After the Rally, Risk Assessments for 2H 2020: Second Wave, US Elections & Deglobalisation
• As we come off the best quarter for S&P 500 (+20%) since 1998, Nasdaq (+29%) since 1999, US investment grade and high yield bonds (+10%) since 2009 and for oil (+80%) in 30 years, it is important to reassess the key risks to monitor in 2H 2020 – (1) Second wave, (2) US elections and (3) Deglobalisation.
• Investors are recommended to use a “barbell” strategy for 2H 2020 -
On the one hand, to stay invested as we have been advising to buy global equities and credit after the large price falls in March to take advantage of the global recovery and abundant liquidity;
While on the other, to hedge against key risks (second wave, US elections, increasing geopolitical tensions amid deglobalisation) with defensive strategies such gold, dividend stocks and quality corporate bonds.
Best quarter for many asset classes in recent history
As we come off the best quarter for S&P 500 (+20%) since 1998, Nasdaq (+29%) since 1999, US investment grade and high yield bonds (+10%) since 2009 and for oil (+80%) in 30 years, it is important to reassess the key risks to monitor in 2H 2020.
Firstly, one of the risks is a second wave and what that could mean for the global economy. Secondly, US elections as the market starts to focus on this over the summer. Thirdly, deglobalisation and what that means for the long-term investment trends. The most recent conflict between China and India is another example of the trend and could be an important watershed event for Asia.
(1) Second wave – Another complete lockdown is not our base case scenario
Firstly, a second wave appeared during June in the south and west of the US, and localised outbreaks emerged in China, Australia, and parts of Europe. In addition, Latin America, India, and Indonesia remain solidly in their first wave. However, while media coverage is often black and white, the reality is shades of grey.
For example, the states in the US having renewed infection rates in reality never had a first wave, as 50% of cases were in the New York metro area, and as a result, these states opened too early. While the states that had a first wave on the East Coast are not seeing a surge.
Furthermore, at a broader level, the hospitalisation and mortality rates have not gone up in proportion likely reflecting better preparedness, younger age of cases, and perhaps even a fading mortality rate of the infection.
Finally, the amount of people infecting others or reproduction rate at a national level has barely moved about 1, a critical level for accelerating transmission. Hence, a risk globally but should not be overstated at this point. This is why risk markets shrugged off virus fears into quarter-end.
Our base case remains that a second wave requiring closing of entire countries is not likely at the moment. The base case are localised closures and restrictions to control the epidemic. The economic costs of a total lockdown are circa 3% of GDP per month or 36% annually! Therefore, while there will definitely be setbacks, the bar is high in developed countries for total lockdowns.
(2) US elections – Joe Biden is leading in national polls
US elections in November will be an increasing area of interest for financial markets this summer. It feels like a long-time ago indeed when the US had a 50-year low record unemployment rate of 3.5% in the Spring of 2020! (which has now increased to 13.3% at the end of May).
Regardless of whether it is President Trump’s fault or not, the bottom line is when there is a recession within two years of an election, the incumbent has won just twice in seven elections. The most recent incumbent losers include George H. Bush in 1992 and Jimmy Carter in 1980.
However, there is ample time until the election and politics are inherently unpredictable. Nevertheless, at this point, former Vice President Joe Biden takes lead over President Trump by a wide margin nationally in polls, and importantly leading in the key swing states that will determine the election result if it is close.
The next question then is what the main policy differences are. Key to keep in mind is Biden is a moderate, not a Bernie Sanders. Currently, Joe Biden has not released much detail on his policy platform. However, one would expect some moderate rollback of the massive Trump tax cuts and recommitment to Paris climate accords.
Biden supports universal insurance similar to Obama care but not a single payer system - so evolution not revolution. He would re-engage multi-lateral institutions as well. Don’t forget one of the few areas of bipartisan agreement is on China. Therefore, intellectual property, fair trade, and human rights will continue to be areas of tension.
(3) Deglobalisation - A watershed moment as we move to a multi-polar Asia?
The big event geo-politically in Asia is the China-India border dispute, an open conflict for the first time in over 50 years. The backlash in India has led to calls from some to boycott Chinese products. In fact, the Indian government recently asked on-line retailers to post country of origin of products.
Furthermore, India announced a surprising ban on Chinese apps including Tik Tok. India is Tik Tok’s largest foreign market The big prize at risk is that later in the century, India will likely be the largest consumer market in the world.
Chinese companies have leading positions in handsets and have big ambitions in India given its immense size. When we look back in history, this could result in the emergence of a multi-polar Asia with the two most populous nations, and potential implications for further deglobalisation.
At a global level, since the global financial crisis of 2008, trade was already stagnating as a share of the world GDP, in what some have called “slowbalisation”, or “postpeak” globalisation.
Further to the trade war between Washington and Beijing since mid-2018, the trend of deglobalisation is accelerating due to the COVID-19 global pandemic, which has massively disrupted the supply chains globally. Geopolitical tensions also greatly increased recently after the introduction of the new Hong Kong security law by the China Communist Party.
Global trade (as % of GDP) was stagnating after 2008 Global Financial Crisis
Source: World Bank, as of Dec 2018 *For illustration only and not represent any investment recommendation.
Many companies have already shifted or are starting to re-shuffle their supply chains in a bid to diversify and ensure longevity. Further regionalisation/localisation will likely lead to a consolidation of players, with weaker competitors being eliminated.
In the global semiconductor market, China is a relatively small player with Huawei’s chip designing arm HiSilicon the only Chinese entity featured in the top 10 global semiconductor players. A handful of American companies dominates this sector and only Samsung Electronics, TSMC and SK Hynix* are able to command market share.
Hence, Taiwan and Korea are likely to be the main beneficiaries from this deglobalisation theme, given their specialised capabilities on wafering technologies as well as the availability of existing high-end facilities. The recent ban by the US on Huawei to utilize TSMC may result in the acceleration of China’s plan on self-sufficiency in energy, power and technology by 2025.
To conclude, investors are recommended to use a “barbell” strategy for 2H 2020 –
on one hand, to stay invested with exposure to risk assets and buy on dips as we have constantly advised since the Covid-19 crisis to take advantage of the global recovery and abundant liquidity;
while on the other hand, to hedge against key risks (second wave, US elections, increasing geopolitical tensions amid deglobalisation) with defensive strategies such as gold, dividend stocks and quality corporate bonds.
CIO INSIGHTS – GDP & CPI FORECASTS
The continuing economic recovery in China is encouraging sign for the rest of the world. Key economic indicators were better than expected in June, albeit it may take several months before the economy returns to normal levels of activity, given the severity of the shock suffered in the first quarter of 2020.
As mentioned previously, demand will continue to be challenged, both domestically and globally. Additionally, geopolitical risk and the potential re-emergence of the coronavirus and subsequent lockdowns will also act as a headwind to the recovery.
In Europe, the gradual re-opening of economies has led to a significant improvement in business sentiment indicators such as the flash PMIs, French business confidence and the IFO business climate in Germany.
In certain cases, the rebound in June was the strongest on record, after the collapse in March and April. Consumer confidence in the Eurozone, France and Germany has also improved, but in a less forceful way than business sentiment.
Our inflation outlook is generally unchanged. We continue to expect a gradual economic recovery as policy measures take effect. Our base case is still for a 2H recovery for majority of the economies. Thus, we expect demand to return and inflation to start picking up in the second half of the year and into 2021.
Nonetheless, inflation will likely still remain weak for the whole 2020 given the drastic drop in demand due to the pandemic. For the US, we expect inflation to be around 1.2% for 2020 before rebounding back to 2.2% for 2021, while for Japan, we expect deflation for both years at -0.2%.
CIO INSIGHTS – EQUITIES
• Global equities have risen 42% since their March low, bringing them just 7% away from their February record high. Vaccine hopes, signs of economic stabilisation, rapid money supply growth and spectacular mobilisation by monetary authorities and governments have fed this optimism.
Valuations are elevated but are supported by high level of excess liquidity (M1 growth versus GDP growth). Nevertheless, fundamentals would eventually need to confirm the high expectations.
• We expect volatility to dominate markets over coming months. Risk factors includes a resurgence of the COVID-19 virus, whether higher capacity utilisation rates and employment levels return, bankruptcy trends, and the US presidential election or geopolitical threats.
We have also downgraded UK equities from positive to neutral as we see subpar growth trends as well as increasing uncertainty of a “no-deal” Brexit scenario.
CIO INSIGHTS – FIXED INCOME
• According to Fed’s dot plot in June (first edition since December), the central bank will likely keep rates at current levels (0-0.25%), at least until the end of 2022 to support the economy. Interestingly, no members wished for negative Fed funds rate and most believed that the economy requires at least 3 years before it can return to its pre-covid level of activity.
The Fed also stated that their bond purchase program will likely continue at the current pace (USD80bn Treasuries and USD40bn Mortgage Backed Securities every month), while Fed Chair Powell revealed that the Committee is actively discussing explicit forward guidance and yield curve targeting.
• June brought forth stabilisation and even certain degree of risk-on in the markets with further re-opening of economies globally. EM bonds hard currency bonds were up 1.8% in June. Asian credit also showed strong performance.
We have upgraded Hong Kong and Singapore credit to positive from neutral. We have turned positive on HK IG residential developers, which are trading at attractive valuation when compared to China IG issuers with similar credit rating.
• The commitment of the Fed to keep rates low and the weakness in USD are both beneficial for the EM/Asia asset classes. Credit spreads have also retraced nicely back to near pre-covid levels. Despite positive medium-term outlook amid continued economic recovery, we prefer to stay neutral on EM HC bonds as some consolidation may be expected in the short-term after the strong rebound.
CIO INSIGHTS – FOREX
USD: The USD could be poised for a broad move lower in the second half of 2020 after a period of consolidation. Yield differentials have compressed to the extent that hedging costs for global investors with USD exposure have dropped considerably. USD funding conditions have also improved significantly, reducing the need to hoard the greenback for liquidity purposes.
NZD: NZD continued to benefit from the rally in risk assets, driven by the recovery in China, the significant easing of lockdown restrictions in the country, and a reduction in short positions. The RBNZ expanded its Large Scale Asset Purchase programme potential to NZD60bn, while viewing the economic outlook as skewed to the downside and highlighted it is prepared to expand the QE programme further. Near term, the more accommodative stance of the New Zealand central bank could limit the appreciation potential somewhat. Our 12-month target for NZD/USD is 0.66.
CIO INSIGHTS – ALTERNATIVES & COMMODITIES
GOLD: We remain positive on gold, and raise its target range to USD 1700 – 1900, as its key fundamentals remain in place. The current ultra-accommodative monetary policy is expected to last for a while, and real bond yields should remain negative or very low for longer. Massive quantitative easing is also scaring some investors, increasing the attractiveness of gold as a hedge.
OIL: Oil prices have stabilised as lockdown measures and travel restrictions worldwide are slowly being lifted. Supply side is also looking better with lower US inventories and efforts by OPEC+ to continue its production cut. The combination of a rebound in global demand and a fall in supply should help the price of Brent recover towards $45-55/b in the second half of 2020.
LONG-SHORT EQUITIES: We are positive on long-short equities. The indiscriminate sell-off gave managers a chance to buy high quality businesses at a discount, with strong recovery potential. The crisis will no doubt create survivors and losers, offering attractive long/short opportunities for fundamental stock pickers. Short restrictions in continental Europe have been lifted. We remain cautious on quantitative market neutral managers, as they are less likely to correctly adapt to the new post crisis market paradigm, even if a lot of assets have now left those strategies.
GLOBAL MACRO: We are positive on macro managers. After Central Banks and governments have injected the most liquidity ever in exchange for hugely increased debt, FX and fixed income markets are bound to offer trading opportunities. Increasing deglobalisation and differentiated country fiscal policy should offer more relative value opportunities. CTAs have a role to play in portfolios, as tail hedge in case of a lasting bear market. But they are also subject to reversals in the current fast changing environment.
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