Equities: in the recovery position?

Key points:

• Equities recent strength seemingly relies on distant hopes of a vaccine and a quick economic recovery. Both appear questionable
• Gold prices have been reaching new highs in recent days and may have further to climb with low US treasury yields
• Equity valuations look elevated and driven by a handful of growth stocks. It may be time to be more selective in the regions, sectors and stocks being targeted
• Diversification is key to building resilient portfolios. Rather than growth versus value strategies or cyclicals versus defensives, a focus on finding quality stocks appeals most.

Equity valuations have been extremely resilient since March’s sell-off in the face of worsening COVID-19 infection levels, as localised spikes in infection numbers hit leading economies. This apparent strength seemingly relies on distant hopes of a vaccine and a relatively quick economic recovery. Both appear questionable.

Finding a vaccine is one thing. There is likely to be a lag between discovering a vaccine and immunising people around the world. This could last a few months or several years and then depends on factors such as the strength of antibodies and a willingness to be vaccinated. Investors should not expect a vaccine to quickly translate into a much stronger economic momentum.

Opening the spending taps

The level of support provided by governments to shield the economy from many job losses during this crisis has been unparalleled. Investors expect governments to maintain some level of support to help the economy through the pandemic.

Similarly, investors appear excited by the prospects of large infrastructure spending plans coming from both sides of the Atlantic. Here again, tempering any excitement may be called for. If the plans ever become reality, they are unlikely to translate into increased activity before 2022 at best.

Central banks and the recovery

Alongside governments, central banks have intervened like never before to support economies and allowing financial markets to function properly. There is little doubt that this support, both in terms of low interest rates and quantitative easing, will remain active for some time.

But markets are much more responsive to flows rather than stock when it comes to central bank accommodation. While it now appears that there is virtually no limit to authorities’ interventionism, both the US Federal Reserve and the European Central Bank seem willing to “wait and see”.

The market may ultimately get what it wants, but we can’t rule out that this won’t happen until a sustained fall in equities or financial conditions tighten too much. Reassuringly, the market appears to recognise some of the above risks. Indeed, the performance of various asset classes and equity sectors suggests that a strong recovery is not being banked on.

Gold shows its mettle, crowded Tech trades risk

Gold prices have been reaching new highs in the last month and yields on US treasuries flirting with their March lows.

Meanwhile, a booming equity rally has been driven almost exclusively by a few “growth” stocks exhibiting earnings resilience and limited correlation with the macroeconomic backdrop. On the other hand, some of the more cyclical groups, such as banks or industrials, which should perform best in a recovery, have been notable laggards in the last month. This narrow market leadership indicates a lack of irrational exuberance among investors while pointing to significant risks should this trend reverse.

Because investors’ enthusiasm may be questionable and the reliance on a handful of growth stocks to drive upside represents a risk, it may be time to be more selective in the regions, sectors and stocks being targeted.

Diversification: focus on quality

Diversification is key to avoid being over exposed to crowded trades, such as technology stocks, and missing high-quality under-owned names. This is not about value versus growth or cyclicals versus defensives. It is all about finding quality in the form of solid balance sheets, attractive cash flow generation and sound growth prospects wherever it happens to be.

For this reason, and because both volatility and dispersion of returns are likely to remain elevated, raising allocations to actively managed assets and private markets in the search to boost returns appeals.

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