take bold steps to support their corporate credit markets, so the risk-reward opportunity in this sector has become more constructive. We would continue to distinguish between investment grade and speculative ‘high-yield’ grade debt however, where the latter risks continue to outweigh the positives. | |
| Emerging Market Debt | - | Just as the COVID-19 pandemic has driven a rise in governments’ public debt globally, some emerging market countries are judged to have less room for manoeuvre in terms of supporting an effective healthcare and economic response, and consequent recovery. Alongside the impact to the near-term global growth outlook, this could have adverse implications for cyclically sensitive emerging market economies in particular. We consider an active investment approach essential. | |
| Alternatives | |||
| Convertibles | + | Convertibles can provide an attractive combination of bond-like downside protection and equity-like upside. The recent record levels of issuance seen so far this year, as corporates seek to bolster their balance sheets, is providing a supportive investment environment in terms of both breadth and liquidity. | |
| Property | - | While political uncertainty has fallen following the UK General Election, removing a headwind for UK commercial property, we continue to hold concerns over the liquidity of open-ended collective investments in the sector. Further, as a result of COVID-19, the pandemic has arguably only served to accelerate some of the existing structural challenges facing the sector. | |
| Structured Investments | = | Structured investments can provide superior yields to bonds and can have low correlation of returns relative to equities. However, we recognise that the returns provided by auto-calls can become more correlated with equities if markets suffer a significant correction, as we have seen during the COVID-19 pandemic induced market volatility. | |
| Currencies | |||
| US Dollar | The US Dollar appears finely balanced. Despite the Fed cutting interest rates towards the zero lower-bound earlier this year the US Dollar currency has continued to find some support as markets have sought out its safe-haven status as risks around US-China trade or pandemic second wave spikes have threatened. However, as economies emerge from the shadow of COVID-19, markets are watching to see if the global stimulus and money supply growth from the Fed in particular might lead to a muted or even weaker dollar outlook. | ||
| Euro | Despite the economic risks from COVID-19, while the European Central Bank has stretched the boundaries of its mandate, there is a lack of coordination between monetary and fiscal policy. Should the EU27 members deliver a region-wide government spending plan, this could boost growth expectations and the Euro, but Northern EU member states continue to be reluctant to support broader EU debt mutualisation. The currency also faces domestic sentiment headwinds, not least from Italy, given its fragile coalition government. | ||
| Yen | The Yen has seen a modest strengthening this year alongside lower interest rate differentials such as between the US. Against this, Japanese policymakers will be keen to keep the yen weak to support the country’s large export sector, particularly with confidence already impacted from the COVID-19 pandemic and the near-term impact to global growth. |
Important information
All data provided by Brooks Macdonald and as of 30 June 2020 unless otherwise stated. Past performance is not a reliable indicator of future results. Investors should be aware that the price of investments and the income from them can go down as well as up and that neither is guaranteed. Investors may not get back the amount invested. Changes in rates of exchange may have an adverse effect on the value, price or income of an investment. Investors should be aware of the additional risks associated with funds investing in emerging or developing markets. The information in this document does not constitute advice or a recommendation and you should not make any investment decisions on the basis of it. This document is for the information of the recipient only and should not be reproduced, copied or made available to others.
The MSCI information may only be used for your internal use, may not be reproduced or re-disseminated in any form and may not be used as a basis for or a component of any financial instruments or products or indices. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. Historical data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI Parties”) expressly disclaims all warranties (including, without limitation, any warranties of originality, accuracy, completeness, timeliness, noninfringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages. (www.msci.com)
Brooks Macdonald Asset Management Limited is regulated by the Financial Conduct Authority. Registered in England No 3417519. Registered office: 21 Lombard Street, EC3V 9AH. Brooks Macdonald Asset Management (International) Limited is licensed and regulated by the Guernsey Financial Services Commission. Its Jersey Branch is licensed and regulated by the Jersey Financial Services Commission. Brooks Macdonald Asset Management (International) Limited is an authorised Financial Services Provider, regulated by the South African Financial Sector Conduct Authority. Registered in Guernsey No 47575. Registered office: First Floor, Royal Chambers, St. Julian’s Avenue, St. Peter Port, Guernsey GY1 2HH.
This article does not constitute advice, should you require advice or further information please contact your usual consultant. Alternatively, you can contact us via telephone on 02476 388 911 or by email to [email protected]. We are available Mon - Thursday 9am - 5pm and Friday 8:30am - 4:30 pm.