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Dis-ease at the rise of Robin Hood and his merry men

Optimistic price action combines with retail trading uptick, but are the hobbyists overlooking basic investment fundamentals?

After a tumultuous first half of the year, financial markets started July in a relatively constructive fashion. Economic newsflow has been broadly supportive of late, as evidenced by the Economic Surprise Index reaching a record high in recent days.

Meanwhile, hopes with respect to vaccines and therapeutic treatments for the coronavirus appear to be offsetting worries relating to the ongoing spread of the disease in Southern and Western US states, as well as in many emerging markets.

With the policy backdrop remaining supportive, core government bond yields have continued to trade within a range in the past week. Credit spreads have pushed tighter, with supply set to dry up as we move towards a blackout period ahead of corporate results.

In Europe, spreads in the periphery have also been supported by a German compromise with respect to its Constitutional Court, which had threatened the ECB’s asset purchase programme, plus rising hopes that an agreement on the recovery fund will be concluded in the course of the next few weeks.

A weaker US dollar has also helped risk sentiment across emerging markets and, generally speaking, it seems that in the absence of bad news, there is a sense in which markets seem to be inclined to climb the COVID-19 wall of worry for the time being.

Looking to H2 2020

The first thing we continue to be struck by is the prevailing sense of uncertainty. It is fair to say that during the past six months, we have all lived through a period without precedent in our lifetimes and one which we scarcely can have imagined, away from some portrayal in a Hollywood disaster movie.

Certainly, it is hard to imagine anyone correctly foreseeing recent events and, in this way, it is understandable that this could diminish confidence in being able to accurately look too far into the distance.

Furthermore, it would seem that many forward-looking projections may hinge on the trajectory of the virus in the coming weeks and months and the ability of policies, adjusted behaviours and medical advancements to contain this effectively.

Should a second wave of infections prove to be muted and further progress on an effective vaccine be made, then it is possible to characterise a landscape in which economic recovery should be supported by expansionary fiscal and monetary policies.

In this scenario, an abundance of liquidity meeting an upturn in economic optimism could point to further asset price inflation as investors move from fear to greed and central banks tolerate a degree of market exuberance, knowing that inflation remains very muted and that accommodative conditions are necessary to offset the sharp economic contraction experienced during the months of lockdown.

Market optimism could represent a false dawn

On the other hand, it seems equally plausible to paint a picture that is much more downbeat. Should the spread of the virus in the US overload the healthcare system and push the economy back towards lockdown, this could coincide with fears of the virus building in other countries which have sought to move out of these restrictions.

A setback on vaccine development remains a possibility and for all the desire to deploy such a cure as quickly as possible, it is understandable that the development of such treatments cannot be rushed too much. In such a scenario, the recent economic improvement could well represent something of a false dawn, with hopes of a ‘V’ shaped recovery quick turning to a ‘W’ or even an ‘L’. In this scenario, further policy support will be needed and will be forthcoming, yet it may prove difficult to stop corporate and sovereign defaults from accelerating and for fear to remain the dominant investment theme.

Looking at past recessions, we have often seen a pattern where market lows have not been reached for some months after the downturn commenced. For example, in 2008, Lehman collapsed in the September yet stocks only bottomed the following March, notwithstanding the best efforts of policymakers to deliver support at the time.

It is also noteworthy that recent optimistic price action in US equities has coincided with strong retail participation, with traders on the Robin Hood platform marching to the tune of Dave Portnoy and others espousing a bull-market mentality and deriding professional investors’ obsession with terms such as ‘valuations’ and ‘fundamentals’.

However, history has tended to be very unkind to these types of day traders, as was seen in the dotcom bust and again in the decade which followed. In this case, it may well be tempting to think the same could happen once again.

European disparity

Relatively speaking, it appears that policymakers in the Eurozone have done a much better job than their US counterparts in confronting the virus and subsequently re-opening their economies. We expect an agreement on the EU Recovery Fund this month and, for the time being, there appears a climate of solidarity which may see political risk premia reduce and may favour ongoing outperformance from assets in the periphery versus the core.

However, we continue to expect Southern Europe to underperform, generally speaking, and it seems that the summer season is destined to see low levels of tourism, with many taking holidays much closer to home.

Anecdotal evidence from some who are travelling even suggests that some bars and restaurants are currently losing more money since they have tried to re-open than was the case when they were closed.

In this context, a growing disparity in economic performance could lead to renewed domestic political tensions heading into 2021, especially if unemployment gets stuck at high levels.

Upside of furlough

Elsewhere, it appears that some economic data from Q2 has not been nearly as bad as was once feared. In this light, it was interesting to read commentary from Haldane at the Bank of England suggesting how consumer spending has been on a rising trend since April, thanks to policy packages supporting underlying incomes.

Generally speaking, it seems that incomes have been growing due to generous furlough payments, welfare checks and unemployment benefits in the case of the US, where many workers have found that they have temporarily been better off being out of work.

This has broadly been constructive news, but in the coming quarter we expect to see these transfer payments being reduced quite materially. This could see the recent improvement in economic data start to taper off, though for financial assets, the risk could be that disappointment coincides with a juncture at which policymakers in the official sector are actually revising up their earlier forecasts, meaning that further policy support cannot be taken for granted (a message demonstrated in Haldane’s conclusion that it was wrong for the BoE to add to its asset purchase programme at its latest meeting).

Central bank action

Aside from economics, one thing which we know we can rely on for the foreseeable future is central bank asset purchases. Central bank balance sheets are set to grow in the second half of 2020 in line with prior policy announcements.

In our view, this should remain a supportive factor for those assets (namely investment-grade corporate bonds and peripheral government bonds) which seem to continue to benefit from these supportive flow dynamics.

We believe that corporate bond supply in the second half of this year will be much lower than it was in H1, at a rate closer to what was seen in the second half of 2019. Consequently, we believe that the supply / demand balance should materially favour those assets which central banks are buying versus those which they are not – when viewed on a market beta-adjusted basis. As such, we retain a long risk bias in investment-grade assets, whilst expressing a more cautious view elsewhere.

UK countdown recommences

Brexit is another theme expected to return to investors’ agenda in the second half of this year. The clock is now ticking down to the UK leaving under a ‘no deal’ scenario at the end of this year. In our view, it is possible that a last-minute compromise may be reached – but in order to get to this conclusion, it is possible that both sides will need to stare into the downside of a ‘no deal’ before they are prepared to cede any ground.

This leaves us with a broader negative view on UK assets and the pound for the time being. 

Politics so far stay separate to markets

Across the Atlantic, the US elections also loom large. It currently appears that Biden is building an unassailable lead in a number of the key battle-ground states. Thus far, it seems that stocks are not perturbed by the prospect of a Democratic win, yet as the vote approaches, it seems that US politics could exert a much bigger bearing on markets. At the same time, we continue to see relations between China and the US and EU further deteriorating.

Recent moves by the UK to grant citizenship rights to Hong Kong residents in the wake of China security legislation are likely to antagonise Beijing and the atmosphere in Hong Kong itself remains very volatile. Meanwhile, stories relating to the Russian payment of bounties to Afghans targeting US troops risk further conflagration in the US/Russia relationship, meaning that geopolitical themes remain capable of flaring up at any time in the coming months.

EM considerations

During the past several months, it has been striking that many emerging markets have been able to deliver material fiscal and monetary stimulus, including central bank asset purchases. This degree of policy flexibility has been a very supportive factor and with market conditions also enabling market access to some of the more stressed issuers, so fears that COVID could be a trigger for an EM-specific crisis appear to have been exaggerated.

With younger populations, many EM countries are better placed to weather the COVID storm, yet as we look forwards, we continue to worry that a reversal of globalisation and overseas capital flows could see a number of countries struggle in the quarters to come.

We believe that there should be more heterogeneity in relative performance, with it becoming clearer which are the relative contributors and detractors. We expect this to show up in credit performance and also FX, where we believe that correlations should drop, with more currencies being driven by their underlying fundamentals rather than their historic correlation to movements in the S&P index.

Short-term outlook

We wrote last week that, in our view, markets may adopt a constructive stance at the start of July if there was no evidence of an acceleration of the virus in the US putting the country back into lockdown.

In recent days there have been a number of measures imposed to close bars and restaurants and to slow planned re-openings in several states. Yet, for the time being, there remains a sense that it is largely the young who are becoming infected and that death rates are declining. If this narrative can hold, then there is no reason why we couldn’t see a melt-up in asset prices, which coincides with supportive incoming economic data and further news on fiscal policy initiatives.

This mindset could easily be challenged, but as time passes it seems that there is a sense that something more dramatic is needed to challenge this possible atmosphere of complacency.

Retaining a slightly constructive stance on risk assets in the areas which are receiving the most policy support seems merited for now, but it is difficult to know how long this will last for and so ensuring positions are sized appropriately to the prevailing level of uncertainty remains important for us in portfolio construction.