Most economies around the world, with relative success, are in various stages of easing restrictions put in place to counter the Covid-19 outbreak. Still-flattening curves assuaged fears of a second wave after restrictions eased, while more testing and falling positives cases in a number of regions suggests Covid-19 has been contained in some parts of the world, with the exception perhaps of sizeable pockets of Latin America and elsewhere. The race for a vaccine is also encouraging with more than a thousand clinical trials underway, likely accelerating the development period from original forecasts of “at least eighteen months”.
At the same time, demand, including that within services, is picking up. Restaurant reservations are rebounding strongly in places such as Australia and Germany. In the US, the jobs report for May surprised significantly to the upside, while the all-important housing market looks poised for a V-shaped recovery with sales up well above forecasts, and auto sales up too. It is early to say the coast is clear on the economic front, but it is encouraging to see that patterns of demand may not require extensive repair as originally feared.
Despite these encouraging developments, rolling surges in geopolitical risk have seemingly become the norm, most recently reflected (again) in rising tensions between the US and China. Despite the tit-for-tat between Washington and Beijing, we still believe the Phase 1 trade deal will remain in place. US President Donald Trump certainly needs it with the upcoming election, having blown yet another chance to appear presidential during the eruption of riots amid rising racial tensions. Nevertheless, for the near term, the prospects for recovery remain the primary focus and large quantities of stimulus still in savings are awaiting release by pent-up demand.
This month, we introduce our cross asset hierarchies, which describe the team’s cross-asset views at three different levels: (1) growth versus defensive, (2) cross asset within growth and defensive assets, and (3) relative asset views within each asset class, which is the same as before except now with aggregate scores neutralised. The hierarchy levels describe our research and intuition that asset classes behave similarly or disparately in predictable ways, such that cross-asset scoring makes sense and ultimately leads to a more a deliberate and robust portfolio construction.
We marginally favour growth over defensive mainly on the success of economies opening up, which are so far avoiding a second wave of Covid-19 while their activity begins to recover. Meanwhile, central banks continue to provide unprecedented support for the global financial system and markets. Many risks lie ahead, but better news on the back of massive (and growing) fiscal stimulus offer further support for growth assets to continue in their recovery.
On the growth side, we favour selective equity markets where demand is beginning to find support from re-opening economies. We remain cautious on high yield (HY) where there is still elevated risk attributable to damaged balance sheets and cash flows. On the defensive side, we favour credit for better yield support over sovereigns that are vulnerable to improving growth conditions. Risks include policy mistakes and rising geopolitical tensions, mainly US-China, where gold (inflation) is a better hedge on both fronts.
Asset class hierarchy (team view1)
1The asset classes or sectors mentioned herein are a reflection of the portfolio manager’s current view of the investment strategies taken on behalf of the portfolio managed. The research framework is divided into 3 levels of analysis. The scores presented reflect the team’s view of each asset relative to others in its asset class. Scores within each asset class will average to neutral, with the exception of Commodity. These comments should not be constituted as an investment research or recommendation advice. Any prediction, projection or forecast on sectors, the economy and/or the market trends is not necessarily indicative of their future state or likely performances.
Growth assets include equities, alternatives (REITs and infrastructure) and high-yielding assets (HY and Emerging Market [EM] bonds) that are correlated insofar as general notions of risk appetite but with different underlying drivers of risk. Equities follow future prospects of cyclical and secular demand, while alternatives generate more stable returns from the rentier portion of the economy. HY depends on cyclical cash flow prospects while EM bonds generally follow global growth, derivatively connected to the direction of the dollar.
Returning cyclical demand favours equities
Lockdowns are lifting, but no one can be sure when demand will return, given the extent of the economic pause and the unprecedented rise in unemployment. The income shock and persistent Covid-19 fears are likely to impede demand, particularly for services.
In the case of income, fiscal stimulus offered almost a full backstop across the developed world. As economies are coming back online, so are jobs, many of which are simply rehires as companies come out of hibernation. There is also nascent evidence of returning demand. While many risks remain that could derail a steady recovery, we still believe the most compelling case for growth assets is the outsized stimulus where policymakers were almost universally comfortable erring on the side of doing too much than too little.
Chart 1: Non-farm payrolls surprise to the upside
Source: Bloomberg, June 2020
Deflation to reflation?
In mid-2014, when the US Federal Reserve (Fed) was close to ending its asset-purchasing programme, the US dollar rallied aggressively while inflation expectations collapsed. Persistent dollar strength has kept inflation expectations mostly weak over the last six years, marking a new low at the market bottom in late March. The Fed has since unleashed massive asset purchases—dwarfing those during the global financial crisis (GFC) in terms of size and speed—helping to weaken the dollar and lift inflation expectations, albeit modestly.
Chart 2: Dollar pressures may be easing, helping to lift inflation expectations
Source: Bloomberg, June 2020
Fed policy is only one component factoring into the direction of the dollar and inflation expectations, but if one considers the potential for demand returning more quickly than originally feared, sloshing excess liquidity coupled with massive fiscal stimulus could certainly fan the reflation fire.
Conviction views on growth assets
- Prefer equities over growth alternatives: We are mildly in favour of traditional equities assets over growth alternatives, mainly REITs, given their sensitivity to rises in rates and the likely deep negative impact of Covid-19 on various real estate assets. Infrastructure will likely remain more resilient as cash flows remain stable.
- Emerging markets (EM) back in favour: EM assets have struggled for the better part of the last decade, partly for economic imbalances following the GFC, but also because of strong dollar headwinds that have kept liquidity conditions tight. Given the massive stimulus (and a decade of reforms), we see potential for the tide to finally turn in favour of EM, supporting equities, bonds and currencies.
- Secular (quality) growth still attractive: A reflationary environment sometimes supports a rotation out of US equities into the rest of the world. However, the importance of technology and US dominance in the sector keeps us sanguine on earnings prospects in a post-Covid-19 world. Rather, we prefer to fund from Europe that is likely to continue to suffer from broken supply chains.
- Value in Japan, no longer a trap: Japan equities are very inexpensive and while value alone does not offer a buying opportunity in Japan, the all-important yen has finally begun to weaken, lending better earnings support.
- Cautious on high yield: HY is attractive from a valuation perspective, but the asset class remains challenged given the shock to cash flows and predictably rising bankruptcies. Clearly, the outlook improves as demand begins to normalise, but we see better risk-adjusted upside among other growth assets.
While we have become relatively more sanguine on growth assets, defensive assets remain important for portfolio diversification in protecting against downside surprise. First, our case for growth is still nascent and vulnerable to a second wave of Covid-19 or a more stunted version of returning demand. While central bank printing presses are in high gear, such policies are impotent against weak demand.
Still, rates have fallen dramatically across the developed world, making yields not just unattractive but leaving them with limited upside in the event that rates compress further. We prefer defensive assets such as investment grade (IG) corporates and gold, which are likely to do better than sovereigns in a reflationary environment.
China first in, first out
Markets have rightly taken a cue from China in its navigation through Covid-19 as to what the West might expect, from lock-down to containment to the return of growth as containment restrictions eased. China has navigated the journey comparatively well, and growth does indeed seem to be returning, albeit with notable exceptions given the collapse in demand for its exports.
Given the rise in China yields that followed the return of demand, the outlook for global bonds may be challenging if demand similarly recovers, as it seems poised to do. In recent weeks, bond yields across the developed world have also begun to lift on the prospect of returning demand. Chart 3 compares US 10-year yields lagged by 30 days to China 10-year yields, which show a surprising degree of correlation into the crisis and the beginning of the recovery.
Chart 3: US 10Y yields lagged 30 days to China 10Y yields
Source: Bloomberg, June 2020
Importantly, sovereign bonds across the developed world are receiving rigorous support through variations of explicit and implicit yield curve controls that had previously only been employed by the Bank of Japan. However, unlike Japan, economies such as the US are still susceptible to changes in inflation expectations, which have remained flat in Japan for many years.
Conviction views on defensive assets
- Favour credit over sovereigns: We have long preferred IG credit over sovereigns for the yield pick and mostly the same defensive characteristics. Currently, credit is even more attractive for wider spreads that have the potential to compress into a recovery.
- Gold offers better convexity: Lifting rates is a negative for gold, given that any improvement in yield looks more attractive than the negative carry of gold; however, a weaker dollar does lend support to the commodity. As bond yields compress close to zero, convexity begins to flatten whereas gold prices can continue to rise. Lastly, gold is a good hedge against policy mistakes as well as rising geopolitical risks, such as rising US-China tensions.
- Cautious on defensive currencies: We increased our cautious view on USD and JPY in favour of growth currencies, such as emerging markets, on the premise of heavy stimulus and returning growth, which are headwinds for these safe haven currencies.