H2 2020 Investment Outlook - Investing during a de-freezing cycle

Letter from the CIOs

The Covid-19 crisis drove the global economy into an unprecedented deep freeze in the first half of 2020. The combination of monetary and fiscal stimulus will help the global economy de-freeze in H2. As was the case with the virus cycle, the recovery will be sequential and involve different regions at different times - on a ‘first in, first out’ basis - and will depend on the size of the policy response. As the global economy gradually de-freezes, investors will turn their focus back to geopolitics. The climax will be the US presidential election – the outcome of which appears increasingly open. It will influence the US vs. China dispute, which will shift from trade to technology and healthcare supremacy – and more broadly -- the new geopolitical order and the role of Europe within it. In Europe, we are monitoring the budgetary process and the recovery plan. This could redesign the future of Europe towards more sustainable and equal growth, the upcoming end of Merkel’s political era, Brexit and the response of the ECB to the German constitutional court, due in August. 

For financial markets, this extraordinary year has been the story of the interconnection between the three cycles (pandemic, economic and financial cycle). With the flattening of the contagion curve, markets have started to price in the effects of unlimited policy action and of a subsequent economic recovery. Risk assets have recovered too much and too quickly in our view: discounting an immediate return to normality at a time when many painful adjustments in the real economy and the corporate sector need to be made. In the second part of the year, a reality check on earnings growth has to be considered. Investors should be aware that the cycle remains fragile and could be derailed by many factors, such as the risk of a second pandemic wave, high debt, geopolitical risk and expensive valuations in some equity segments. These elements will keep volatility high. As such, investors should not jump blindly into aggressive assets, but instead keep a moderate exposure to those assets, playing relative-value themes and dislocations that could benefit from the de-freezing of the economic cycle.

We see four themes for H2:

• Search for yield in good quality credit, EM debt, illiquid assets. On the yield-hunting front, H2 will open on a better starting point than H1 for investors, as valuations are now slightly more attractive in both the credit and EM space, and central banks (CBs) will be a key element of support. Balance sheet resilience and quality of assets will make all the difference and investors should be highly selective.

• In equities, remain cautious and play the rotation towards cyclical and new structural themes. As the economic recovery unfolds, the equity recovery will likely broaden towards cyclical sectors, small caps and value. The sustainability of balance sheets and of business models will remain a key element of discrimination. Once the catch-up of the cyclical part of the market is exhausted, the focus will return to earnings, and this could become a moment of truth, with some volatility returning to the market. We believe the Covid-19 crisis will also accelerate some structural themes such as digitalisation, medi-tech, e-learning/education and infrastructure investing with a green focus, and that this could provide long-term opportunities to investors.

• In EM equities, it is a ‘first in, first out’ story. The Covid-19 crisis will further exacerbate the differences between EMs, with some more resilient to the crisis than those with external vulnerabilities, high debt and limited policy room. China and Asia are the main candidates to exploit the road to recovery. With globalisation under threat, the relocation of supply chains and the domestic demand engine theme will be further reinforced.

• ESG more and more mainstream. ESG investing has proven resilient during the crisis, attracting flows both on the passive and active side. The pre-existing trends will remain at the forefront, with a dominance of climate-related themes, but with a rising relevance of the ‘S’ pillar and increasing attention on long-term societal issues. From an investment perspective, we see a progressive shift from a ESG-static rating approach (investing in the ESG leaders of today) to a “dynamic improvers” concept, towards companies that can embrace a virtuous path in ESG.