Please see the below article posted late yesterday (24/08/2020), by the investment management team at Legal & General.
Summertime, and the living is easy
Markets have effectively been flat-lining recently and trading volumes have collapsed by even more than normal in the summer. We believe this is a sign that there is not yet broad exuberance in markets, but also that the risks around crowded trades are bigger than normal.
This update represents solely the investment views of LGIM’s Asset Allocation team.
A known unknown
The ‘inflation versus deflation’ debate is likely to intensify in the coming years, but at least for a while it’s mainly going to be a theoretical discussion. Some great economists have recently predicted runaway inflation, as today’s policy measures are injecting cash directly into the hands of consumers, while other equally great economists have forecast continuous deflation, pointing towards the demand shock and output gap.
We need to acknowledge that so far there hasn’t yet been a satisfying explanation for why there has been so little inflation in recent years, despite strong growth and record low unemployment. How can the market possibly have conviction on the future path of inflation when we collectively were not very good at predicting the past five years?
What does this ‘known unknown’ mean for our inflation positioning? In the absence of a strong directional view, we will need to play inflation tactically; positioning and the market narrative become the important drivers. At the moment we are short UK and European inflation, as we think both are overpriced.
Nothing to see, yet
The first half-year review of the US-China Phase One trade deal has been postponed and not yet rescheduled. It is unclear what caused the delay in the talks, although President Trump has said he cancelled them. Markets have ignored the delay for now as both sides still have incentives to keep the agreement intact before the US elections and expect the talks to happen relatively soon.
We believe China views the deal as a stabiliser to bilateral relations with the US, while from Trump’s perspective the deal is an important political asset during the presidential campaign.
On a different front in what we see as ‘the new cold war’, the US again tightened restrictions on Huawei, by blacklisting more of the Chinese company’s subsidiaries and reducing its access to chips and technology that have been developed or produced with US involvement.
We don’t think Huawei is an immediate breaking point for China, where reactions to the news were muted. Over the medium to long term, we believe Huawei and 5G will certainly become a major area of competition between the US and China. In the short term, however, Huawei can in our view survive until after the US election.
Wall Street versus the High Street
Clients often ask us whether we perceive a disconnect between markets and the real economy.
We believe there are three reasons that explain their apparent divergence:
- Central banks have slashed rates and restarted asset purchases while governments embarked on fiscal stimulus. This has pushed interest rates even further down. All else being equal, lower yields are good for risk assets through the discounting of future earnings.
- Markets are a forward-looking mechanism. It’s the collective view of market participants on the future state of the world, not the current state, that drives asset prices. It is therefore the expectation of a better economy in the future that drives markets up today. We believe markets look forward about three to 12 months. Given this window, the question around the discovery of a vaccine comes into play. The probability of such a vaccine by mid-2021 is around 80%, in our view. Focusing on this allows investors to imagine a world in a somewhat normal state by then.
- The outperformance of mega-cap technology stocks is distorting the market picture as well. The Nasdaq has outperformed the S&P 500 year to date, for instance, while the S&P 500 ex Technology is still down in 2020. This could end up in a technology bubble, but we don’t believe we are there yet. Our bubble monitor, the Heiligenberg Index, is elevated but not yet in the stratosphere. We therefore remain overweight technology.
The combination of these three factors should give some comfort that the disconnect between financial markets and the real economy is a matter of perception. Having said that, we remain cautious in our current positioning as we believe the market has gone too far, too quickly in its optimism on earnings, the economy, politics, and the shorter-term virus dynamics.
Its good to have an insight into how some of the big investment companies Asset Allocation teams think, it helps us get a view on current market trends and how these are being factored into investments funds and portfolios.
This year has been a unique year for markets and investors and you can see a range of views, Legal & General being more cautious, from fund managers.
Keep checking back for more updates as we navigate our way through these strange and unprecedented times.
Andrew Lloyd
25/08/2020