While fears of a second wave of coronavirus bring renewed volatility to Europe and the US, investors are looking East for reassurance. China, which entered the pandemic three months ahead of the rest of the world – and now boasts positive economic growth – offers a useful template for the trajectory of the rest of the developed world.
As witnessed in China, we expect a significant pickup in activity from Europe and the US now that social distancing measures are relaxed. The downward trend has finally slowed in these areas and economic indicators have risen above April lows, marking a positive first step in this direction. This was, and will likely continue to be, led by activity in the service and consumption sectors, as social distancing measures are lifted further and people learn to live in the new post-Covid environment.
We anticipate the recovery will be faster than consensus expects, with the real possibility most economic activity could return close to pre-crisis levels by the beginning of next year. In fact, we believe the unprecedented amount of fiscal and monetary policy stimulus might fuel a temporary overshoot of economic growth in 2021 – before falling back toward more subdued long-term trends.
Despite the very real risk of a second wave, of which we are already seeing signs, we do not believe this will result in another full-blown lockdown in developed countries. Instead, we would likely see more targeted measures, which would not derail economic recovery. Nevertheless, the recovery will remain concentrated in developed countries following in China’s footsteps, while the rest of the developing world – countries mostly dependent on manufacturing and commodity export – are likely to experience a far less robust recovery.
Positioning for recovery
Before these positive developments are fully priced in by markets, now is still the time to increase risk exposure. But with ultra-low bond yields and sky-high equity valuations, many investors do not know where to turn. The key is to consider every aspect of an asset’s characteristics, including its merits compared to the available alternatives, as there is always relative value to be found.
While short-term rates across developed economies are set to remain anchored at or close to zero for the foreseeable future, volatility (even mild) on long term rates can offer opportunities. The 20-40 bps increase at the long end of the curve for US and European bonds in early June has made these assets slightly less expensive, while restoring some of their performance and decorrelation value. For this reason, we increased duration in our portfolios through 10YR treasuries.
Equity valuations, which regained pre-crisis highs in some sectors, may appear expensive given the current economic situation. However, it is necessary to go beyond purely intra-equity market metrics and consider equity valuations within the current rate environment. Taking into account the excess return currently offered by stocks over cash and bonds, equities are not expensive at all. In the US, this equity risk premium is close to a historic high. Therefore, combining both internal equity metrics and risk premia, we still see value in equities.