When hope trumps experience

On the surface, equity markets have remained extremely resilient in the face of a deteriorating health situation, particularly in the US, since a sell-off in March (see chart). This apparent strength seemingly relies on distant hopes of a vaccine to COVID-19 and a relatively quick economic recovery. As such, we rely increasingly on diversification and our focus on quality to generate returns.

Vaccine hopes

With more than two dozen vaccine candidates undergoing clinical trials, the near constant news on this front has supported markets. Unsuccessful candidates seem to be quickly ignored. Meanwhile, market participants appear to be cheering, sometimes more than once, any positive headlines, even if details are still sparse at this stage.

As we’ve highlighted in the past, a vaccine represents the main upside risk to our “cautiously optimistic” outlook. We also acknowledge though that there will be a lag between finding one and immunising people around the world. This lag could last anywhere from a few months to several years and will depend on factors such as the strength of antibodies and willingness to be vaccinated.

Although rightly welcoming positive scientific progress, investors should not expect a vaccine to immediately translate into a much stronger economic momentum.

Promise of more fiscal stimulus

The level of support provided by governments during this crisis has been unparalleled. Whether it’s via furlough schemes, tax deferrals or outright income payments credited on households’ bank accounts, authorities have been able to shield many from job losses and the like for now.

In fact, according to several studies, it appears that coronavirus relief measures often pay workers more than work itself. This is obviously unsustainable and benefits are expected to roll over later in the year.

Investors expect governments to maintain some level of support but, even if that’s the case, we wonder if it will be enough to avoid a worsening the macroeconomic outlook. Similarly, investors appear excited by the prospects of large infrastructure spending plans coming from both sides of the Atlantic. Here again, we would temper any excitement as, if they ever become reality, these plans are unlikely to translate into increased activity before 2022 at best.

Hope for more central bank liquidity

Alongside governments, central banks have intervened like never before to support economies and allowing financial markets to function properly. There is little doubt that this support, both in terms of low interest rates and quantitative easing, will remain active for an extended period of time. But markets are much more responsive to flows rather than stock when it comes to central bank accommodation.

While it now appears that there is virtually no limit to authorities’ interventionism, both the US Federal Reserve and the European Central Bank appear willing to “wait and see”. The market may ultimately get what it wants, but we can’t rule out that this won’t happen until a sustained fall in equities or financial conditions tighten too much.

“Growth” as the engine of upside

Reassuringly, the market appears to recognise some of the above risks. Indeed, the performance of various asset classes and equity sectors suggests that a strong recovery is not being banked on.

Gold prices reached new highs and yields on US treasuries are flirting with their March lows. Meanwhile, the equity rally has been driven almost exclusively by a few “growth” stocks exhibiting earnings resilience and limited correlation with the macroeconomic backdrop. On the other hand, some of the more cyclical groups, such as banks or industrials, which should perform best in a recovery, have been notable laggards in the last month.

This narrow market leadership indicates a lack of irrational exuberance among investors while pointing to significant risks should this trend reverse.

Staying mindfully invested

While investors’ enthusiasm may be questionable and the reliance on a handful of growth stocks to drive upside is a risk, hope can be a powerful force that should not be ignored.

However, we are increasingly selective in the regions, sectors and stocks being targeted. We believe that diversification is key to avoid being over exposed to crowded trades, such as technology stocks, and missing high-quality under-owned names.

This is not about value versus growth or cyclicals versus defensives. It is all about finding quality in the form of solid balance sheets, attractive cash flow generation and sound growth prospects wherever it happens to be. For this reason and because we expect both volatility and dispersion to remain elevated, we are incrementally relying on active management and private markets to extract alpha.

Investments can fall as well as rise in value. Your capital or the income generated from your investment may be at risk.

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