Macro update: November 2020
Welcome to our monthly macro update, the FOURcast. Much like a weather forecast, it provides a guide to what we think may be coming, and how to position portfolios to prepare for the future climate.
Is equity market leadership set to change?
Cyclical vs. defensive stocks
Cyclical sectors are those which are more economically sensitive, and performance tends to fluctuate in line with economic strength. Defensive sectors on the other hand are more resilient to the economic cycle.
Cyclical sectors have in general been notable underperformers in 2020. However, this could be set to change. We have been advocates of high-quality companies this year, with a particular focus on defensive sectors. And we are not the only ones – investors have understandably prioritised defensive assets, materially widening the valuation gap between cyclical and defensive stocks.
Valuation Premium/(Discount) Cyclical vs. Defensive stocks
Notwithstanding a moderate rebound recently, cyclical stocks continue to look discernibly cheap. At these valuation levels, we expect any improvement in economic momentum to be supportive for cyclical stocks, and there are tentative signs of this. Economic sentiment picked up in October (US ISM Manufacturing Index jumped to a two-year high) while China’s strengthening demand should support global trade and growth.
That being said, we do not anticipate a uniform cyclical recovery and we believe it is critical to focus on the high- quality names within these sectors (strong balance sheets, high levels of cash, positive ESG characteristics). In particular, we favour the consumer discretionary and industrial sectors where it is apparent that valuations are more disconnected from economic fundamentals than other sectors.
Snapshot of views
Underlying financial conditions continue to be supportive, with low credit costs creating a positive environment for equities in particular. Economic conditions are improving, albeit off a low base, but rising Covid-19 cases and tighter restrictions in many major economies are clear headwinds – although the positive progress towards a vaccine is promising.
Despite modest market falls in October, equity and credit valuations are expensive, and even with a vaccine, the crisis has caused long term, structural shifts that must be accounted for. We remain in the Downturn phase of the market cycle but recognise that policy support continues to be the dominant factor for asset prices and warrants a moderate allocation to high quality risk assets; hence our overall rating for risk assets is a neutral.
As we set out in our asset class views, opportunities still exist, but only in certain areas of return-seeking markets. Take corporate credit for instance; broad credit markets are only offering very modest returns, so a selective approach is preferable. We are encouraged by vaccine progress and continued signs of improving economic data, likely supports for one of our emerging themes – cyclical sectors – which we cover in more detail below. But we would caution that current headwinds, most notably the growing second wave of COVID cases and subsequent pressure on service industries, favour a continued bias to high-quality companies. Balance sheet strength will continue to be key. Likewise, we favour assets with built-in downside protection, such as structured equity, which provide risk-managed upside.
A selective approach continues to be key for credit markets
Central bank support has compressed credit spreads significantly since late March and, combined with the low interest rate environment, has reduced expected returns in credit markets. But whilst the low-hanging fruit tied to early recovery has now disappeared at an index level, there are opportunities when using a more selective approach. We’ve seen this recently due to increased spread volatility and expect the same going forward as record supply this year gives way to lower issuance. We anticipate bouts of market volatility to continue alongside corporate credit stress.
Record annual levels of new issuance in credit markets with 3-months of 2020 remaining
Source: SIFMA, US corporate issurance
This argues more than ever for a targeted approach. As a result, where we have client discretion, we have increased our allocation to industry and issuer-specific opportunities, whilst reducing our broad market exposure. The opportunistic vehicle we seeded this year targets these dislocations without sacrificing on credit worthiness. Credit selection with a focus on default avoidance is critical, particularly in high yield, where it is likely that stresses will emerge despite companies taking steps to reduce their vulnerability.
How will the US election impact markets?
We saw volatility rise over October with equity markets suffering a temporary pull-back in the run up to the US election. This provided us with an attractive entry point to add to equity exposure, where our clients provide discretion, particularly as we saw the various likely outcomes of the election as broadly positive for risk assets. Markets reacted positively to the news of a Biden Presidential victory and likely Republican Senate. This outcome will likely result in further fiscal stimulus and a more stringent approach to the pandemic, without having the senate majority to enact sweeping tax and healthcare reform. Higher long-term spending under a Biden administration will also
be beneficial for growth, outweighing the risks of moderately higher corporate and capital gains taxes. More broadly, the election result is a victory for globalisation and international cooperation, with Biden already declaring intentions to re-join the Paris Climate Agreement.
This article has been issued and approved by River and Mercantile Solutions, a division of River and Mercantile Investments Limited which is authorised and regulated in the United Kingdom by the Financial Conduct Authority (Firm Reference No. 195028; registered in England and Wales No. 3359127) and is a subsidiary of River and Mercantile Group Plc (registered in England and Wales No. 04035248), with its registered office at 30 Coleman Street, London EC2R 5AL. Please note that all material produced by River and Mercantile Investments Limited is directed at, and intended for, the consideration of professional clients only within the meaning of the Financial Services and Markets Act 2000 (“FSMA”). Retail clients must not place any reliance upon the contents .The information expressed has been provided in good faith and has been prepared using sources considered to be reasonable and appropriate. While this information from third parties is believed to be reliable, no representations, guarantees or warranties are made as to the accuracy of information presented, and no responsibility or liability can be accepted for any error, omission or inaccuracy in respect of this. This document may also include our views and expectations, which cannot be taken as fact. The value of investments and any income generated may go down as well as up and is not guaranteed. An investor may not get back the amount originally invested. Past performance is not a reliable guide to future results. Changes in exchange rates may have an adverse effect on the value, price or income of investments. This article is confidential and is intended for the recipient only. Unauthorised copying of this document is prohibited.
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