Looking back over the first half of the year, January seems to be a completely different era. In between, an unprecedented health crisis has uprooted medical care, financial markets and the prospects for the global economy. In spite of the sharp rebound in markets, allocators are still reeling from the vehemence of the sell-off.
As economic numbers are now released, the severity of the downturn becomes slowly apparent, with further contractions expected for the rest of the year. Repeat lockdowns and voluntary social distancing, as well as uncertainty around re-opening, continues to negatively impact economic activity. Consumer confidence remains the priority for the post-lockdown world.
While unemployment has been kept in check with financial support from governments, as these policies stand to run off, as surely they will, uncertainty about jobs could delay consumption, leading to further decline in activity and a vicious cycle of defaults and further unemployment. These could possibly freeze up financial conditions, exposing vulnerabilities of already over-indebted households and corporates.
Though we have witnessed a sharp rebound in risk assets, we do wonder whether the market is pricing in a quicker recovery than what the ground reality is telling us. Analysis shows that the S&P 500 Index and Consumer Confidence has historically trended together, but recently there has been a decoupling, with a parting of ways for the two.
S&P 500 / Consumer confidence
As we look forward, what started feeling like a macro shock has slowly started to morph into a macro regime change. Government borrowing across the developed economies have reached eye watering levels, the proceeds being used to buying back government and for the first time, corporate debt, both investment grade and high yield.
Corporates themselves are going through an identity crisis, with business models and profitability coming under pressure from changing consumer preferences. Usage in public transport and workplaces have been way below baseline, with residential numbers higher than baseline in spite of re-opening. Thus, sectors like retail, energy and commercial property come under pressure.
Google UK mobility data
Even as business activity restarts, heightened health and safety concerns will continue to slow progress. It is likely that the recession we are in will be long and drawn out. Thus, with this context in mind, valuations of equities and fixed income, especially credit, appear to be stretched.
If markets were being irrational before the crisis, it looks to continue being irrational for some time to come. In fact, John Maynard Keynes’ pithy comment comes immediately to mind, ‘The markets can remain irrational longer than you can remain solvent’. In times like these, portfolio risk comes to the fore for our allocations and client solutions.
To achieve investment goals and meet the needs of clients, we need to stay invested, as the alternative would be inherently unproductive. Without risk, we would not have a return. Thus, we need to focus on putting together a portfolio of ‘desirable’ risks – risks which can be mitigated if the need arises, like the risk arising out of investments like equities and fixed income.
Risks like liquidity are the undesirable ones as there is nothing one can do if no one wants to buy illiquid holdings. Focusing on risk in this way helps us achieve our objectives, while keeping our powder dry to take opportunities as and when they arise, which they certainly will.
Clients in decumulation – What is the best defence against market volatility?