Volatility sets in as growth momentum rolls over

In short, we don’t think so, at least not permanently. We do however concede that the world will most likely have to adjust and learn to live with COVID-19 and its lasting effects in one way or another.

COVID-19 cases are on the rise again and expected to spread faster with the arrival of cold weather in the northern hemisphere. This is not a surprise given that a working vaccine is not yet available and lockdown measures were relaxed during the summer months which resulted in an enthusiastic response by many younger individuals. Certain countries and sectors will unfortunately be more negatively affected than others. Southern Europe as an example is very sensitive to the tourism and hospitality industries, and the re-introduction of restricted measures to curb the spread of the virus will inflect serious pain on companies and sectors that were already experiencing financial difficulty during the first wave of the virus. Government will have to step in again to ensure that many of these companies remain solvent and in operation. In the near term these events are expected to slow down the pace of recovery as is already evident from high frequency mobility data in countries most affected. Investors should however not lose sight of the fact that the above-mentioned measures should be viewed as necessary, but importantly also transitory in nature and are therefore not expected to derail the global economic recovery which is currently fuelled by unprecedented monetary and fiscal policy interventions.

The good news is that although cases have been increasing at a brisk pace a significant component of the increase can be explained by an acceleration in testing. In addition, the fatality and hospitalisation rates are currently a fraction of what they were earlier this year because new infections are skewing towards younger and less vulnerable populations, with the result of much less pressure on healthcare systems. At the same time, older (and less economically active) individuals appear to have been self-shielding, as they recognised the increased risk they face. Medical treatments for COVID-19 have also advanced rapidly and played an important role in reducing the severity of illness and mortality rates. Collectively these are important developments which will reduce the pressure on politicians to enforce the same draconian measures that were implemented during the onset of the pandemic when the motivation at the time was to limit pressure on healthcare systems and prevent increases in mortality.

It is therefore highly likely that governments will accept modest levels of infection cases as a necessary cost for maintaining a certain level of economic activity. This is especially the case now given that the current wave of infections looks very different given that the majority of cases are either mild or asymptomatic, which allows governments to be more specific in their approach towards containing the spread of the virus, instead of implementing broad based shutdowns of economic and social activity.

The discovery and approval of a successful vaccine/s as a means to strengthen herd immunity levels will be a game changer and assist in speeding up mobility rates and in turn the economic recovery and news on this front has been rather encouraging. Vaccines normally require around a decade to become operational but given the pressured timeline it is now expected that a vaccine could be approved as early as next year. Even though there is sure to be manufacturing and distribution challenges that will need to be overcome, the approval of a vaccine bodes well for a sustained improvement in economic activity and there is increased confidence that this will materialise sometime in 2021. In the interim with real growth expected to be lower equity investors must expect increased levels of volatility and lower returns going forward whilst they will have to be increasingly selective in their investment making decisions.

We have recently made use of volatility in investment markets to tactically increase the equity exposure to Neutral from a one notch underweight position previously. The change in allocation was primarily driven by our belief that following recent central bank comments interest rates will be held low for a prolonged period and continue to provide an underpin to valuations while the economic recovery takes hold. Following its latest meeting the US Fed has indicated that they expect interest rates to remain unchanged until 2023 and signalled that the tolerance to inflation has become more balanced, given their “new” 2% average inflation targeting objective accompanied by maximum employment. This view is very much supported by central banks globally. The outlook for earnings growth has also improved in line with economic fundamentals, with an expectation of a strong rebound over the next year. Although we don’t expect future returns to be in line with the expected recovery in earnings given the already strong recovery in share prices, we would expect the asset class to outperform both cash and fixed income securities over the next year.

Government and corporate bonds have been, and still are, very much supported by the aggressive buying from developed market central banks, which has in turn resulted Asset Classes Equities Neutral Fixed Income Underweight Cash Plus Overweight Bernard Drotschie / Chief Investment Officer in much lower market interest rates and strong growth in liquidity as measured by money supply. These measures will probably continue for a while longer and have served their purpose in providing companies access to liquidity as well as lowering the cost of funding to record low levels. Although these events bode well for borrowers, that is not necessarily the case for bond investors who will be receiving unusually low to negative absolute and real yields on their capital. We are comfortable to maintain a maximum underweight position to developed markets bonds. In addition, volatility this year has afforded us an opportunity to cautiously accumulate Credit and High Yield in the fixed income strategies to enhance returns.

The neutral position in global equities and maximum underweight in fixed income have left portfolios with an overweight position in cash, which serves as a risk mitigator in portfolios. In addition, the overweight cash position will provide us with ample capital to deploy when more favourable conditions or valuations present themselves.

Economic data releases have been upbeat but past activity does not guarantee a lasting theme – at least at the current pace, which remains flattered by recoveries from depressed down levels. The Federal Reserve recently tweaked their mandate with regards to inflation and now seek that it ‘averages 2% over time’. This has implications for the interest rate outlook, signalling that rates will remain unchanged even if faced with inflation rising above target. Near-zero interest rates and the ongoing pandemic should, in theory, add to the attractiveness of the government bond market but yields at current levels have factored much in and allow little in the way of a safety net in the event of higher inflation and an ongoing economic recovery. Vast money supply creation may contribute to higher inflation in 2021 and if vaccine hopes becomes reality, a ‘risk on’ mood should pervade. If this unfolds and the economy successfully navigates this terrible episode, then attention will quickly turn to an eventual dialling down in stimulus measures. This could be particularly damaging to government bond yields which at current levels are not priced for this scenario. As such, we remain defensively positioned with respect to duration as only marginally higher yields on longer-dated debt are not nearly enough compensation for the added risk.

In the UK, the sugar-rush from stimulus measures and easing of lockdown restrictions seems to be running out of steam. Whilst key economic data releases point to a healthy expansion, albeit from a very low base, more recent indicators for both the manufacturing and the service sectors are off the highs experienced in July. There is no doubt that the potential for the recovery to slow, or even stall, has risen following the Government’s new restrictions as Covid-19 cases again climb. The Monetary Policy Committee (MPC), continue to hold interest rates near zero, however there is increased speculation that the MPC may, at some stage, implement negative rates. We are not yet convinced, the lesson from Germany is that this highly unconventional policy can be very difficult to reverse and can quickly have diminishing positive effects. However, it appears the bond market has already made up its mind on this matter with UK Gilt yields already trading in negative territory out to seven years in maturity. Negative or not, we do know that an almost zero interest rate policy will be with us for quite some time.

The recovery in Investment Grade (IG) and High Yield (HY) corporate bond markets has been dramatic following severe capital declines in March and spreads are edging closer to pre-COVID levels which certainly doesn’t appear to make them look cheap. However, the environment for both taking risk and yield hunting remains supportive. Central bank initiatives have increased the allure of riskier fixed income assets and those that can pay an income stream above government debt are greatly benefitting as the world remains starved of yield. One could argue that the global marketplace’s reliance and in many respects complacency towards central bank support is possibly creating a bigger issue down the road, and this is entirely plausible. However, the past six months has clearly demonstrated the pitfalls of being too risk averse in an environment where the central bank ‘has your back’. We continue to hold IG debt with a smaller allocation to HY in our fixed income strategies and any upcoming weakness may persuade us to increase weightings to both.