Despite calls from some commentators that markets will retest their lows, at this stage policy makers have successfully subdued the panic that characterized the first 3-4 weeks of the sell-down. Caution is high and sentiment still fragile, but we think investors are now more focused on determining the fundamental impacts of the economic hit rather than selling risk and raising cash at any costs.
This is not to say we won’t get further, and potentially significant, periods of weakness, but unless it is driven by material downside surprise (either economic or health related), we think bouts of risk-off are more likely to be more discriminate (less disorderly) and focused on stocks and sectors most exposed to economic weakness such as consumer and industrial related cyclicals.
In fact, as we have written previously, markets are becoming more de-sensitized to the scale of the economic downdraft that is unfolding and perhaps as a result, it’s no longer about the depth of the quarterly decline (does it really matter if US GDP growth falls - 35% instead of -25% in a single quarter?), but more so the duration as this is when second and third order economic impacts become harder to offset.
While the catalyst for this bear market has been like no other before it for almost 100 years, the playbook has not been too dissimilar to prior recession periods (begging the question as to why it would be any different coming out the other side?). For instance, bonds picked up weakness in the growth backdrop followed by equities.
Within equities the sell-off started with consumer and industrial related cyclicals and then traversed through high multiple growth stocks before infecting defensives, including yield sensitives which initially took ground cover from falling bond yields. Credit was the last domino to fall as it finally shed its de-coupling mantra. In the end, while a lot has been written about how the sell-off is different from those before it, the bear market has rolled through risk assets in a reasonably familiar manner.
So, if the panic has subsided, what are the questions at the top of our mind that provide some insight into where we are going and what to do next? We address these below:
- Does it matter that everyone has now converged on the same catalysts to mark a bottom in risk assets?
- If so, many commentators are now suggesting, it’s a “once in a lifetime buy opportunity” why does asset allocation not (currently) reflect this? and
- Why is there so little focus on the playbook for “how to navigate a recession” by equity investors?
First, we don’t think it matters that everyone is now focused on the same thing to mark a turning point in risk assets. For a sustainable turn, the consensus must be reasonably aligned and it is clear that this is around peak infection rates in the US and less so Europe.
Perversely, there is not a lot of concern around how the epicentre is in perpetual motion and will shift to other countries once the US and Europe are looking better. Nevertheless, we think the turning point becomes more robust and sustainable if the catalyst is well understood.
We think there is more uncertainty around what constitutes a turning point in infection rates than there is on this being the catalyst for a turn (i.e. could the US face a similar situation to HK and Singapore which recently invoked a second round of containment measures to prevent another wave of infections?). Sometimes we want to outsmart the consensus but sometimes there is safety in numbers, and we think this is one of those instances where avoiding downside is a better risk than missing the first of the upside.
Second, commentators who are suggesting this is a “once in a lifetime buying opportunity” are for the most part talking about stock specific rather than asset allocation shifts at this point in time. These commentators might be benchmarked (and hence trying to get ahead of their peers) or they could be unconstrained such as hedge funds.
If institutional money is the so called “smart money” then we don’t detect the smart money to be making broad asset allocation shifts. Instead, there appears to be selective buying of oversold stocks accompanied by a narrative that over the long term, the market will recover (and we don’t disagree). The problem with this narrative is that if the market falls, institutional investors only have to fall by less (or have hedged the downside) so its job done.
For a retail investor, a further decline in their portfolio is a hard pill to swallow. Similarly, if portfolios are at benchmark and fully diversified, then there is no need to add risk at a stock level because capital preservation is still key for the majority.
Third, why is the recession playbook getting so little attention? We don’t know…maybe because most Australian investors don’t know what a recession looks like (unless you were born in the 1960’s or earlier) or that few see it as being relevant because this is an unusual downturn.
But we think it is relevant and that a recession playbook should be a useful guide (not necessarily definitive) on how to play the downturn and the recovery.
Traditionally as the market sells off, allocation is all defensive, but after large sell-downs and when the market begins to “consolidate” allocation favours defensives/quality (Utilities, Healthcare, Staples) with some early cyclical exposure added in (Financials, Technology, Materials and selected Discretionary).
It is only during the “recovery” phase that you shift overweight cyclicals (Energy, Industrials). Hence, it is consistent to add risk at the bottom, but a portfolio is still defensive until recovery takes hold. We urge investors to differentiate between what is changing at the margin (like adding some cyclical exposure) versus what your portfolio remains primarily exposed to (predominantly defensives). What’s different this time around?
Instead of taking on oversold cyclical exposure in the first instance, we think investors are looking at high quality growth stocks and instead of consumer discretionary exposures they are looking more towards domestic Industrial’s which are less consumer spending driven. Broadly speaking we think the rest of the playbook remains intact and think investors should not be so quick to discard it on the basis that this time is different!
Jason and the Investment Strategy Team