Following a period of strong rebounds by risk assets since April, many investors have been pointing towards the growing disconnection between asset returns and macroeconomic fundamentals. The Standard & Poor’s 500 index recently returned to its end-2019 level, and the NASDAQ index hit its all time high. The MSCI Asia ex-Japan index is still down 6% year-to-date, but it has rebounded by 33% since the trough in March. Yet, worries over a second wave has prompted investors to turn more cautious. A rise in new cases in a number of U.S. states, such as Florida, Texas and California, as well as a new cluster in Beijing, are raising concerns that the re-opening of the global economy is going to be neither smooth nor quick.
We have highlighted in recent weeks that while the first stage of global economic recovery is underway, this is unlikely to bring us back to the pre-pandemic level of economic activity any time soon. Social distancing will continue to impact the retail and hospitality sectors and delay a full resumption in international travel. A second wave of infections could push this back even further. For this second stage of recovery to take place, we will need a widely distributed vaccine, or at least accurate and efficient tests to identify and track those infected. Meanwhile, central banks and governments will need to maintain their policy support in the months ahead. Withdrawing fiscal support before the economy makes a sustainable recovery could also worry investors.
Experienced investors would correctly argue that we should assess the long-term economic and corporate fundamentals when investing in equities. Hence, we should not be only looking at the 2020 earnings recession, but also consider the earnings recovery in 2021 and beyond. This would make forward price-to-earnings ratios less demanding. That said, we should also recognize that there are some uncertainties with long-term earnings outlook.
The first question mark is relating to the pace of recovery from the COVID-19 pandemic. There is still significant variability on the pace of recovery in sectors that are sensitive to the pandemic, such as airlines, travel & leisure, and retail. These sectors have been the laggards in equity rebounds, but unfortunately potential leaders when risk appetite retreats and correction takes place again.
The second question mark is politics and geopolitics. A rise in U.S.-China trade tensions was a drag on global growth in 2018 and 2019. While the U.S. has been pressuring China on more specific issues, such as technology transfer and financial de-coupling, instead of broad-based tariffs, the risk of escalation can still weigh on sentiment. Meanwhile, the U.S. presidential campaign in the next five months could also prompt rapid adjustment in market confidence.
EXHIBIT 1: PORTFOLIO CONSTRUCTION, ASSET CLASS RETURNS AND VOLATILITY
The risk of a near term consolidation, or even a correction, in global equities reinforces our view that Asian investors should remain balanced in their asset allocation. Corporate credits and high quality emerging market fixed income have lower volatility compared with equities. Their risk of credit spread widening is also partially mitigated by a potential fall in risk free rates if risk appetite declines. Central banks’ support for corporate credit is also helpful.
For equities, if we see a second wave of infection, sectors (such as technology and healthcare) that have a proven track record of being resilient in the current pandemic could see greater support. Geographically, this could benefit the U.S. and Asia, even though the recent rebound in cases originate from these two regions. We also think that a correction could provide an opportunity for investors to build their equity position to their desired level according to their investment objective, especially for those who have missed out on the April/May rally. The range between early-March to late-May provides a useful guide on gauging market sentiment until we have made a decisive breakthrough in the battle against the COVID-19 pandemic.