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In these markets the normal rules do not seem to apply

Friday 19th June 2020

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It is a sign of how distorted markets have become that some of the same forces that contributed to precipitous falls a few months ago are now spurring the recovery. For investors, it can seem like a lottery to try to pick winners in markets where the normal rules do not seem to apply. Only a handful of assets, to my mind, look resilient. 

During the market crash in March, six factors combined to shake investors’ portfolios: asset price dislocation from underlying economics; the proliferation of social media; “fallen angel” risk in corporate debt markets; the growing popularity of algorithmic trading strategies; the multiplicity of global supply chains; and the dominant weighting of tech companies in indices. 

Some of these factors continue to pose significant risks to markets as they mount a recovery, creating potential drag effects. 

Take the severe dislocation between strong markets and weak fundamentals, which means that we are perpetually vulnerable to a negative swing in sentiment. Following the April rally, the MSCI US index, which measures large-cap and mid-cap stocks, has been more expensive just 1 per cent of the time since 2003, based on our composite valuation measure blending earnings, book value and dividend yield. The MSCI US Growth index, meanwhile, has never been pricier. A second wave of Covid-19 infections that results in renewed lockdowns could bring this mini-bull market to an abrupt end. 

Social media also remains a headwind. It fanned fear and misunderstanding in the virus’s early days and still acts as an echo chamber for anxiety, exacerbating collapses in both investor and household confidence. 

The complexity of global supply chains will continue to weigh on portfolios, too. Although China has lifted a lot of lockdown measures and businesses are reopening, the step-up in containment measures elsewhere in the world is now feeding back through global supply chains, dragging on China’s own recovery. Enduring political tensions between Washington and Beijing may result in additional trade actions against China, from which many other countries would see collateral damage.

However, three factors that had helped accelerate falls in markets have flipped to become unlikely boosts. 

At the outset of the Covid-19 crisis, triple B-rated bonds accounted for about 55 per cent of the US investment-grade credit market — up from about 30 per cent a couple of decades earlier. Many investors, including ourselves, worried that a market downturn could prompt a wave of downgrades to high-yield status, creating so-called “fallen angels”. This could lead to forced selling from certain investors and more companies struggling to stay afloat. 

What we had not counted on was the response from central banks. The US Federal Reserve is expanding its corporate lending programmes to include the double-B portion of the high-yield market and the European Central Bank has hinted it may follow suit. These actions relieved the market of its most pressing threat and have encouraged inflows into high-yield credit funds. Perversely, given the underlying economics, it has become a “risk-on” market environment. 

Systematic investing, too, which has grown hugely in popularity over the past decade, accelerated moves in stocks at the outset of the crisis as funds were forced to sell fast-falling assets. But now, as volatility fades — helped by Fed support measures — strategies such as “risk parity” funds that are sensitive to price swings are adding to their equity exposures, buoying markets.

And lastly, consider the monstrous dominance of technology stocks, which until recently we had considered a systemic risk to markets. The products and services of tech giants now underpin most global businesses, so we thought that any event that hit this sector could rapidly transmit shocks across most classes of assets. But as it turned out, the systemic importance of the tech behemoths, and their sheer weight in market indices, have been a saving grace.

The government response to the Covid-19 outbreak has been a gift to technology firms, especially software companies geared towards helping businesses operate virtually. Software shares are now at sky-high valuations, but we think their remarkable resilience will persist, reflecting a belief that the pandemic will accelerate a shift towards virtual meetings and reinforce businesses’ dependency on technology. Facebook, Apple, Microsoft, Amazon, Netflix and Google now account for more than a quarter of the value of the S&P 500 index. Their outperformance will drag the whole index higher.

When apparently positive signals can turn negative and back again in a short timeframe, it makes sense to weight portfolios with high-quality, defensive assets such as mega-cap tech stocks and investment-grade credit, with a bias towards the US. Anything much riskier than that looks set for a white-knuckle ride.

The writer is chief strategist at Principal Global Investors

Source: Financial Times 

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