Article October 30, 2020

FOURcast: October 2020

Our four phase framework reflects that markets continue in a downturn environment

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Welcome to our monthly macro update, giving greater insight into our outlook for investment markets and the investment ideas that currently interest us. We are well known for our agile approach to investing assets, and in these current volatile conditions, this is incredibly important.

We make our internal views more accessible using our four-phase framework, the FOURcast. Much like a weather forecast, it provides a guide to what we think may be coming, and how we should position portfolios to prepare for the climate to come.

  • Equity markets fell over the month amidst a growing number of risks. Credit spreads widened modestly.
  • The US election, rising COVID-19 cases and an impending Brexit deadline contributed to rising uncertainty in financial markets.
  • Stimulus continued to support the economy, but the recovery is uneven and imbalanced. Consumer confidence is rising, albeit off a low base.
  • Valuations look expensive but are partly justifiable given the considerable policy response.

September saw US, Europe and Asian equity markets decline as investors weighed up lofty valuations with a growing number of risks. US equities fell close to 4%, whilst most other major equity markets fell c.2%.

Credit markets also fell, but central bank purchase continue to support underlying credit conditions. Near term economic conditions are improving, albeit off a low base, with significant stimulus and low mortgage rates encouraging spending. But rising COVID-19 cases and tighter restrictions in many major economies are likely to make any economic recovery uneven and imbalanced. Despite modest market falls, equity and credit valuations are expensive. As a result, 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 therefore warrants a moderate allocation to high quality risk assets.

  • Economic conditions are improving but uneven. Hospitality and leisure are clear laggards, whilst some manufacturing and industrial sectors are making good progress. Consumer confidence is rising, and government intervention has prevented mass long-term unemployment for now. But as governments withdraw support, economic scarring is likely to materialise.
  • Credit conditions have fallen slightly over the month but remain positive given the economic backdrop. Corporate borrowing costs remain low.
  • Valuations continue to look expensive, particularly in the US, but are partly justifiable given the considerable policy response. This warrants a selective approach to risk assets, using tools such as structured equity to provide downside protection.

RISING COVID-19 CASES

Rising COVID-19 cases could set back the pace of economic recovery heading into the winter. The spike in new cases is not uniform across countries; whilst most US states are tightening restrictions again, China has had more success in reopening their economy safely. But social restrictions look inevitable going into the winter and have scope to cause further market volatility and economic uncertainty. On the positive side, vaccine timelines have shortened dramatically since the start of the pandemic, and monetary and fiscal stimulus is already triple that of the 2008/2009 recession.

ANOTHER BREXIT DEADLINE LOOMS

With the transition period set to end in just 3 months, negotiations are coming to a crescendo. The UK government’s move to overrule parts of the Withdrawal Agreement brought added scepticism they could agree a deal, with sterling weakening accordingly. Senior political figures have attempted to inject some impetus into talks ahead of the 15th October European Council, but Macron's insistence on access to UK fishing waters remains a key sticking point. Failure to agree a deal has the potential to weaken UK and EU equity markets, in particular exporters who rely on cross border trade.

US ELECTION

Biden remains the favourite, with his polling increasing after the first debate. Trump’s COVID-19 diagnosis also refocussed conversation on the administration’s health response, with the potential for further damage to his re-election chances. Just as importantly, polls now show Democrats more likely to win control of the Senate, enabling a more progressive agenda on tax reform and healthcare.

IMPLICATIONS FOR PORTFOLIOS

Markets are largely proving resilient to the economic climate, thanks to continued policy support. But with the economic recovery uneven and imbalanced, and with notable risks on the horizon, we continue to favour high quality assets with strong balance sheets. Companies that came into this crisis with stronger balance sheets are in a better position to weather the storm and pick up cheap assets. Conversely, companies with weak balance sheets will be distracted by restructuring. We believe this is an important theme, particularly in equity markets.

We also continue to believe that liquidity is highly important. We expect many illiquid assets to come under pressure as economic stresses emerge, and we do not think pricing sufficiently reflects this in many cases. In the coming months, it will be to key to maintain high levels of liquidity to take advantage of opportunities as they arise.

What is the FOURcast?

This is our version of a weather forecast which provides a guide to what we think may be coming for investment markets and therefore how we should be positioning ourselves.

The output from the FOURcast produces one of four market phases, as we define them:

Upward re-rating
The most obvious phase to name perhaps is when valuations look cheap and credit conditions and economic conditions are improving. This is then the time to be fully invested.

Downturn
Contrary to an upward re-rating, the FOURcast usually transitions to Downturn before a significant market fall - sometimes six months early. This works well for us as it gives us time to plan. Valuations are expensive and economic and credit conditions are deteriorating.

Apprehension
This is where valuations look expensive but credit conditions are still supportive. Economic conditions may be mixed.

Stable
When everything generally looks okay - valuations are fair, economic conditions are broadly positive and credit conditions are improving.

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