Assessing risk scenarios: Selloff. Rebound. Now what?
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One of the biggest fears in the markets now is a second Covid-19 wave. A second confinement period to halt another outbreak is of particular concern, as it would halt economic activity again and destroy the nascent recovery. But we believe this is unlikely — at least for the time being. In the meantime, geopolitical risks have also crept back to the fore, starting with a rise in US-China tensions sparked by, amongst other things, a blame game over the virus outbreak and China’s plan to impose a national security law in Hong Kong.
These tensions are likely to simmer in the background at least until the US election, particularly with Democratic presidential nominee Joe Biden trying to “out-hawk” US President Donald Trump. However, we believe that we will continue to see more bark than bite. The US economy is fragile and adding tariffs or jeopardising the rally does not make much sense ahead of November. Sounding tough on China might get votes, but acting tough is a much riskier position. As we move closer to November, US elections will take over the headlines and investors will need to assess which candidate will prove more market friendly.
In our view, some higher volatility is to be expected in the run up to the elections, especially as polls have proven rather unreliable recently. Still, that should not lead to a marked sell-off. Looming in the background, the post-Brexit trade relations between Europe and the UK still needs sorting. With the deadline to extend the transition period beyond Dec 31 unlikely, the risk of a “hard Brexit” is likely to persist. We do not expect a full trade deal by the end of the year, but enough agreements on strategic areas to allow for post Brexit life to start and still negotiate a broader agreement remains a possibility.
Post–crisis, bankruptcies are expected to rise even as we reopen. We also do not know how many businesses will prove viable with ongoing social distancing measures. The first risk is on consumption, as persistent high unemployment could lead to lower consumption, though we would never underestimate the US consumer and initial indications are that spending will pick up as we return to normal. The spillover effect of bankruptcies into debt markets needs to be monitored, as defaults are expected to reach nearly 10% in US high yield.
We believe that central banks will work to ensure we avoid the worst case scenarios of credit events, but we nonetheless remain more cautious on high yield as risks remain. Of course, selective opportunities can be found, but a broader allocation appears risky for now.
Further out, you also have the risk of bubbles as valuations have risen sharply with the market rebound. Certain regions have reached all-time highs, and flows are likely to continue given the amount of liquidity being injected by central banks globally. As bubbles have been a concern of central banks in the past, will we see them act to prevent bubbles in the current context? Federal Reserve chairman Jerome Powell answered this decisively: The Fed is not concerned with bubbles, they are focused on persistently high unemployment. The boundless liquidity is also raising the fear of inflation, but a lot of the stimulus unveiled by governments so far has been in the form of income relief or replacement. The velocity of money also remains low, suggesting little inflationary pressures for the time being. At the same time, lost productivity due to new safety measures could lead to higher costs for consumers. The repatriation of strategic industries could also lead to higher inflation over the longer term, but neither of these appears imminent.
Disappointment risk
We are however more concerned with a disappointment risk. Indeed, markets are priced for a perfect V-shaped recovery that is unlikely to materialise seamlessly. As we head into 2Q data releases and earnings season, there is a risk that announcements may disappoint. Until now, in the US in particular, data has surprised on the upside, leading economic surprise indices to record highs. But as the economy reopens and expectations rise, data suggests it might not be strong enough to sustain current market forecasts.
Yes, the recovery will be staggered and gradual. It will take a long time to go back to pre-crisis levels but most major economies appear to be on their way. As we move into the summer, 2Q earnings could show a dismal quarter but moving on, we believe that higher volatility and market corrections are likely. That said, the downside appears more limited now, as there is still a lot of cash on the side-lines, most investors missed the rally, and the consensus remains relatively bearish. That is not to say we expect markets to continue to rally in a straight line up, but we believe that we are unlikely to see a massive sell-off or re-test the March lows.
In conclusion, we believe it is too early to become too aggressive and we do not like the idea of chasing the rally as we need to use these opportunities to build positions for the longer term. Indeed, there are plenty of risk scenarios abound but we do not expect them to upend the rally. That said, markets are pricing in a lot of expected good news already but we might need even more upside surprises for a meaningful next leg up. In the meantime, we believe that the rotation into European assets and value sectors can continue in the short run. And we continue to buy what the central banks are buying — credit, with a preference for investment grade. E
Esty Dwek is head of global market strategy, Natixis Investment Managers Solutions