Uncertainty abounds

While uncertainty is par for the course in equity markets, rarely have investors faced so many potential flashpoints clouding the outlook. Although a “wait and see” approach may feel more comfortable to some, constructing diversified portfolios and employing active management could help unearth attractive opportunities in highly uncertain times.

A higher volatility regime

One way to measure investors’ hesitation is through implied volatility. The most widely followed volatility indicator, the VIX (see chart), has remained stubbornly elevated despite stock market indices reaching all-time highs. Indeed, since 2012, the VIX, or “fear index”, has largely been stuck in a range between 10 and 20 points.

After briefly spiking to levels comparable to 2008 when the COVID-19 pandemic hit, the VIX appears to have stalled in  a new range that is 10 points higher than norm seen in the previous eight years, reflecting how much more uncertainty is being perceived. In addition, when looking at the VIX curve, the market appears to be pricing an even higher level of volatility over the next three months, pointing to possible concerns over the outcome of the US presidential election.

Dreading the presidential election

The 2020 US presidential race is shaping up to be one of the most contentious votes in recent history. The increasing polarisation of US politics in recent years has caused some commentators to envisage scenarios of continued political gridlocks or a contested election.

Without venturing the probability one should assign to these outcomes, election day, 3 November, may mark a period of more uncertainty rather its end. Over the medium term though, the impact of political events on financial markets remains relatively minimal and should not be seen as a determining factor when considering asset allocation decisions.

Pondering a post-coronavirus world

Another key question mark for investors revolves around the world after the COVID-19 crisis subsides. Whether it is about the timing of any vaccine becoming available, the continued popularity or not of homeworking and online shopping or if a period of deglobalisation is under way, the pandemic has completely reshuffled the cards. This leaves investors wondering what’s to come next?

While the world will undoubtedly be different in some aspects (like even larger government indebtedness), there are also secular trends that should be unaffected: the increased usage of digitalisation, the shifting shape of demographics or the impact of climate change on policy should continue unabated, providing investors with some degree of long-term visibility.

Questioning earnings forecast

While long-term trends can be resilient anchors for portfolios, most investors still pay (too much) attention to shorter term developments, often in trying to time their entry points accordingly. Here, earnings growth trends are a key determinant and, on this front too, uncertainty runs high.

Quarterly earnings figures have lost some of their relevance in the wake of the pandemic as exemplified by 85% of US companies beating consensus expectations in the second quarter. As such, the third-quarter numbers might not be considered too relevant, although another way-better-than- expected quarter may be seen.

Looking further ahead, despite all the uncertainty surrounding the US election, the shape of the economic recovery and the timeline for a possible COVID-19 vaccine, the consensus still expects 2021 earnings to be back at 2019 levels (see chart). While possible, this projection appears to be more the result of analysts refraining from updating their models and passing on 2020 cuts rather than the reflection of strong conviction about 2021 numbers. Without clear guidance from many companies, and analysts alike, investors can be left guessing what aggregate earnings growth will look like.

Fearing elevated valuations

Doubts surrounding companies’ ability to generate earnings have ripple effects on investors’ ability to value them, adding to the present level of uncertainty. Indeed, with equities trading at 20-year high valuation multiples (on dubious earnings forecast), there are growing concerns that a bubble may be forming and that a correction is nearing.

As we’ve explained previously, we believe that the current backdrop of low interest rates and interventionist central banks, justify moving to a relative rather than absolute-valuation framework and, in this context, equities seem to be the most attractive asset class.

Indeed, even if, on aggregate, US companies generate no year-on-year earnings growth in 2021 (against the +27% currently expected), the equity risk premium would be north of 300 basis points, in line with its 2017-2018 levels and well above the -200bps reached in the lead up to the popping of the dot-com bubble.

Balancing risks and rewards

As we’ve established, there is no shortage of reasons for investors to sit tight and wait for better days to put their capital to work. Yet, we believe this approach could be detrimental to long-term wealth preservation, especially when real interest rates are negative. Risks are inherent to investing and waiting for the “all clear” may result in getting involved at the top of the market.

Rather, the focus should be to manage those risks in order to reap the highest possible rewards. Encouragingly, whether it’s through the VIX or the equity risk premium, it appears that the market is pricing some of the risks likely to occur in the coming months. As such, staying invested appeals at this juncture, while focusing on diversification and active management to help try to improve the risk/reward trade off.

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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