Markets didn’t blink in May continuing their upward trajectory buoyed by accommodative policy settings for risk assets. Many investors have been left scratching their heads given the poor economic outlook and increased geopolitical tensions, coupled with civil unrest in the US. However, what it does tell us is that markets like liquidity. This is not a new play book, as markets have been supported by accommodative central bank policy since the global financial crisis in 2008 – we are simply seeing it applied much faster and on a more unprecedented scale than before. Looking at fundamentals remains important in analysing markets, however understanding money supply is also essential.
In our most recent asset allocation committee meeting we did not make any changes to the existing asset allocation settings. The previous move to neutralise our slightly underweight exposure to equities has benefited the portfolios as equity markets have continued to rise on the view that COVID-19 cases have peaked across many key economic regions, and that economies will begin reopening for business. At the same, time further fiscal stimulus packages have been announced within Europe as well as China, which the market has reacted to favourably.
In March and April, we saw our valuation signals go ‘green’ for most risk assets as asset prices fell. Since then we have seen valuation opportunities within equities as share markets reduce, most notably in the US, where shares have recovered since their trough in March. Our valuation model indicates that most asset classes are trading at fair value, with the exception of government bonds, which continue to look expensive, and A-REITs, which look attractive on a relative basis.
Liquidity and policy remain favourable as central banks and governments continue to prop up economies via monetary and fiscal policy measures. Cyclical indicators remain weak, with most economic indicators such as unemployment figures and PMIs continuing to show weakness. Finally, risk indicators such as the VIX and MOVE indices continue to trend down. Indeed the MOVE index, which measures implied volatility within bond markets, is back at pre COVID-19 levels.
While markets have shown strength, risks remain. The impact of COVID-19 on company earnings remains unclear at this stage. The market has been pricing in negative news, meaning any news regarding company earnings that is worse than expected will likely adversely impact markets. Geopolitical risks, while ever present, are in the spotlight again. Tensions between the US and China are elevated, and the path forward is unclear. This is against the backdrop of the upcoming US election in November and recent civil unrest within the US.
Despite the rebound in markets we believe portfolio diversification remains important. Having some defensive assets in portfolios remains warranted as we get a better picture of the impact of COVID-19 on company earnings. While we have neutralised our exposure to risk assets from a slightly underweight exposure, we have been further diversifying our portfolios from a bottom-up perspective both from a source of return and risk perspective.