11 september 2020
Welcome to CLEARCUT, a monthly discussion on macro and allocation
It makes sense after all_ Far from taking a break over summer, the market continued to advance at a brisk pace until the end of August. Since then, signs of tension have started to build, concentrated around the Nasdaq. The news broke out that Softbank may have deployed a massive call option trade that could retrospectively explain the price action of the past few months. Things make sense after all.
Covid on the backburner_ Starting with the macro, the Covid-19 pandemic continues to unfold in the background. Three dynamics are at play. First, the US situation is gradually improving after a sharp rise in infection cases over the summer. We now see a stabilisation in Texas, Florida, and California, three key populous states. Then, a second wave started to develop in Europe, concentrated around Spain and France to a lesser extent. Third, the pandemic is strongest in emerging markets, especially India and Brazil.
Emerging pandemic_ Of these three dynamics, the key risk now lies in emerging markets. In the US and Europe, the hospitalisation and fatality rates have remained well contained, limiting drastically the risk of overburdening hospitals. Also, progresses on vaccines continue with no less than 8 candidates currently in phase III of developments (Exhibit 1). If our base case is that a vaccine is approved by the FDA before year end, it is likely to become widely available by mid-2021. None of that is true for EM, however. The fatality rates are significantly higher, and rising, and the delay between vaccine approval and availability is likely to be longer than in rich countries. The Covid risk has definitely migrated to Emerging Markets.
Exhibit 1: Eight vaccines in phase III
Source: LSHTM – September 2020
Data up and down_ Regarding macro data, the economy rebounded quicker than expected in Q3. Markets reacted accordingly and it seems that most of the good news is now behind us. A clear illustration is the surprise indices (Exhibit 2). After bottoming around April, they kept rising until July and are now turning down again. This is primarily because market participants have adjusted their expectations higher, making them more difficult to beat. Also, the catch-up effect post lockdown is starting to sputter, especially in Europe. Moving forward, we see the macro as neutral to negative for markets. A key component will be economic policy and further stimulus before year end.
Monetary exhaustion_ Central banks learnt lessons from 2008 and 2012, having reacted with impressive speed to the pandemic crisis. They have hereby fuelled the argument that markets are becoming liquidity addicts and of the disconnect between Wall Street and Main Street. Still, they may have to do more before year end. The ECB is missing on its inflation objective, while the euro’s recent appreciation is exerting additional pressure. There seems to be limited room for larger asset purchases, which should however be prolonged beyond June 2021. The most potent tool at their disposal to counter the currency move would be to lower yet again the deposit rate below the current -0.5%. This is an area to watch closely in their language.
Exhibit 2: Economic surprises are turning
Source: Citi, SILEX – September 2020
Congress’s last word_ In the US, the Fed seems content with its current stance. The recent change to the policy framework has few short-term implications, except that yield caps are no longer on the table. As a result, the key policy catalyst this month will be on the fiscal side. Congress is reconvening after the summer recess to agree on a fourth budget package. A compromise will have to be found in a heavily politicised environment. Failure to come to an agreement may amplify the slowdown in the economy in Q4 and put pressure on the Fed, and in turn on bond yields.
Taiwan on the radar_ Overall, we see the risk map moving from health to geopolitical risk. With President Trump trailing in the polls*, he will likely attempt to weaponize foreign policy and China. The US has recently made gestures towards Taiwan, including through its allies from Eastern Europe. The island is considered a core strategic interest in China and tolerance for provocation is likely to be low. A risk therefore is rapid escalation of tensions, that could go well beyond the trade and tech areas where China has shown remarkable restraint.
*FiveThirtyEight’s forecasting model points to a 70% chance of winning for J. Biden.
Cold hard Brexit_ Finally, the lack of progress with Brexit may weigh on UK assets in coming weeks. Talks between the UK and the EU were supposed to intensify before the soft deadline of October. Chances for an agreement in time are thin. The British government now has a choice between extending the deadline and walking away in the cold. With the Johnson government in a tricky situation internally after the pandemic, their choice is highly uncertain. Our base case goes with an extension of the transition period by 6 to 12 months.
Nasdaq whale_ All investors blaming central banks and liquidity for the irrational behaviour of markets in recent weeks can be reassured. The massive performance in US tech may have to do with a giant investor in call options, Japanese bank Softbank. Such a massive bet from a single private investor goes a long way explaining the disconnect between stock markets and the economy, as well as the valuation gap between tech stocks and the rest of the market (Exhibit 3).
Exhibit 3: Valuations are very polarised
Source: MSCI, IBES, SILEX – September 2020
Crowded trading_ The Softbank trade may be the straw that breaks the camel’s back. Of course, Covid has accelerated the trend towards digital consumption and services. Massive and prolonged QE is pushing equity valuations up and favours momentum and large caps. A new wave of retail investors, the ‘Robinhood generation’, is also amplifying the price action for fashionable stocks. But the fact that a very large institutional private investor takes such positions implies significant crowding in the Tech mega-caps that will need to be washed out.
Resilience_ The key question is therefore whether other parts of the market can hold up in a scenario of extended correction in Tech. Our answer is yes for several reasons. First, macro risks are rather supportive for cyclicals and traditional sectors. If a vaccine reduces future Covid risk, it should mostly benefit those. If geopolitical tensions rise, Tech may be disproportionately impacted. Second, valuations are not an issue for most of these stocks, which trade cheap to fair compared to historical average. Third, investors are largely underweight in these areas and have mostly gained exposure to equities through a narrow set of stocks since April.
Exhibit 4: Investors are no longer underweight in risk assets
Source : Bloomberg, AAII, BofA, SILEX – September 2020
Barbell_ As a result, our view is to design equity exposure through a barbell strategy. On the one side, getting out of the digital disruption thematic sounds unreasonable. The transition towards a numeric economy and an entrepreneurial age has been accelerated by the pandemic and many companies look set to benefit from arising opportunities. If anything, the wave of IPOs in recent weeks (Palantir, Asana, Snowflake) deepens the investment universe of newcomers. However, this strategy will have to be careful in order to avoid crowded and expensive names, which implies to stay in the small and mid-cap areas and away from the passive investing swamp.
Good old economy_ On the other hand, as explained above, we see potential in a second strategy focussing on the cyclical recovery. More traditional parts of the economy do not suffer from either expensiveness or crowding and may benefit from the recovery and vaccine. Sound companies in the wrong sectors, that have been beaten down by the pandemic, look particularly attractive.
Exhibit 5: Massive long positioning on EURUSD
Source : CFTC, SILEX – September 2020
Duration risk_ At the same time as the equity market becomes challenged, we see fixed income as unlikely to be much of a support to performance. In our view, long-term bond yields are excessively low and likely to move higher in coming months, especially in the US. First, inflation expectations may continue to adjust to both stronger prices and higher tolerance to an inflation overshoot by the Fed. Second, endless fiscal support translates into unprecedented debt supply which will only be digested through higher yields. If US Treasuries return to 1% or above, this implies very poor returns for sovereign debt and negative returns for IG credit. We prefer therefore spreads to rates, i.e. high yield over investment grade and Europe over the US.
Dollar bear_ Our broad macro scenario is consistent with a continuation of the dollar downtrend. Despite its recent decline, the greenback is still expensive compared to most of the G10 and more so against EM currencies. A cyclical recovery and a return to search for yield are more likely conducive of further weakness. Also relative carry has strongly deteriorated. However, the near term may be dominated by positioning and current market dynamics look very extended (Exhibit 5). As a result, a consolidation for EUR/USD in the 1.18-1.20 area may be most likely for now before the euro can resume its march higher.
Wobbly Gold_ As we had warned, gold looked too good to be true in July. Significant speculative capital had entered the asset class and a burst of the mini bubble looked set to take place. We think it may have a bit more to go, especially if interest rates go up. This will be an opportunity to re-enter as gold remains an asset of choice in a cross-asset portfolio.
Exhibit 6: SPARK expected returns and Sharpe ratios
Source: SILEX. Euro-based investors – September 2020
Sharpe(ly) down_ What does SPARK make of these views? The first take-away is that Sharpe ratios are much lower in September than they were in June (Exhibit 6). Expected returns for the remainder of the year are unlikely to be stellar. The risk/reward being similar in equities and credit, but with much higher volatility in equities, the algorithm favours an overweight in credit, especially the European IG and HY segments. In government debt, short-dated bonds are preferred to long-dated. Gold is underweight while copper is overweight.
Stock of stocks_ In equities, the barbell strategy is expressed via overweight positions in the Eurozone and Japan, where cyclical stocks are most abundant. The US is neutral but again, leading Tech mega-caps do not look the most compelling within that market. Switzerland is underweight while the UK is neutral. Finally, SPARK recommends underweighting Latin America compared to the rest of Emerging Markets.