We recently wrote about the tactical active asset allocation decisions made by our model portfolio team during our March and April meetings amid the multidimensional uncertainty brought on by the COVID-19 health crisis. We provide an update on our key asset class views here, as discussed during our latest meeting on May 11.
Overall, our view on the impact of COVID-19 on economic growth has not changed. We continue to expect improved economic growth in the second half of 2020 and into 2021. Given the unprecedented amount of stimulus introduced to improve the functioning of markets and provide stopgap funding in many economies, the recovery should be well supported. We need to be mindful of signs of a possible second wave of infections in countries that have eased confinement guidelines—such as China, Germany and South Korea—to understand how that may impact policy if governments determine that economies may be reopening too quickly and the resulting regulatory response. Further, while developments in the treatment of COVID-19 have progressed, this will be a very fluid process, and at this point, there appear to be few definitive advances. In our view, this indicates an increased risk for prolonged social distancing measures, which would pose incremental negative consequences for economic growth and markets.
Markets have shown significant resilience and have bounced significantly from their lows in March. As we look forward, it raises the question of “too much, too soon” and the path ahead. To help frame that, we look to understand investor risk sentiment. Our Market Regime Indicator (MRI) is a tool that looks at implied volatility in equity and currency markets and at spreads on risky debt to give a global, multi-asset perspective on how investors are pricing risk. This indicator had been elevated to extremes, which is a positive contrarian indicator for us. But recently, the MRI retreated to a high-risk regime. In some respects, this can be viewed as an encouraging development, as equity and currency market implied volatilities have dropped and credit spreads have tightened. The still-elevated MRI reading, however, suggests that global equity markets are more vulnerable to shocks than usual and may still give investors a bumpy ride.
Key asset class views: Becoming much less constructive on global equities
Our models have become much less constructive on global equities. Valuation is a notable driver, as strong price returns and weakening earnings have combined to create stretched readings. In addition, the steep decline in economic activity has depressed earnings sentiment, with both top-and bottom-line forecasts seeing downward adjustments. While the drop in earnings expectations is not a surprise, and we have been adjusting qualitatively, expectations are that this will continue and struggle to support the price multiples in equities. What’s more, the strength in the recent April rally indicates the potential for a price reversal, which is also pressuring equity forecasts. Specifically, European and US small caps are challenged by weak medium-term momentum indicators, as investors worry that these segments may be more impacted by weak economic growth, given their higher leverage profiles. In particular, US small caps have return forecasts similar to those of other equity segments but are more vulnerable to the impact of social restrictions on their business models, and they come with higher risk.
The prospects for REITs continue to deteriorate, as recent underperformance weighs on momentum and relatively poor and declining expectations for sales and earnings drag on sentiment. In addition, record unemployment and restrictive social distancing guidelines continue to stifle demand as the retail, hospitality and food services industries remain under extreme duress. Added to these factors is a consumer demand shift to online shopping, which is likely to materially impact cash flows and dividends for REITs in 2020.
Credit valuations are more attractive, with our models anticipating slight spread tightening driven, in part, by an overall lower level of interest rates. Credit risk premia on corporate bonds provides an attractive incremental return, but with less risk than equity. Furthermore, while earnings pressure could impact dividends for equities, bond cash flows are more insulated. Finally, while some factors appear less favorable, such as seasonality and elevated volatility, the Federal Reserve backstop provides important direct support for segments of the credit markets.
Directional and relative value trades reflect near-term risks for equities
With this information in mind, the team meaningfully reduced risk assets (-4%) to a net underweight position while deploying proceeds into investment-grade credit and high yield bonds (+4%). Our decision was driven by heightened levels of risk aversion, deteriorating equity forecasts, and concerns over economies reopening too quickly.