After riding the market wave over the past few months, maybe now is the time to take a moment to reflect and relax before supply resumes in September and brings with it potential opportunities to put cash to work.
Risk appetite remained relatively healthy during the past week as markets consolidated July’s gains. There was little new to report from Wednesday’s FOMC meeting and, despite evidence of a second COVID-19 wave starting to gain momentum, it appears that investors are reassured that policymakers will continue to provide liquidity in order to support asset prices.
Ultimately, this view may prove to be far too complacent, but it seems unlikely that central bankers will do much to challenge this thinking for the time being, given their overriding concerns with respect to developments in the real economy.
Consequently, it may be tempting to think that a quiet summer period could see volatility dropping and financial repression stemming from ultra-low cash rates pushing investors into higher-yielding credit and other assets which offer the prospect of at least some positive return.
V-shaped hopes wane
However, valuations have come a long way in the past four months. In our view, it seems that if April was the time to be adding risk, now is the smart time to be going in the other direction. Furthermore, as we head into August, there are several reasons why we believe that it is appropriate to adopt a more defensive view.
We would note that the recent rally in risk assets has coincided with a period when there has been a sharp improvement in economic data coming from the March/April lows. This has led to hopes for a V-shaped economic recovery, yet we believe that data releases in the coming weeks may lead to some disappointment in this regard.
The acceleration of COVID infection rates in the south and west of the US has led economic re-opening initiatives to be reversed over the past month, given increased requirements to enforce social distancing. Weekly claims data point to jobs being lost and it is likely that business and consumer confidence has also taken a hit.
Travel restrictions enhance ‘coronaphobia’
Meanwhile, an uptick in the virus in Europe seems also likely to weigh on sentiment. With countries such as the UK suddenly imposing quarantine on Spain, this is likely to further undermine the summer tourist season. In addition, it may appear that more generalised corona-phobia is increasing rather than diminishing as we track through the summer months.
Increasingly, it seems to be striking home that the current adjustments to daily life are likely to extend well into 2021 – an observation exacerbated by pictures of deserted city streets and newsflow from major corporations announcing that most employees will remain at home for many months to come. Notwithstanding this, it appears that the best of the ‘V’ in the data may now be behind us for the time being.
With respect to the virus itself, there has been some encouragement in recent days from a perceived flattening of the infections curve in some US states. However, we suspect that in some instances this may reflect a slowing in the pace of testing.
In addition, mortality rates remain elevated in states where the health-care system is seen to be under pressure, speaking against the narrative that it is only the young and the healthy who are contracting the disease. It also appears increasingly apparent that the more which is done to normalise economic activity, so the greater the risk of infections starting to spike.
Arguably, the relevance of this observation coming into August is that we have witnessed a period of two or three months where improvements regarding the virus and economic sentiment have gone hand in hand. However, on a forward-looking basis, this appears unsustainable.
Moreover, until a vaccine can be deployed it seems that there may be a natural speed limit on the extent of economic normalisation which can take place without allowing the R-rate of the virus to run out of control.
Election hype overshadows political sense
We also believe that political risks are rising in the US with politicians now more concerned about scoring points from one another than they may be in terms of ‘doing the right thing’.
In the short term, this is being manifest with respect to the wrangling over the extension to the CARES Act, with provisions relating to supplemental unemployment benefit set to expire as soon as the end of this week, in the absence of an agreement on a new deal.
With Congress scheduled to be out on summer recess after the end of next week, there would seem to be considerable pressure on both sides to achieve a compromise, yet, with the stock market riding high, we have sometimes seen how this can breed policymaker complacency. In many respects, a short sharp sell-off could ultimately be needed to knock heads together.
Meanwhile, we would note that multiple fiscal and monetary policy-easing measures have been a catalyst for markets to rally in the past few months, yet aside from the focus on the US, it seems unlikely that there will be further support for the remainder of the summer.
Assessing market valuations
Credit spreads remain undeniably wider than they were at the start of the year. However, when one strips out those issuers and sectors which are particularly badly impacted by COVID itself, in many cases we have returned to end-2019 levels.
Similarly, the S&P index is now slightly up on the year – albeit largely thanks to the strong performance of some of the mega-caps in the tech sector, which have been relative winners through this crisis.
From a positioning standpoint, we have also been struck by survey data showing positioning net long risk via CDS credit indices. It is tempting to believe that some investors have been wary of adding too much corporate bond risk to portfolios, for fear of a return to the illiquid trading conditions seen in March.
However, this suggests to us that if there is a retracement in markets, then it is likely that these liquid CDS positions will be among the first which are cut.
Away from credit, there remains little to report in core government bond markets, other than to note a new record low in the MOVE index of Treasury volatility.
Quasi-yield curve control is likely to suppress yields for some time to come and although there may be an opportunity taking a short-duration stance at a later point in time, it seems this may not be until later in 2021 – unless a vaccine breakthrough can give way to more optimistic reflationary hopes.
By contrast, FX markets have been a source of rising excitement with the dollar trading weaker versus other currencies – partly due to relative travails in dealing with the virus and a narrowing of growth and interest rate differentials. Dollar weakness has been pretty widespread – with even Bitcoin and gold trading stronger as FX proxies.
Sentiment in Europe has been helped by the agreement on the stimulus package two weeks ago and this has been buoying the euro.
Generally speaking, most developed-market currencies have managed to rally more than emerging market FX, notwithstanding the higher beta that naturally applies to many emerging market currencies.
On a medium-term view, we would not be surprised to see some further softening of the greenback. However, in the short term we are struck that short dollar seems suddenly a very consensual view. Consequently, we have been reticent to jump on to this move, given that we are somewhat fearful that a reversal of sentiment in August could create something of a position flush.
We feel that it is appropriate to pare risk coming into August. Compressed valuations mean that markets may grind tighter on good news, but are more vulnerable to gapping wider on bad news, in our opinion.
The summer can often be quiet – though statistically we have seen a number of historic instances in which August has been a challenging month. With heavy supply set to resume in early September, we believe that there will be plenty of opportunities to put cash to work in a month from now, if we believe that it is appropriate to do so.
In that sense, we feel that it has been enjoyable to ride the credit-market wave over the last few months, but maybe now is the right time to take risk off and sit on the beach!