While CBs engaged in unconventional policies on both occasions – now and in 2009 – this time the valuations are so extreme that a bull market driven by multiples expansion seems unlikely. |
Equities: a bear rally or a meaningful rebound?The big question we are debating is: should we raise the allocation to equities and chase the market rally or not? While we maintain our strategic preference for risky assets, we are convinced it is tactically safer to stay in the IG space (supported by central bank umbrellas) given that we believe a relapse in equities is due, as explained below. The economic backdrop has rapidly deteriorated: both hard data and economic momentum have reversed, hurting risk sentiment. We recognise that the medium-term recovery scenario that will probably play out later in 2021 provides significant potential upside. However, equity markets are anticipating the upside scenario now, at a time when profound uncertainties persist. These uncertainties relate to health care policies around treatments. While testing and vaccine are on a fast learning track, a lot still needs to be done. There is no clarity on a timeline for availability of a treatment or a potential vaccine. On the fiscal side, full capacity has to be tested and maintained in the medium term: the speed of implementation is choppy, spending quality still needs to be assessed (in terms of composition and targets), and capacity (of fiscal packages) to recover from the damage has not been fully estimated. On the other hand, central banks – after having dealt with the 2008 financial crisis – were quick to respond this time and allowed financial conditions to ease, particularly in the US. This was the most convincing factor for the markets to move higher and multiples to expand. This is where we detect the dangerous inconsistency of falling earnings per share generation and total returns moving higher. Conversely, bond yields and oil prices remain depressed, and the rebound has not benefitted cyclical areas that much. Earnings revisions are pointing sharply down to historical lows, pushing P/E ratios back towards their peaks. The chart below explains our rationale for current caution. In 2009, we saw a profit recession and central bank efforts paved the way for a full asset reflation regime to play out. Today, valuations (P/E percentiles for 2020 earnings) are completely different, with all the major equity indices already at peak. In fact, an MSCI US valued in the 84th percentile (in the blue bubble) may not offer the best possible case for upside. This is the major difference between the situation now and in 2009. In the latter case, P/Es were already in their low percentiles (grey bubble) and the unconventional monetary policies of central banks allowed upward movement in equities. The only exception to this is the TOPIX, which is in a lower percentile now and shows more reasonable valuations. One could argue that this is because Japan is already in a recession, but compared to other advanced economies, a later but smaller shock is likely, with Covid-19 outbreak being largely contained. The unprecedented lockdowns and monetary and fiscal policy responses help us maintain our ‘strategic’ preference for risky assets, but high valuations don’t provide the best possible upside. To close, we would say that unconventional monetary policies have once again reflated asset prices. However, when compared with 2009, current earnings per share are depressed and P/E levels are so extreme that a bull market driven by multiples expansion is unlikely. 
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We maintain our defensive stance on equities; positive view on credit and on peripheral bonds as supported by Central Banks action |
Manage risk dynamically; avoid following the bullsThe economic backdrop is characterised by global recession and sequential slowdown, followed by de-synchronised recovery paths across countries. The length of the weakness, the extent of permanent output loss, and of demand destruction will depend on the duration of lockdowns and the effectiveness of the fiscal/monetary push. We confirm the scenario of growth stabilisation around Q4 2020. Throughout the crisis, we have focussed on active management of risk exposure – protecting credit positions, keeping hedges in place, and prioritising quality of holdings and credit selection. High conviction ideasWe remain defensive on European and US equities because of tight valuations and ambiguity regarding the impact of Covid-19 on global growth. The consensus for 2020 earnings growth has corrected, but it still remains too optimistic for 2021, in our view, despite low visibility. In an environment in which risk remains clearly tilted towards the downside, we wait for markets to provide better entry points (the 2650-2700 level is the trigger for the S&P 500) to act and change our current stance. We maintain a neutral view on EM as market volatility remains high, but continue to prefer China, South Korea and Taiwan due to strong stimulus and relatively better containment of the virus. We have a neutral stance on duration, as we believe central banks will aim to keep the cost of public debt low to support governments’ fiscal needs, leading range-bound movement in for yields. A Treasury yield of around 60 bps is consistent with the Fed’s stance and a sharp worsening of the macro picture. We remain constructive on US 5Y vs Germany 5Y, as USTs should benefit from safe-haven flows (although to a lower extent than in the past) and Fed purchases, especially in short- to medium-term segments. Regarding US inflation, we are now positive on a medium-term perspective and believe inflation swaps and TIPS breakevens are trading well below their historical averages. As we exit the pandemic, reflationary forces, such as deglobalisation and debt monetisation, should support higher inflation risk premiums and demand for inflation protection. The search for yield continues on the Italian curve, as it offers relatively attractive yields. We maintain our constructive stance on Italy 30Y vs Germany 30Y and are now positive even on Italy 10Y BTPs, as ECB actions are helping to put a ceiling on yields and spread volatility. The German court ruling represents a downside risk; however, the ECB is unlikely to change course. We maintain our stance, as it could provide balance to investors’ portfolios. With a focus on liquidity, we are still constructive on credit, supported by CB umbrellas in the US and the Euro area, but we prefer IG to HY. EUR HY could suffer from high default rates and slowing top-line growth. Accordingly, we are very defensive. Given the high uncertainty and divergence of fundamentals and valuations, we have a neutral view on EM debt and see a gap between IG and HY countries. In external debt, the IG sector should remain more resilient in the coming months. HY, however, presents a binary risk/tradeoff between default risk for distressed countries and a catch-up from very depressed valuations. On local rates, the main driver for debt is the currency exposure and we believe room for further compression is limited. On DM FX, we are no longer constructive on the EUR/CHF, owing to safe-haven status of the franc, high money supply growth in the Euro area, and the German court ruling which could pressurise the EUR. We maintain the NOK/EUR position, as the Krone has already corrected significantly and is a way to benefit from a more optimistic scenario. Risks and hedgingHedging instruments in the form of the JPY, derivatives and gold remain key to protect portfolio returns in this phase of high uncertainty. |
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We look for market dislocations and also strive to stay away from names that won’t withstand this crisis. This is even more important as the BBB market share has increased substantially |
Credit quality is keyOver the past month, we have seen a gradual improvement in market conditions after massive price and liquidity dislocation in March, but we are still not back to normal. Investors should remain cautious, continue to maintain sufficient liquidity, and be mindful of potential rating migration which could cause volatility in credit markets. On the other hand, they should try to make tactical adjustments in order to benefit from market events – for instance, if there are attractive issues in the primary market – without changing strategic convictions. Global and European fixed incomeWe have an overall neutral stance on duration, with a constructive view on the US and cautious ones on Japan and Germany. Investors can take advantage of yield curve movements (curve flattening in US, Europe, UK; steepening in Japan). While we remain positive on Euro peripheral debt, we are more cautious but still constructive on Italy (strong investor appetite as €22 billion raised recently through BTPs). Concerns on German court ruling and increased debt burden are balanced by Franco-German proposal for a sort of ‘recovery fund’. On credit, US IG (we recently became more positive on this segment) and EUR IG remain well supported by CB actions, but credit selection and quality are important to distinguish issuers who will make it through the crisis vs those that will become insolvent. We like subordinated financials, telecoms, pharmaceuticals and insurance, but are cautious on US energy. Bond issuance in the US has been concentrated in IG borrowers and on BB-rated corporates (Fed’s decision to include fallen angels and HY ETFs in its programme). We have confidence in BB sector, but search for qualityis key here. Activity in US HY has resumed (demand exceeded supply) but activity is muted in Europe. However, investors should exercise caution. US fixed incomeSecurities and sectors with limited prospects for price appreciation, such as insurance-linked securities (which have delivered 2% returns YTD) and AAA consumer and commercial real estate securitisations, have been resilient and may provide opportunities to serve as funding sources for long-duration IG corporates and some HY credit at deep discounts. We remain positive on RMBS outside of the AAA-rated tranches, as their spreads grind tighter but are overly discounted. Being careful to maintain adequate liquidity, investors should hold positions in UST, TIPS and US government agency mortgage bonds, and cash. In addition, this is a time to consciously pare back idiosyncratic risk when liquidity and pricing afford opportunities. Spread tightening in leveraged loans may enable investors to exit BB names at prices near par, and improve liquidity and quality while extending credit duration. EM bondsWe are mindful that the Covid-19 crisis is weighing on global growth and corporate earnings, with negative effects on EM outlook, pushing many countries into recession. We have been cautious on names dependent on exports, commodities and tourism. Portfolio hedges and liquidity remain important. On HC, we are positive, particularly on HY (Ukraine). There are opportunities in primary market to gain exposure to IG names at discounted levels (Mexico). We are cautiously constructive on local rates in Mexico and South Africa, and positive on Russia. FXIn DM FX, we are positive on the USD and JPY, given their safe-haven status, and are less negative now on the CHF but cautious on the EUR and GBP. On EM FX, we are defensive. 
GFI= Global Fixed Income, EM FX = Emerging markets foreign exchange, HY = High yield, IG = Investment grade, CHF = Swiss Franc, EUR = Euro, USD = US dollar, UST = US Treasuries, RMBS = Residential Mortgage Backed Securities, ABS = Asset Backed Securities, HC = Hard currency, LC = Local currency, TIPS = Treasury Inflation-Protected Security, GFC = Global Financial Crisis of 2008, JPY = Japanese yen. |
Dividends are now likely to be pro-cyclical because they will reflect the environment in which companies operate, as the latter will be accountable not only to shareholders but also to society 
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Low earnings visibility calls for cautionOverall assessmentAs governments ease lockdown measures and the world gradually moves out of the Covid-19 crisis, we are likely to see ballooning government debt, low interest rates and economic growth, a rise in the importance of ESG (especially the S factor), growing inequality, political fragmentation and increased geopolitical tensions (US-China, EU unity). We observe a stark contrast between ‘market sentiment’ and ‘economic fundamentals’. While it is important to note that policymakers can provide short-term liquidity, the demand recovery also depends on fear and confidence. This in turn could still impact earnings and long-term corporate solvency. Investors are forced to navigate this situation with exceptionally low forward visibility in an environment with potentially a wide range of outcomes. European EquitiesOverall we urge caution, given the heightened level of uncertainty and deteriorating fundamentals. It is crucial to maintain process discipline, focus on stock selection, and ensure appropriate liquidity levels. We continue to favour balance sheet strength and believe investors should balance near-term risks with medium-term opportunities through extensive use of scenario analysis. Opportunities exist and we suggest investors to apply barbell strategy with exposure to attractive stocks in the defensive sectors (utilities, health care, consumer staples) on the one end and non-disrupted and discounted cyclical sectors (luxury, construction) on the other. In addition, identifying some structural winners in some accelerating trends, such as e-commerce, will be key in generating long-term returns. From a style perspective, there are selective opportunities within value in non-disrupted cyclical areas. US equitiesUS equities remain one of the best long-term asset classes in the world, and the outperformance continues to build in these conditions. We expect the market consolidation that started in mid-April to continue. In terms of convictions, we believe the winners will continue to win. Investors should avoid the sector/stocks that are under extreme short-term pressure, including airlines, challenged retailers, cruise lines, high fixed-cost and low-margin businesses, and commercial real estate. Instead, we think investors should focus on sector leaders with sustainable businesses in an ESG integrated approach. This approach proved to be right during the correction and we recommend investors continue to follow this path. Sustainable companies with market-leading positions win when market conditions are tough. Now is also a time for investors to marginally start adding cyclicality to their portfolios, as low volatility is overpriced. At a sector level, we prefer financials, communications services and industrials while we are cautious on consumer staples, utilities and materials. EM equitiesWe are focusing on countries at a later stage of the coronavirus cycle (China, Taiwan, Korea) and less vulnerable names within stories of resilient domestic growth and progress in structural reforms (EMEA, India). While there could be headwinds as global uncertainties remain, skillful bottom-up selection, a careful top-down assessment, and liquidity management can help investors weather the current storm. In conclusion, although we prefer to maintain an overall cautious stance for the time being, our outlook is constructive for EM assets in the medium term – as long as the risk of a second wave of infection does not materialise. 
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