Investors swept up in optimism need to ask themselves two questions
Investors express a range of views at any given time about asset prices and the future. But whether your lens is bullish or bearish, it pays to retain a healthy sense of scepticism — particularly given that the post-Covid-19 environment for economies and the broader financial system present serious challenges for investment portfolios well beyond 2020.
In recent weeks the equity market has sent out strong signs of optimism over the shape of the rebound from the pandemic. Sentiment over the past few days has been bolstered by Europe increasing its monetary and fiscal stimulus efforts. The brighter mood was capped on Friday by a stunning gain of 2.5m US jobs during May. Economists had expected a loss of 7.5m.
A sustained upswing from the shock of Covid-19 will look very good for recent buyers of risk assets, while leaving behind many defensively oriented portfolio managers. And all around the world, there are encouraging signals, where stock markets are starting to catch up with the pacesetting US benchmark, the S&P 500. A weakening US dollar and rising commodity prices are easing shackles imposed on many emerging markets.
In spite of this, investors have good reasons to reflect and to ask themselves hard questions. Namely, whether current stimulus efforts can truly repair the economic damage wrought by the pandemic; and whether the long-term consequences of shutdowns will prove inflationary.
It is reasonable for governments, central banks and investors to expect that current relief programmes will bridge the gap between an end to lockdowns and an eventual recovery. The current recession was triggered by a sudden hard stop in activity, and those at the sharp end of this contraction, such as low-paid workers and small businesses, are suffering the most.
Even so, as huge amounts of stimulus have swilled through financial markets, few investors have paused to assess the ultimate effectiveness of each dollar, euro and pound expended.
So where does this leave investors running diversified portfolios?
Chris Watling at Longview Economics argues that the evolution of credit conditions is a critical factor for long-term investors to watch in coming months. This will determine, he says, whether the US and global economy is poised “to enter an inflationary boom or a deflationary bust”.
Loose credit conditions will sustain the wall of money that currently drives the apparent divergence between asset prices and the state of the broader economy. Such looseness is good for asset returns, up to a point. But growing public unrest, exacerbated by the pandemic, raises the risk of government policies that redistribute wealth in the coming years.
Higher taxes, regulations and a more inflationary environment all pose a threat to corporate profit margins, which should ultimately clip equity returns. One small comfort for portfolio managers who stick mainly with stocks is the likelihood that bonds perform a lot worse, given that their current low fixed rates provide scant protection in an environment of higher inflation.
For now, credit conditions are tightening, meaning that banks are taking a more restrictive approach to lending. This ultimately starves weaker companies and sectors such as commercial real estate that have enjoyed ready access to cheap money over the past decade. That duly heightens the deflationary challenge facing central banks at the moment and overshadows the trajectory of an eventual economic recovery. Nervousness over such an outcome is visible in shares of listed private equity companies, which are dependent on cheap and easy debt, and which have trailed the S&P 500 by some 15 per cent during the current rebound. It is also visible in junk-rated debt, which has lagged behind higher quality, investment-grade paper.
The backstopping of credit markets by central banks has certainly bought a little time for companies with junk credit ratings, and those on the cusp of being downgraded from investment-grade status. But their heavy dependence on debt leaves them with few options to counter a lacklustre recovery over the next few years.
“Fiscal stimulus only bridges the gap up to a point, and problems for small businesses will feed back into the economy and hurt bigger companies,” says Mr Watling.
That spectre of long-term damage inflicted by the pandemic explains why plenty of investors are not fully buying in to this equity market rebound. It does not appear to take account of elevated levels of unemployment, for example, or much higher savings rates by business and consumers.
Shamik Dhar, chief economist at BNY Mellon Asset Management, is optimistic about the prospects of a stronger global recovery, but also believes equities are running ahead of the underlying macro story. It makes sense then, he says, to buy insurance for portfolios in the form of sovereign bonds, gold and other hedges, “given the balance of risks at the moment”.