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An evolving outlook

23 July 2020 Ed Perks, CFA, Chief Investment Officer at Franklin Templeton Multi-Asset Solutions

Economic activity slowed more abruptly in the second quarter than was generally expected at the end of the first quarter. The global economy experienced a sudden stop as many countries adopted stringent lockdown measures to slow the spread of the coronavirus.

These actions led to a broad global recession that has been deeper and faster than any in living memory. We believe the low point has probably passed for many economies. Despite a heightened level of uncertainty, we believe expectations have largely caught up with the true depth of economic damage that had been suffered. However, the pace and nature of recovery remains more uncertain than usual.

We have seen an ongoing commitment from central bankers to do “whatever it takes” and growing evidence of the coordination of monetary and fiscal policy, that has become a new normal. However, ongoing—stimulus may be required. We see policymakers having no alternative but to continue their support. The next question we ask is “ for how long?”

Global challenges of the COVID-19 recovery

We continue to see the challenges of recovering from the current virus-induced recession as global in nature. The level of trade and inter-connected activity will impact many economies, even if they have made more rapid progress in reopening their own countries, as China has experienced. However, we are optimistic activity will resume in all economies as they exit the most stringent phase of any lockdown they have experienced.

Europe may now be taking steps to accelerate its recovery, having been early in closing economies, and suffering a disproportionate hit from the virus. French President Emmanuel Macron and his German counterpart, Chancellor Angela Merkel, have taken the lead in driving forward a coordinated European Union (EU) response to the COVID-19 crisis. The proposed EU recovery fund, offering significant levels of support in the form of grants, rather than loans, is a notable step towards greater fiscal cooperation. Funding some part of this through the issuance of joint liability bonds would be ground-breaking.

The US equity market has benefited from the rapid and unstinting support of the Federal Reserve (Fed). Select companies have been especially well-positioned to take advantage of rapidly changing consumer and business preferences. Accelerated adoption of technological solutions to allow remote working and new ways of conducting business have boosted the fortunes of many companies in the technology sector. We expect these transformational changes to persist even as the immediate driver of the change eases with the virus threat.

As the restructuring of the economy progresses, we expect new businesses to take up the slack left by legacy activities that will not bounce back as quickly, if at all. However, the recovery is unlikely to be smooth and any setbacks to the optimistic assumptions currently gaining dominance may see sharp declines in market confidence.

A multi-asset view of volatility

Our Multi-Asset Solutions investment approach sees volatility as a period of opportunity that produces potential disconnects between market pricing and our expectations. Typically, in such environments market correlations increase and what feels like a refuge underperforms in the ensuing rally. We believe it is important to maintain diversified portfolios, particularly in times of increased investment uncertainty. We also need to recognize that our longer-term outlook may not be reached along a smooth path, and that the current environment is more uncertain than usual.

Namely, the current recession created a gap in private sector income statements and balance sheets that has not yet repaired in many sectors. This gap has been temporarily filled by large-scale fiscal stimulus and monetized by central banks. As an expansion ensues, barring a COVID-19 second wave, it remains to be seen whether policymakers can continue to plug this gap in a fragile, recovering economy, especially in an election year with heightened political risks. Likewise, there is also a risk of diminishing returns to policy actions.

To this point, central-bank support has bolstered the prospects for high-yield bonds. This strategy appears to be part of a wider effort to insulate the market from shocks and avoid a financial crisis coming on top of a pandemic. The market is currently placing a great deal of faith in the ability of policymakers to underpin the full breadth of market sectors. In the case of high yield, the inability of the Fed to protect the solvency of companies makes a rise in defaults highly probable. In our opinion, the most attractive balance of risk and reward is found in higher-rated, investment- grade corporate bonds.

Looking more broadly across asset classes, we maintain a modestly higher conviction toward global equities than bonds, despite ongoing volatility, reflecting relatively more attractive valuations. In broad terms, bonds have become more highly valued and equity prospects have improved relative to them.

Balancing risks and opportunities

The US economy remains more dynamic than many others around the globe. However, it is also vulnerable to a second wave of infection from the coronavirus. With significant levels of fiscal and monetary stimulus already in place, markets are taking an optimistic view of the balance of risks and opportunities.

The need to make decisions about the ongoing provision of government support for individual consumers as well as businesses is complicated by the impending election. The highly charged political climate in the United States may make longer-term policy harder to deliver, if it offers political advantage to one party or the other. For investors, there’s also a heightened risk that inequality and populism will lead to rising tax rates and regulatory oversight, particularly in key sectors such as technology.

We believe that for the balance of the year, politics will have a growing impact on investment decisions. However, the health and related economic variables are likely to be more important than narrow, traditional political considerations.

In sum, we see the prospects of more modest returns from all assets in the years ahead and continue to see benefits from remaining flexible in our investment approach. Finding assets that offer natural diversification benefits and offsets to any rise in inflation will be particularly appealing. However, in the longer-term we focus on the return potential for stocks. We believe that they should earn their equity risk premium over time, offsetting shorter- term concerns that have tempered our enthusiasm.

 

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