After hitting YTD lows in late March, risk assets put up a rally over the last month
After hitting their year-to-date lows in late March, risk assets have put up a formidable rally over the last month.
We had earlier on 27 March upgraded our overall view on equities to overweight. Our belief at that juncture was that although it would have been unusual for a definitive low in equities to be made so early in a crisis, the unprecedented speed and degree of stimulus action from the Fed and policymakers was starting to effectively curtail liquidity-driven risks of a larger financial implosion, and that attractive bottom-up opportunities were available given the risk-reward at depressed prices then. This turned out to be a right call as global equities have since rallied in excess of 25% from their low on 23 March.
This risk-on move was also evident across the asset landscape. Developed markets high yield (DM HY) spreads tightened about 280 basis points to about 800 basis points over this period - in no small part due to the Fed’s announcement on 9 April that it would purchase US high-yield bond ETFs.
Similarly, emerging markets high yield (EM HY) spreads tightened about 230 basis points which also resulted in our overweight view of EM HY bonds performing well over this time.
The three signposts that we were watching for were in April were 1) peaking of infection rates, 2) risk of virus resurgence, 3) stimulus from policymakers.
The first and third signposts played major roles in driving investor optimism over this rally. Containment measures in major economies are taking effect and, as anticipated, we are starting to see infection rates peak in the US and Europe. In addition, G7 policymakers have successively fired stimulus bazookas over the last few weeks. For perspective, the US government has committed to fiscal stimulus equivalent to a whopping 11% of GDP, and the Fed has over the last month purchased more assets than the entire QE2 program.
While the timing of the market upturn was warranted, the magnitude of the move deserves examination. With the sharp rally, much of recent positive developments have been priced in but one needs to ask if the downside risks are fully discounted. Specific asset classes, such as UIS Treasuries and US credit, will be supported by the Fed, but orphaned asset classes, such as equities, are in question.
Earnings estimates have eased significantly over the year to date but remain too high in our view. Even using elevated earnings consensus estimates, forward price-to-earnings valuations of global equities have already rallied to near cycle high; they would appear to be even higher if earnings are further adjusted down.
Incoming corporate results and economic data suggest that uncertainty remains heightened and that the situation will get worse before things improve. The percentage of earnings beats so far are the lowest seen in this decade, and more than 90% of the S&P has withdrawn guidance.
Importantly, the second signpost we have been watching for – the risk of subsequent waves of outbreaks – continues to make us uneasy.
Despite being forefront in controlling the Covid-19 outbreak, China’s experience demonstrates the difficulties posed by asymptomatic spreaders, and we understand policymakers have had to reimpose lockdowns in several locations.
Despite a concerted effort to resume economic normality for a few months now, the path towards resumption in China appears to be long drawn out. Economic activity remains below average, even in the domestic service sectors which have been less affected by weak export and manufacturing demand.
In the absence of a vaccine, we believe that the process of exiting containment measures globally is fraught with uncertainties, and the risk of a more drawn-out recession longer than 12 months needs to be watched carefully.
The widely held baseline expectation is that the global Covid-19 recession will be short-lived, but we are wary that the bear case of an extended recession longer than a year could lead to significant market downside ahead.
All considered, the risk-reward in equities appear less attractive at current prices. In terms of our asset allocation strategy, we now move our view on equities from overweight to neutral. We believe that investors looking for opportunities should not try too hard to chase this rally and should exercise careful capital management in gradually averaging into long-term high quality companies.
Over the longer term, we are cognizant that the flattening of the virus curves and the gradual exit from containment measures, plus an unprecedented degree of fiscal and monetary stimulus in the backdrop, is potentially a potent setup for market upside. Given where valuations are and the risks in play today, however, we believe a neutral stance is optimal at this juncture. We will be keen to turn more constructive on equities ahead if valuations turn more attractive or if the risk factors as laid out earlier abate meaningfully.
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This article was first published by Bank Of Singapore on April 30, 2020. The Opinions expressed in this publication are those of the authors. They do not purport to reflect the opinions or views of Bank OCBC NISP Private Banking Tbk. or its affiliates