News on the Investment Landscape:

Investment Outlook – October 2020

Didier Duret

Chairman of the Board

« Everybody knows » is one of my favorite Leonard Cohen’s song these days. It distils a necessary distance to the noise and fury while entering the last mile towards the US election 4th of November, a moment in the race when the rhetoric gets nasty and personal and bears little policy relevance. This pure power quest can easily distract us from the essential economic forces marching towards an economic recovery. Policy makers have made it loud and clear that interest rates are low for a long time (until 2023, dixit Federal Reserve Board) and that monetary and fiscal support programs are on duty call to counter depressionary forces caused by the C19. 2021 can become the year of a slow return to normal economic conditions. The quest for asset returns, financial liquidity and the forward-looking nature of financial markets can logically explain the gap with the current economic arduous times populations and governments are facing. The general dynamics remains constructive for risky assets based on the scenario outline at the bottom of this note, it has not changed since Spring.

Every investor knows she/he has to diversify to mitigate adversity on its investment return. Nothing new under the sun. Textbook readymade rules or out of the cuff advice abounds on the forms and shapes of diversification. The generalities of diversification are sound albeit not all investors abide to their wisdom and discipline. Strategic asset allocation remains the anchor for driving 80% of the medium-term performance for the asset blocks. But the devil is in the details and portfolio adjustments or position building in Q4- 2020 can be building stones for effective diversification. Here enters the judgment on tactical actions that could contribute to this medium-term goal.

Reviewing crowded trades, contrarian views and safe haven positions for better diversification

Practically, it is relevant to review crowded trades, contrarian alternatives and revisit safe haven ideas within each asset classes as here rest decisions with significance for a prudent exposure and sound diversification. In technical terms, crowded trades refer to the momentum supporting the winners of yesterday, contrarian views related to non-obvious opportunities, and safe havens are aimed at equilibrating portfolio risk. The C19 « flash economic depression » and the gigantic policy stimulation have changed what we can expect from these three categories.

• Crowded trades in megatech stocks may be also a recognition of a structural diffusion of technologies or changes in client demand and the exponential use of digital tools to support sales and access to clients.
• Contrarian ideas can be shots in the dark as they need more conviction and evidence in the recovery process (i.e. for the cyclical sectors) or a corporate repositioning in the competitive landscape.
• Safe haven positions also need to be revisited. Gold for instance is highly correlated with other risky assets. Its price is gyrating with the ebbs and flows of financial liquidity.

Equities: hard to dismiss the medium performance engine

• Tech giants, pharma (due the race for a C19 vaccine) and work-from-home-stocks are crowded but necessary in portfolios: these compagnies have demonstrated their capacity to rebound after the end Summer correction. Buying future earnings growth is expensive and will continue to be so until the broad indexes earnings base is restored. The thematic of cybersecurity implies a heavy dose of tech exposure.

• Cyclicals such as energy, industrials, consumer discretionary and even financials may be opportunist buys after their appalling underperformance year-to-date. The rotation into sectors facing cyclical and structural headwinds will happen in sequences and probably over the full 2021. Asia equity markets have the potential to outperform as a cyclical exposure, considering China’s lead in the recovery.
• Dividend stocks or sectors such as utilities, and consumer staples will keep their defensive status in consolidation or correction phases. The C19 shock is redefining corporate quality and the thematic of « governance angels » is the most impactful way to get involved into ESG investments.

Bonds: New realities and remaining relevance

• Investment Grade (IG) markets are heavily crowded by public purchases. Single investors are in direct competition with central bank purchasing programs and large institutions. The natural erosion of the bond portfolio due to reimbursements is a steep challenge for portfolio managers to generate income. Credit risk is an « uncomfortable lunch » for the investor.
• Opportunities rest with specific niches in IG/ High Yield (HY) crossover strategies and programs. Non-standard bond proxies such as infrastructure and private debt may be alternatives for income generation, but illiquidity and selection risk are high and limit their access to qualify investors. With straight bonds, USD denominated EM bonds are islands above the sea with positive nominal yields.
• Government bonds with their negative or barely positive yields are expensive safe haven, to paraphrase again Leonard Cohen, «  the dices are loaded » by central banks.  Bonds yields may still enter in further negative territories should the world experience another recession. Investors can hold long bonds as insurance but at the expense of high duration risk. In absence of explicit burst of inflation, 10-year Treasury Note yields above 1% may be levels to build positions.

FX and oil

• • Euro remain crowded and it has lost the strength to break the 1.2 in USD terms, even after EU’s pivotal policy commitments over the Summer. We can infer that the USD will keep its primus inter pares status among major currencies.  USD has safe haven features despite undeniably  poor debt fundamentals.
  • Chasing good’old safe haven by accumulating CHF around 1.10 against Euro.

• Consider NOK and SEK as diversifying cyclical currencies. GBP below 1.3 against USD remains attractive and a diversifier despite the Brexit realities,

• Oil: world economy gathering momentum can revive oil demand (WTI price range 40 to 70 USD/b).

Only an aggravation of known risks or emergence of unknown risks could capsize the boat

• Risk in the months and years to come may come from a slippage of known risks, such as a tougher confrontation between the West and China, although analogies with the Cold War and the Thucydides trap (the emergence of China as challenging power to the US as Athens was to Sparta) may be only rhetorical. The factual economic interdependence between powers is the utmost difference and is limiting outright confrontation. A « confrontational coexistence » seems more appropriate with more strategic constraints for firms. Applying specific scoring in stock selection can mitigate this risk. Other known triggers such as higher C19 fatality rate, possibilities of a technical market corrections are largely discussed, analysed and largely build into the equity risk premia.

• Two tail risks may not be totally discounted, possibly because we prefer to deny them as we did with the epidemic… One is our dependence on digital technologies, and the risk is of a partial or a global « cyber sudden stop » which may be a worst blow than the C19 pandemic. Imaginative solutions to adapt with more technologies has increased complexity and security issues.  The second tail risk rest in the erosion of market discipline to price risk. One should reflect on the role of bond markets to price properly government debt risk for instance. Money-for-free and central bank market activism have destroyed the capacity of the market vigilantes to attribute higher yield to highly indebted nations of firms. Are we facing a man-made systemic risk of a new nature? I am not totally sure G10 government would have embarked such massive fiscal stimulus to cope with the C19 should the borrowing rates would have been 4 to 6% for governments. At a point in time, differentiation between good borrowers and bad borrowers could hit with a revenge, when the economic front improves (a distant possibility so far), then adjustment of central bank policies can ignite volatility and differentiation.

Conclusions: With the hopes of an economic recovery and constructive financial conditions (medium volatility regime and the opportunity set), the equity bull run can mature and survive correction phases of 5% and be redistributed into lagging and less expensive segments. Passive world equity market instruments can provide « automatic diversification » as playing actively swift rotations is far from obvious. Active managers with a technology/ cyclical barbell could be preferred. Trading up quality in the core bond portfolio is wise with adjunction of selected crossover active strategies, EM exposure and UST as safe haven as yields eventually move up.

Reminder of the scenario: incremental return to economic life is the underlying expectation behind the rally unfolding in risky assets, supported by the need of investors to find return for their capital.

1. A new, multi-year cycle is unfoldingout of the C19 short depression with an acceleration of technological and social trends.
2. Massive and affluent liquidityprovided by central banks to stay until economies recover their trend growth: 2% in US, 1.5% in EU and 5-6% in China. The carpet bombing of liquidity will insure proper functioning of financial and credit markets. 
3. The recovery is to be shouldered by the massive fiscalboost in the major countries to recover the loss in domestic demand.

Potential tactical actions to be discussed based on portfolio updates.