A Preference for Taking Risk in the Credit Space ISG “Alpha Meeting” Notes for August 10, 2020

Asset Class Views Summary

We have extended our underweight to equities and shifted to credit within fixed income. We continue to allocate the majority of our risk budget to relative value positions, favoring US large cap within equities and credit over government bonds within fixed income.

Overview

On the global economic front, both manufacturing and service PMIs continue their upward trajectory (with many in expansionary territory), suggesting that economic activity is gradually recovering. What’s more, the recent spike in COVID-19 cases in the US appears to be decelerating as hospitalizations in recent hot spots have peaked and started to decline. So far, COVID-19 appears persistent rather than exhibiting any seasonal patterns, which suggests countries may be able to continue the gradual re-openings with disciplined social distancing guidelines. This may signal that fears of a second wave in the winter months may be exaggerated. Further, the ongoing commitment from central banks and stimulus injections will continue to provide a tailwind for economic growth.

However, some economic indicators have not been as strong, e.g., data on credit and debit card holders suggest that the rebound in US consumer spending has stalled but not yet reversed course. In addition, renewed trade consternation and geopolitical concerns are making headlines. Although the recent spike in COVID19 seems to be abating, the recovery is likely to be choppy and until some form of treatment is widely available, and the potential disruption in demand will overhang markets.

Risk Sentiment

Our Market Regime Indicator (MRI) has continued to abate and has moved into a Normal regime, indicating that investors have become more neutral toward risk sentiment. The move lower was driven by meaningful declines in implied volatility on equities and a decrease in risky debt spreads, which point to further improvement in risk appetite. However, a spike in implied volatility on currencies has kept the full MRI just outside of High Risk, suggesting that myriad risks still weigh on investors’ minds, as well as that global equity markets remain susceptible to shocks.

Directional Trades

We have increased our underweight position to equities while further extending our overweight to credit bonds. A positive macro environment and improving sentiment measures buoy the outlook for equities, but diminishing price momentum and stretched valuations weighed on our forecasts and resulted in a net negative view. We have tempered our positioning somewhat as unprecedented policy support has supported equities – some asset classes have returned to near pre-COVID-19 levels. We continue to prefer taking risk in the credit space, which we believe provides a better risk-adjusted return potential. Impacts from COVID-19 continue to weigh on a number of industries, threatening profits and leaving many equities vulnerable to a correction. Credit bonds represent an opportunity for incremental returns while also providing some downside protection given the relative security of a bond’s coupon payments.

We also initiated an underweight to broad commodities. While broad commodities may benefit from similar reflation themes that support other risk assets, negative roll yields and phased re-openings, which limit how fast economics can recover, suggest greater opportunities elsewhere.

Gold continues to look attractive across most technical and fundamental factors, and we continue to hold an overweight position. While prices have reached elevated levels, negative real yields, rising debt levels, creeping inflation expectations, and strong trend indicators all support an allocation to the precious metal.

Relative Value Trades

Equities

US large-cap equities continue to be well-supported by strong long-term momentum and constructive macro indicators along with positive earnings and sales estimates, which offset weak valuations. While risks of uncertainty from the upcoming US presidential election remain, the US appears to be re-flattening the COVID-19 curve and the trend seems to be improving.

US Sectors: We continue to favor technology, consumer discretionary, and consumer staples sectors. Technology is the top-rated sector, with positive scores across all indicators we consider with the exception of value. In addition, momentum has improved for the sector and quality measures, such as relatively low levels of debt, provide support. Consumer discretionary is ranked second, with strong momentum and sales; improving earnings sentiment also contributes. Consumer staples rounds out the top three. Not surprisingly, staples is a bit more of a mixed picture, with relatively weaker short-term momentum offset by stronger quality and earnings sentiment characteristics.

We continue to see challenges from Pacific equities and have extended our underweight position. While valuations appear to be neutral, poor earnings and sales sentiment, weak price momentum, and a deteriorating macro score dent the outlook for Pacific equities.

The prospects for REITs continue to erode as they rank poorly across all the indicators we consider. Higher financial leverage, negative valuations and weakening earnings, and sales estimates challenge the outlook.

Fixed Income

Credit valuations remain attractive, as our forecast anticipates continued spread tightening for both investment grade and high yield bonds. This is partially driven by a lower cost of capital given historically low interest rates and the prospect for a steepening yield curve as the economic backdrop improves. Strong momentum from equities combined with relatively lower volatility, suggest a beneficial environment for credit bonds going forward. These assets also remain well-supported from a policy standpoint and should benefit from the liquidity being created by central banks (as low government bond yields push investors towards higher yielding instruments). Further, the longer spread duration on long corporate bonds provides diversification to our credit exposure.

We continue to forecast muted absolute and relative returns for government bonds. For the near term, central banks have been clear that rates will be held low for some time. Longer term, the fundamentals project a mixed picture. The continued ascent in PMIs along with current inflation levels is suggestive of higher interest rates, but the significant decrease in GDP growth, eliminating the positive spread between nominal GDP and the yield on 30-year treasuries, advocates for lower rates. As investors start to look past the weaker GDP numbers to improving service and manufacturing indicators, inflation expectations may put upward pressure on longer-dated bonds. But the potential for yield-curve control and continued central bank bond-buying may limit the threat of higher interest rates, keeping expected returns for government bonds subdued.

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