Given somewhat greater confidence on virus containment, the improving policy response and some valuation adjustment that has occurred, particularly the impact of low risk-free rates, we are reinforcing our suggestion to start to move towards more neutral equity and credit holdings in portfolios. An outright negative stance is no longer merited. This is now taking us closer to a more neutral stance. This does not mean that we believe markets have bottomed today or built a base for any soon-to-come sustainable market rebound. There is unfortunately quite a likelihood that ultimate market lows still lie ahead. However, it is equally true that precisely timing the bottom of the market is all but impossible, and that these are better entry points into risk assets than we have seen for many years, for those prepared to ride out some volatility and downside risk in the near term. This is what we are recognising in terms of our stance, not an expectation that all the troubles are now behind us.
Given high volatility and the need for patience through further market sell-offs, an averaging-in process for those rebalancing by adding risk, is appropriate. There should potentially be several attractive entry points to avail of improved valuations and high volatility, which argues for a unit cost averaging approach rather than a one-off addition to risk. We have already recommended some rebalancing activity, and it seems reasonable to take this building of positions further into periods of high volatility and market weakness that we might see looking ahead.
Where are we?
There are still many uncertainties on the path ahead for risky assets. Owing to the many unknowns on the virus that have been unfolding on a global scale over the past few weeks, it has been difficult to be confident on either its duration or severity. Even now, uncertainties remain high on ‘curve flattening’ progress in economies at an earlier stage of disease progression, or which have different COVID-19 testing norms like the US or even the UK.
Of much less doubt is the economic impact from the virus-led lockdowns now unfolding. There is little doubt now that this a more severe economic shock than that seen in 2008/9. Global GDP is now by common consensus likely to fall further into negative territory than during the Global Financial Crisis.
The rapidity of the economic downturn that has unfolded has taken a dramatic toll on risk assets. By Monday March 23, 2020, global equities had fallen by 30% (some markets by rather more), with credit markets similarly very severely impacted, credit spreads moving to levels not seen outside of the Global Financial Crisis. The S&P 500 fell into a bear market in the briefest period of all time, and with vast straight line falls in many risk asset markets. Market volatility hit levels which were only matched in the Global Financial Crisis, with even the dotcom bubble put in the shade. Liquidity seizures in fixed income markets became commonplace and even normally highly liquid and broadlyheld equity names saw a pronounced widening in bid-ask spreads. If this is what was happening in supposedly liquid markets, it was unsurprising that illiquid risk assets, private real estate being arguably the most widely held, became all but frozen.
Our Medium-Term views - A recap and update
Our negative stance on risk assets – credit and equities, predated the corona virus scare. This was not because of some prescience on the arrival of a virus creating havoc in the way it has, but rather because we felt that too much good news was becoming priced into markets coming into 2020, and valuations had markets priced for near-perfection. As we know, the coronavirus came and severely punctured this optimism. Our view had been that the market had become vulnerable to any kind of bad news such as an intensification of the China-US trade conflict or disappointments over global growth. Of course, it is very true that these disappointments would not have shocked the markets anywhere near as much as the COVID-19 scare has.
On to the present. With large market falls having now occurred in the past month or so, we have been reassessing what our stance should be. As we know, market falls do not themselves imply corresponding valuation improvements. Corporate profit falls in the next quarter or two look inevitable and this needs to be factored into the true valuation adjustment which has occurred. Likewise, with corporate revenues under severe pressure, some casualties have become increasingly likely – both Standard and Poor’s and Moody’s have in the past week issued a projection of a double-digit default rate becoming much more likely and credit downgrades are rapidly accelerating. Even so, it is clear from where equity and credit valuations are today, that a fair-sized valuation adjustment has occurred. We will provide a more detailed update on both equity and credit valuations over the course of this week.
What has changed?
It is worth doing a quick tally of what has changed in the market landscape to make us now take a less negative outlook.
- First, although conviction on this is not very strong, it is becoming a little more reasonable to take a view that the Pandemic curve-flattening will likely be successful in the next couple of months. We have laggards in disease progression and containment, like the US, but to the extent that social distancing is now becoming the norm, it is possible to look beyond the hill towards a flattening, though we can hardly be certain. We acknowledge that disease progression could be very dangerous in a number of poorer countries with inadequate healthcare, but this may not be as much a market-moving phenomenon as disease progression statistics out of Europe and North America. We recognise this is oversimplifying and making light of numerous uncertainties on the pandemic, but what has changed for us is a bit more conviction on the containment view.
- Second, and arguably more important, the policy response to the viral lockdown and the economic consequences, haphazard at first, has gathered momentum in the past fortnight. We expressed scepticism on the purely monetary response from central banks who cut rates by as much as they could, but this has now been followed by a strong fiscal response too. Though not particularly globally coordinated, the size of fiscal stimulus globally now looks large. The UK response has already been very large and impressive in terms of loan guarantees and income subsidies to employees and self-employed. The recently agreed US stimulus amounts to no less than 10% of GDP and its emphasis on getting help to employees and businesses facing extinction will not prevent substantial economic damage being seen but should arguably provide a safety shield to build on once the social distancing measures ease. This is not saying that enough has been done to prevent a large fall in output in the next few weeks and months. This is not so. What we are saying is that it may help to stop the destruction of capacity that could make the viral downturn last much longer. That was the fear a few weeks ago and this has eased.
- Third, the valuation adjustment has been significant. While the effects on corporate cashflows and profits are undoubtedly severe, our view is that markets are prepared to see bad news on an expectation that this is a matter of months rather than a year or more. The more cautious message is that once the damage to business is allowed for in scaling the adjustment, valuations still do not yet look like they are presenting a large buying opportunity in the way they did at market troughs in previous recessions and bear markets. This makes us think that they could go still lower. However, there is a counter-weight to this. It is worth remembering that so called ‘risk-free rates’, i.e. government bond yields, are likely to remain very low in a way not seen in previous market cycles (See our note from last week - AA View: Pandemic policy response – fiscal is monetary today). This is all important. Once some semblance of economic normality resumes, the search for yield will resume and, from that point of view, risk asset valuations could once again be sustained at higher levels than you would normally expect – this is after all what we have seen for most of the last ten years, which creates room for risk assets to gain over time. There is nothing like ultra-low bond yields and near zero interest rates to offer lasting support for equities and credit. This means that relative valuations versus risk-free rates could be just as important as absolute valuations, in the way they already have for many years. This is not an ‘off to the races’ expectation for market moves in the slightest. Rather, it is a view that central banks’ activities continue to still play a role in propping up markets medium-term. Our view, recently articulated, that central banks will continue to fund the fiscal response by controlling rates and the yield curve at very low levels is helpful for risk assets to ultimately find a footing, even if it is not in the near-term.
The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice.
Aon's Global Asset Allocation Team
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