We may be living in the new normal, but there has been nothing normal about the economic cycle we’re currently in. We have seen the S&P 500 index drop 34% from February 19th to March 23rd – then witnessed the speediest stock market recovery in history. We have seen a stock rally driven by liquidity and speculative sentiment, although market fundamentals paint a more sobering picture.
As we look to the realities of the post COVID-19 world, we see signs of a U-shaped recovery. Attractive opportunities remain, but volatility is likely to remain high. Investors need to remain prudent and be prepared for further uncertainty and risks ahead.
Market outlook: A gradual recovery
While many analysts initially predicted a V-shaped recovery, we think a U-shaped economic recovery now looks more likely. Under this scenario, the recovery is gradual and a longer period of time is needed before the economy fully bounces back.
There are several reasons why. Until a vaccine or effective treatment is found, governments will continue to face a trade-off between fully re-opening the economy and the health risks of a potential second (or perhaps even a third) wave.
Consumers are likely to be more cautious in their spending habits, given the uncertainty that remains. A global McKinsey survey found that despite many countries lifting lockdowns, incomes have fallen. Many consumers are not feeling too optimistic about their countries’ economic outlook and spending intent remains below pre-COVID levels.
At the corporate level, the ongoing uncertainty will continue to weigh on business investment. Capital spending remains on pause, and businesses are not investing in new equipment or technology. This will leave a lasting impact on future productivity.
Why have equity markets rallied so quickly?
One of the most frequent questions clients have asked us is this: “Why have equity markets rallied so quickly and sharply despite the economic crisis?”
Looking at data such as unemployment rates, the exuberance in the stock market can seem baffling. But bear in mind that while the COVID-19 crisis has been unprecedented, the scale of the monetary and fiscal policy response put forth by governments worldwide has been equally unprecedented in terms of magnitude and swiftness.
In the US, from which most stock markets generally take their lead, the fiscal response of US$2 trillion far exceeds what was seen in the wake of the 2008 global financial crisis.
In an unprecedented move, the US central bank bought US$7.9 billion of corporate bond exchange-traded funds (ETFs) between May 12 and June 29. From June 17 to 26, they purchased another US$1.3 billion of corporate bonds. These actions boosted their purchases under a market stabilization buying program to about $1.5 billion at the time.
This followed an earlier announcement from the US Federal Reserve (Fed) committing to purchase at least US$500 billion in Treasuries and US$200 billion in mortgage-backed securities over the coming months. Central banks worldwide have followed suit, slashing interest rates and pumping massive amounts of liquidity into the system.
These responses have been designed to keep government, corporate, and household borrowing costs low. Additionally, these policies are meant to help avoid a devastating wave of bankruptcies and business failures. It is clear that the forceful and robust policy support we saw globally revived investor sentiment and confidence. Additionally, markets are forward-looking. Investors are still anticipating a V-shaped recovery, which markets are pricing in.
At this stage, nobody can say for sure what will happen over the next few months. But so far, we have seen some notable trends:
- Of the 11 major sectors in the S&P 500, tech and consumer discretionary have enjoyed the largest percentage gains
- Healthcare, pharmaceuticals, biotechnology are experiencing strong growth as trials of potential vaccines have shown promise
The crisis is accelerating society’s move to a digital-first economy. Meanwhile healthcare innovation will be the priority for many governments in the years to come. While it may be tempting to aggressively allocate into these sectors to ride the trend, we prefer prudence and maintain that a well-diversified portfolio is still as important as ever.
Downside risks in the form of a second (or possibly third) wave of infection, heightened geopolitical tensions, and the outcome of the US presidential election in November could lead to fresh market turbulence.
Meanwhile, Wall Street’s “fear gauge”, the Chicago Board Options Exchange’s Volatility Index (VIX), remains high at around 26. Of course, the VIX has come down significantly from its all-time high of 80 in March. But VIX levels have remained persistently in the mid 20s to 30s these past months, considerably above its long-term average level of around 20.
As such, we encourage investors to remain prepared for further volatility. Diversification – having a mix of stocks, bonds, gold and other assets in your portfolio – will help you weather unexpected storms.
What should investors do?
When advising clients, we like to use the core-satellite framework where the core is a multi-asset portfolio like our Core Equity100 portfolio, and the satellites are interesting thematic investments in our REIT+ portfolio.
We believe this strategy can offer some downside protection while realising potential gains from the ongoing rally.
In the event of another market rout, our Automated Risk-managed Investments (ARI) methodology will help limit excessive fluctuations in value within your core portfolio. At the same time, if there is an upside scenario in which an effective vaccine is found sooner than expected, smaller, concentrated investments in 100% equities (Core Equity100) and / or 100% REITs (REIT+) can capitalise on these opportunities.
As we look to the eventual recovery, what’s most important is keeping a long term view. Business revenues will improve, consumer confidence will return, and workers will be rehired. The recovery isn’t a question of if, but a question of when.
For more insights into Syfe’s Q3 market outlook, tune in to our webinar next week, 30 July at 7pm.