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Investment after the pandemic: the crisis as an accelerator of trends

Structural trends that emerged before the coronavirus pandemic have become more pronounced as a result of the global crisis. Government bond yields are now even lower than before the crisis and are likely to remain at these low levels for a long time. The ‘investment emergency’ has intensified. Which asset classes can still offer opportunities?

Coronavirus has drastically changed the world and also the capital markets. Its impact will be felt for much of this new decade. The restrictions imposed on social life and economic activity are affecting households, companies and countries, private and public organisations, and supply and demand all over the world. The result is going to be a very deep, but probably relatively brief recession. Determined and far-reaching supportive action by central banks and governments has helped to prevent an even worse outcome and has laid the foundation for an economic recovery in the near future. However, it will probably take until 2023 for the global economy to make a full recovery and return to pre-crisis conditions.

A significant consequence for investors is that structural trends which emerged before the pandemic have become more pronounced in the crisis and that investing profitably has become even more challenging. Government bond yields are now even lower than before the crisis – and in all likelihood, they will remain at these levels for a long time. Since the US Federal Reserve announced that it intends to keep its key interest rate close to zero for a prolonged period, US Treasuries have been trading close to their historic lows. The same is true for the eurozone and Germany in particular.

Yields have dropped to unprecedented lows

Yields on ten-year Bunds and US treasuries
Yields have dropped to unprecedented lows
Source: Refinitiv Datastream; as at 17 June 2020.

Opportunities in the government bond market are limited to a few selected emerging markets

As a result, safe-haven government bonds from industrialised countries will offer very limited performance potential over the next twelve months. Prices are relatively high and yields are low, if not negative. In addition, governments around the world are taking on huge amounts of public debt through fresh bond placements in order to fund their fiscal support measures. In March 2020 alone, government bonds worth US$ 2.1 trillion were issued globally. Of course, central banks are currently absorbing much of this volume on the buy side. But the persistently high level of supply does make a sustained upward trend in prices unlikely. Selected government bonds from emerging markets constitute an exception to this broader trend. By historical standards, spread levels are currently relatively high. But the focus is very clearly on countries with robust fundamentals that are not at risk of a rating downgrade in the wake of the coronavirus recession.

No risk, no reward

Low interest rates have been cemented for the foreseeable future and are effectively forcing investors to consider more risky asset classes. Union Investment’s experts believe that these asset classes continue to hold potential, even when the rally that occurred over the past few weeks and new risks such as a heightened default risk are taken into account. The revival of economic activity in light of falling numbers of new infections and the comprehensive monetary and fiscal measures adopted to mitigate the economic fallout of the crisis have created conditions in which securities such as US equities and European high-yield corporate bonds have already recovered much of the losses they had suffered since the start of the year. And there are plenty of reasons why risk assets such as corporate bonds, equities and also commodities are likely to offer further opportunities over the next twelve months.

Equity valuations are currently attractive by historical standards

For example, the spread of US equities over 10-year US Treasuries currently stands at around 4 per cent – well above the average of the past 30 years (around 2 per cent). This still applies even after taking the current phase of the economic cycle into account. The coronavirus crisis may be unique in history with regard to the speed at which it spread, but in terms of the way in which the stock markets responded to this crisis, comparable events have occurred in the past. These can now be used to analyse current valuations of US securities. In addition, historical data for a variety of economic variables such as US purchasing managers’ indices, oil prices and 10-year US Treasury yields was used to calculate a ‘fair’ US equity market valuation. The analysis shows that the ‘fair’ risk premium would currently be around 4.7 per cent and thus above the actual spread level (data as at the start of June). This means that – compared with similar market phases – the risk attaching to equity investments is being sufficiently compensated at present.

No signs of an overreaction in the US equity market at present

Comparison of the current actual and ‘fair’ equity risk premium on the S&P 500 US stock market index
No signs of an overreaction in the US equity market at present
Sources: Bloomberg, own calculations, as at 2 June 2020; *calculation based on a set of economic variables

On this basis, it can be concluded that equities continue to offer opportunities despite their volatility. This is also true for equities from Europe. In addition to relatively attractive price levels, the European equity markets are also being supported by inflows of funds. Global investors are anticipating that planned measures such as the European recovery fund will strengthen the unity of the block and push political risks to the background.

With regard to individual sectors, our preferences largely remain unchanged. US tech sector ‘mega-caps’ are currently the big winners of this crisis and their position is likely to continue to strengthen after the crisis. Equities from the healthcare sector will probably also remain in demand and are currently enjoying a political tailwind. In addition, certain stocks in this sector – e.g. those of telemedicine providers – are benefiting from the growth of digitalisation. And last but not least, communication providers should also offer upside potential over the next twelve months.

Corporate bonds supported by central banks

From a price perspective, corporate bonds could also provide opportunities. Spreads on corporate paper remain high by historical standards. Taking into account the underlying volatility risk of an investment in this asset class, this segment could offer a promising risk/return ratio over the next twelve months.

Spreads in the US corporate bond market remain high

Spreads on investment-grade and high-yield US corporate bonds
Spreads in the US corporate bond market remain high
Source: Refinitiv Datastream; as at 17 June 2020.

This applies not only to bonds from the US and the eurozone, but also to paper from the emerging markets. The coronavirus-induced recession is likely to bring with it an increase in company insolvencies and thus a rise in default rates, but this has already been priced in to a large extent in the current spread levels. In addition, this asset class is receiving extensive support from central banks around the world. The European Central Bank has now been joined by the US Federal Reserve as a large-scale buyer in the corporate bond market. The current phase of the economic cycle also favours this asset class: In the past, corporate bonds have rallied particularly strongly after steep falls in key leading economic indicators. But rising default rates mean that careful security selection is becoming even more important. This is particularly relevant for investments in assets from emerging markets.

Equities and corporate bonds are favourites in periods of recovery

Historical performance before and after lows in global purchasing managers’ indices (since 1990)

Equities and corporate bonds are favourites in periods of recovery
Sources: Bloomberg, own calculations, as at 2 June 2020.

Cyclical commodities have upside potential

Commodity prices have been on a rollercoaster ride in recent weeks. Crude oil was a particularly striking example: The coronavirus crisis triggered a demand shock which drove up inventory levels. As a result, US oil temporarily traded at negative price levels in the futures market. Now, the market has stabilised again. The biggest production cut ever adopted by OPEC and its allies should restore the balance of supply and demand relatively quickly. But the oil price is unlikely to rise very high. The OPEC countries remain keen to expand their market share and force US producers out of the market. Any substantial price increase that would make US shale oil production competitive again will therefore probably be met with production increases by OPEC.

Industrial metals, on the other hand, are offering the greatest potential. A key supporting factor in this segment is that economic activity in China, which normally accounts for nearly 50 per cent of global demand, is almost back at pre-coronavirus levels. In addition, many metals are currently in limited supply due to temporary, or in some cases even permanent, mine closures. Nickel and copper could be particularly interesting candidates because they are required not only for infrastructure projects but also in the rapidly growing sectors of renewable energies and battery technology.

Precious metals also continue to provide opportunities. Gold is benefiting from persistently high levels of demand from investors. This is, in part, a reflection of the fact that – adjusted for inflation – even US government bonds are now generating negative yields. Gold can be a viable alternative. The outlook for silver and platinum could be even more promising, because these metals are used more widely for industrial purposes and are therefore likely to benefit from the revival of economic activity.

The coronavirus crisis is accelerating existing trends

Our selection of favourites for the coming twelve months paints a clear picture: Even though the pandemic has caused significant turmoil, the COVID-19 shock is ultimately acting as a catalyst for trends that were already emerging before the crisis. Growth and inflation remain muted whereas sovereign and corporate debt levels continue to rise. This forces central banks to take action and, by extension, cements low interest rates. The inevitable conclusion for investors is that there is no way around a certain level of controlled risk exposure. But selecting securities carefully and keeping an eye on volatility will be of paramount importance. Thanks to the experience gathered over the past few months, the impact of a potential second wave of infections – maybe in the autumn – should be less devastating both for people’s health and the economy. But the capital markets remain highly prone to volatility.

 

As at 24 June 2020.