Note July 24,2020: Q3/2020 – Wishful Denial a Risk

Note July 24,2020: Q3/2020 – Wishful Denial a Risk We see wishful denial about health care as a risk for capital markets, for companies and countries. The full extent and duration remains obscure of damage from Covid-19. Even half a year later, global political responses have evolved from initial denial to bellicosity to hyperbole but seem reactionary. While thankfully avoiding the then allegations of torture, little seems changed in politics over science from four centuries ago versus Galileo on astronomy and now versus healthcare on Covid-19.

Governments have subsidy programs that have ballooned up debt- to- GDP ratios. The worldwide political economy leadership remains fractious. Amid pandemic, it contrasts with the exercise of leadership for sacrifice for higher purposes, for instance during war against evil but also subsequently forward looking massive spending by allies and in defeated and new post-colonial nations for funding for devastated companies, human needs and the reengagement of domestic skill sets.

Central banks have again massively added quantitative intervention. Unlike financial engineering into 2020, the primary investment advantages likely now reside in recognizing solvency needs long term focus by companies and countries alike. Despite massive intervention, not all are likely to succeed. Results for Q2/2020 show pressure. Capital market volatility likely will remain elevated.

Amid economic weaknesses, quantitative and fiscal largesse worldwide of at least $10 trillion but fractured political global cooperation, we favor portfolio diversification including precious metals. Currency volatility has been muted among advanced countries but could rise. It is already so for emerging country currencies. Recovery from Covid-19 at different rates would accentuate it. Anticipating prolonged financial restructuring, we favor diversification in asset allocation, shorter term structures in fixed income holdings and higher quality companies able, irrespective of sector, to wrest advantages over weaker competitors, as occurred post 2007 in world banking.

Notwithstanding minimal interest rates, equity valuations still have to work through changed realities amid augmented volatility. For arguably three consecutive cycles, equities have appeared momentum dominant. For two decades into 2020, S&P 500 equity prices have tended to lag, not lead peaks in earnings. In overarch across sectors and geographies, we favor strong balance sheets and demonstrable operational leadership over reliance on minuscule rates or beating consensus to justify equity performance. In the last cycle, Consumer Discretionary fervor was especially so in aspirational spending built on leverage. In cyclicals, we favor Industrials over Consumer Discretionary; and in Financials, we favor banks over non-bank financials where from the last cycle, proportionately more excess may also reside. In growth, strong balance sheet Information Technology (now market weight rebalanced to hardware and infrastructure over software/concept) and Healthcare seem better positioned than Consumer Staples.

Globally, we expect leadership from the United States will be key, especially on sector rotation with the weak link among advanced country markets being Europe, not Japan. Despite uncertainties in resources, Australia and Canada seem interesting. Instead of seeing emerging markets as a coterie like BRICs, we favor diversified countries like Vietnam and the ASEAN ; as well as India and China for heft and emergent Europe as buttressed by the European Union.

Asset Mix

Central bank intervention has swung massively again to adding to liquidity, accentuating momentum in capital markets. Long term solvency has yet to play out for capital markets. Contrary to momentum alone, risk premiums in capital markets and the valuation of equities in particular depend on the level and sustainability of long term growth as well as on its quality. It is an era of economic weaknesses with further quantitative and fiscal largesse worldwide of at least $10 trillion but also with fractured political global cooperation. We expect heightened volatility. Major international organizations as well as major central banks have indicated that even with some bounce back, global and specific country economic growth may not return to pre-Covid-19 levels at least until the end 2022, let alone to those of the halcyon periods of pre-2008.

The worldwide political economy leadership remains fractious. Among the early releases of Q2/2020 data, countries as varied as Singapore and Britain have practically had freefall. For Q2/2020, China did report GDP growth returning to around 3% year-over-year. It is a far cry from the 6% level that China likely needs to balance internal growth compared to export dependence and only a quarter of its annual growth rate of the 2010s when it was a key locomotive for global growth. Recent EU level negotiations on fiscal largesse were tense in ending with acceptance of Euro 390 billion in grants (out of a Euro 750 billion total package) that appeared only agreed due to fears of Euro currency freefall otherwise. In an election year, fierce tussles between but also within political parties in the U.S. show challenges that are upcoming and which may not be resolved until the next budget well into 2021.

The consumer is a major factor in most economies but seems subject at present to uncertainty. Unlike recent aspirational decades in advanced and emerging countries alike, the consumer globally appears likely to be more challenged in income and in spending patterns terms. As appears taking place in several countries, the interlude of involuntary savings due to Covid-19 pandemic closures may give way to a bounce up. However and as Japan discovered from the 1990s onward, there are many facets to the interface between involuntary and precautionary savings to guard against upcoming uncertainty. Considerations include demographics, unemployment due to structural change and in this Covid-19 environment, the risk of a second wave flareups , all of which contrast with wishful denial.

While thankfully avoiding the then allegations of torture, little seems changed from four centuries ago amid political pressures about Galileo on the science of astronomy and pressures now on epidemiologists and front line medical practitioners about the science of Covid-19 pandemic. Even half a year since emergence of Covid-19 pandemic, global political responses have evolved from initial denial to bellicosity to hyperbole but in the main, seem reactionary in many countries. On forward looking measures taken amid extreme emergencies, outstanding was massive spending of the allies after the second world war. In turn in the defeated nations it was the intertwining of funding for devastated companies, the human needs of the populace and the reengagement of domestic skill sets. All were key for future prosperity. The apprentice program of Germany is one such example that is still in use. The same was true in post-colonial Asia and elsewhere, albeit lesser so.

We espouse portfolio diversification that includes precious metals exposure, cash and short duration in fixed income. Currency volatility has been muted among advanced countries but could rise. It is already so for emerging country currencies. Recovery from Covid-19 at different rates would accentuate it. Across asset classes, we favor focus on quality of delivery (including on debt management). For balance in equities, we favor strong Financials, Healthcare and Information Technology (now market weight rebalanced to hardware and infrastructure over software/concept) for delivery but also Energy, Industrials, and Materials instead of consumer areas for recovery exposure.

Globally, we expect leadership from the United States will be key, especially on sector rotation with the weak link among advanced country markets being Europe, not Japan. Despite uncertainties in resources, Australia and Canada seem interesting. Instead of treating emerging markets as a coterie like BRICs, we favor diversified countries like Vietnam and the ASEAN ; as well as India and China for heft and emergent Europe as buttressed by the European Union.

Equity Mix

Since the lows of March 2020, sharp upswings in equity markets have been price momentum driven even as a full quarter of reporting now emerges that includes Covid-19 pandemic business closures. Much as has been the case since 2009, markets have appeared heavily momentum oriented again. It appears that only brief sojourns have taken place of balance between valuation and the potential for delivery of sustainable growth versus the meeting of the most recent consensus of near term earnings and succor from massive central bank ease policy. Such momentum fervor can be seen in the appearance of being indifferent to the reasons for minimal interest rate policy, namely the risks emergent from economic weakness. It can also be seen in the price momentum fervor for leadership from information technology and within it,  from a coterie of stocks. Such behavior in the past  has not been unknown, for instance for energy stocks in the late 1990s as inflation hedges or in Japan in the late 1980s as possessing of supposedly worthy real estate and business management. In such cases, attempts to contort valuations as either irrelevant or incomplete also emerged but were proved misplaced.

Contrary to momentum behavior, risk premiums in capital markets and the valuation of equities in particular depend on the level and sustainability of long term growth as well as and not least on quality of delivery. The present momentum focus seems to be on liquidity as balm but for sustenance in capital markets, long term solvency has been and is likely to remain critical. Composition notwithstanding, recent valuations appear implicitly to be conflating expectations of bounce back momentum with sustainable growth levels akin to those  that took place pre-2008 but which were accompanied also by underappreciation of systemic risk. If  such a cycle were to repeat, momentum activity in fixed income and equities would be justified, including into the lowest quality as has recently occurred. Instead, we expect heightened volatility and expect the efficiency of delivery to be a key.

Globally, we expect leadership from the United States will be key, especially on sector rotation. Unlike prior periods and for sector mix and economy reasons, the weak link among advanced country markets may be Europe, not Japan. Even with uncertainties in resources, Australia and Canada seem interesting. We would consider emerging markets not as a coterie like BRICs that became so popular as an acronym in prior cycles but instead favor as being the more important segments, diversified countries like Vietnam and the ASEAN milieu; as well as India and China for heft and emergent Europe buttressed by the European Union. As has been characteristic of prior global crises, Latin America seems likely to be under prolonged pressure.

Across asset classes, we favor focus on quality of delivery (including on debt management). For balance in equities, we favor strong Financials, Healthcare and Information Technology (now market weight rebalanced to hardware and infrastructure over software/concept) for delivery but also Energy, Industrials, and Materials for recovery exposure.

Communication Services: We have overweight Communications Services but more so for telecommunications. In addition to years of restructurings of both businesses and financial structure in telecommunications giants that have diversified, the cost advantages and offerings seem diminishing from other newer competitors based on the internet. For social media in which much investment momentum fervor has developed, more pressures appear about quality control. Globally, regulators seem curbing the prior social media model of simply acting as conduits of content, irrespective of veracity. Misinformation and misuse such as for election interference have forced such change which is likely to be expensive. Meanwhile from many large and small businesses, likely to push down internet advertising budgets are Covid-19 pandemic revenue shortfalls of unknown duration.

Consumer Discretionary: For cyclical and ongoing business challenge reasons, we have underweight Consumer Discretionary. Previously in long duration, aspirational spending was a major factor in consumer activity in both advanced and emerging economies. Much has been changing now on cyclical factors including lower and volatile economic growth than earlier decades, short term bounce back notwithstanding. Even ahead of the impact of the Covid-19 pandemic, the evolution of online shopping had become an ongoing industry challenge. At present in 2020, it has been accentuated even amid the tentative retailing re-opening steps that have been replete with Covid-19 flareups. As well, the interface has yet to fully mature between slower spending due to involuntary factors like shutdowns of venues and that due to job losses and precautionary savings as took place in Japan starting in the 1990s. In a fast changing mix between information technology and consumer attention,  the advantages are however likely to accrue to those companies more aggressive and earlier into online servicing. 

Consumer Staples: We have underweight Consumer Staples and instead overweight Communications Services and Healthcare. Even prior to the flaring of Covid-19 pandemic at the start of 2020, Consumer Staples companies worldwide had been under pressure to rejuvenate and once more to reduce their product lines. Multinationals had misjudged the competitive pressures from local providers who for instance were more adept at judging local even sub regional aspects like ideal sizes in packaging. In advanced countries, changing demographics have led to fierce competition for shelf space with otherwise well-regarded massive companies having to or offering to divest prior acquisitions. Further pressures appear in the form of private label or other offerings as internet based shopping options. We expect Consumer Staples restructuring will be longer in time duration than seems expected by consensus. Meanwhile the stretch for yield in capital markets has already elevated valuations and which detracts from the sector as a defensive choice.

Energy: We have overweight Energy. Energy has a long history of being a rough and tumble industry full of intrigue and volatile pricing. The present has been no exception. Being currently evaluated are slower demand for hydrocarbons due to the Covid-19 pandemic and a tussle continuing within OPEC and between it, Russia and the U.S. as the newest largest producer primarily due to its shale industry. In the capital markets, Energy long ago ceded its premier position to Information Technology in terms of size and momentum interest but has value appeal. The demand for hydrocarbon derivatives as input is widespread from healthcare to packaging. In reality, Energy has been business flexible, for instance within transportation from bunker fuels at the turn of the last century to higher octane kerosene today. Dividend cuts and conserving capital expenditure funds do presage change. We overweight Energy by focusing on those integrated companies that are capable of change and of acquiring solvency challenged smaller companies. Some such marque acquisitions have already commenced and are likely to sharply expand the longer prices remain under a likely stable position for crude oil of around $60/Bbl. WTI.

Financials: Amid already existent net interest margin pressures, minimal and even negative central bank administered rates seem likely to force further restructuring simply to attain some return in conventional banking. The massive liquidity injections from the major central banks in response to Covid-19 does have limits. It should not be conflated with the solvency challenges facing many industries and consumers alike. U.S. banking has been initiating additional loan loss reserves closing on $40 billion that are likely to rise and in size, be followed elsewhere in the world. Insurance and other segments face similar challenges about generating income. In its upward momentum resumption since March 2020, capital markets may be overestimating the efficacy of central bank response in being able singularly to boost and sustain economic growth. Recent financial pressures and scandals in several advanced and emerging countries underscore challenges. Nevertheless, this momentum fervor has provided some relief to the investment banking segment of the Financials. In our Financials overweight, we underscore that they are crucial for equity market performance and economies. On industry realities,  we favor overweight those earliest and most thoroughly into restructuring.

Healthcare: We have overweight Healthcare. Even prior to the Covid-19 pandemic, the Healthcare sector had undergone a full cycle of complacency, of subsequently being forced to restructure over years, followed by succumbing to merger & acquisition fervor including biotechnology as new frontier and then undergoing valuation reconsideration in the wake of the inevitable business re-management that characterizes such an acquisition/divestment business cycle. The Covid-19 pandemic has forced upon companies and governments, the ongoing urgency of provisioning for healthcare. If demographics are guide, less unfettered competition and greater cooperation within the drug industry, more value added medical devices capacity and not least less simplistic government healthcare budget considerations are likely to be long lasting. Recent reported results demonstrate that even within the medical devices segment, revenue pressures have intensity and bifurcation. Competition is rising sharply from hitherto external entities. While there remains space for individual breakthroughs favoring concepts, they also inevitably have long time trials. In Healthcare, the core investment diversification likely lies with strong balance sheet and diversified product line companies. It would be thus unlike the investment milieu in Healthcare of say a decade ago.

Industrials: At this stage of uncertainty about consumer preferences about products and shopping venues, in cyclicals we underweight Consumer Discretionary and underweight Industrials. The health urgencies exposed by the Covid-19 pandemic as well as the politics of trade that have exposed weaknesses within global product, manufacturing and logistics lines. We expect urgency in infrastructure upgrades by countries as well as in company facilities and logistics redesign in many industries. Enhanced industrial product expenditures therefrom can be expected in a wide range of industries. On change, we would not be surprised to see the admired German Mittelstand manufacturing and product success of flexibility to be emulated. As broad swathes of business and economies restructure, simply doing less with obsolete facilities is likely not optimal even in the hard pressed, perennially cyclical airline industry. Industrial and specialized product suppliers are likely industry beneficiaries that we especially favor.

Information Technology: With its long history of both innovation but also with extreme and Darwinian capital market behavior, we have rebalanced to market weight Information Technology. An aspect behind our Information Technology has been not only to growth prospects coming from still evolving business growth such as from expansion of 5G networks,  from cloud computing and from remote connecting but also due to the strong balance sheets and solid products/services in the sector. Lately and arguably not unrelated to Covid-19 social isolation and fund injection from authorities to both individuals and businesses, fervor and concept euphoria appears in information technology purveyors that are closest to the end consumer, such as software and video conferencing. Within our now market weight, we would rebalance towards Information Technology hardware and infrastructure providers.

Materials: We have overweight Materials primarily in order to focus upon precious metals for portfolio diversification at both the asset mix and equity sector levels. Currency volatility has been muted among advanced countries but could rise as recovery from Covid-19 occurs at different rates. It is already so for currencies of emerging countries where stresses have already developed. Capital markets have concentrated on momentum from central bank largesse. Still, solvency versus liquidity fragility exists at the country and company levels, as seen even in the recent EU leadership summit on relief funding and in the numerous company reports and bankruptcies, despite funding from the authorities. More generally, extreme restructuring in many Materials areas was a feature that has been well advanced even ahead of the Covid-19 economic shutdowns. For cyclical exposure to potential overall global and country recovery, Materials also arguably has early candidates for exposure thereof.

REITs:  To reflect broader real estate concerns, we have REITs at underweight but see industrial areas as being better placed than say retail or multi dwelling housing or shared office space. Our rationale is that on top of restructuring facilities to become more competitive which has been overdue since 2008, trade and politics have been changing the logistics in global trade in many industries. The raging of Covid-19 across the world has added to these imperatives. Even within single industries, it likely means upgrading of manufacturing facilities in many industries and in many countries for diversification. Pressures have become acute in retail centers where some owners may be trying to backstop anchors, many of whom face or are already in bankruptcy. It however does not address the efficacy of  older retail busines models. In multi-dwelling as in housing generally, the long term ability to pay is an issue that is likely to be exist beyond the simple emergency fund transfers seen in many countries to individuals. Changes to office demand of the shared space type has come up against technology enabling work to be performed from home now and in the longer term, perhaps partially so. When considering such issues of long term solvency, we see focus only on valuation versus present interest rates as being inadequate.

Utilities: We have underweight Utilities instead to favor other sectors that  offer dividend yield, balance sheet strength as well as growth potential. Sometimes overlooked but the slowing of general economic growth has impact on the demand and usage of utilities, electric power in particular. Especially in a period of health concerns, climate change and fast changing technology in the generation of power, demands are likely to rise for facilities upgrades which in the case of utilities involve massive expenditures. Revenue shortfalls among businesses and wage pressures for individual customers as well as other concerns could limit the ability of utilities to increase usage charges. With governments under massive budget pressures, any recourse to them for relief is likely to fall on deaf ears. Even in our favored segment of pipelines, some reappraisal appears of green fields expansion.

Asset Mix 

 

                        Global           U.S.

Equities-cash         52%             57%

            -priv.             6                  6 

Fixed Income         25                20 

Cash                      12                12

Other                       5                  5

Total-%                100              100

 

 

Geographic Mix

 

                      Currency/   Equities   Fixed     Cash

                         Real                         Income

Americas               61%              65%           67%     55%

Europe                  22                  20             26         37

Asia                        9                  13                6          3

Other                      8                    2                1          5

Total -%              100                100            100      100

 

 

 Equity Mix

 

                    Global   U.S.     Stance

Comm. Serv.     6.0 %     12.0 %     Over-weight telco, under social

Cons. Disc.       4.0         5.5       Under-weight favor basic online

Cons. Stapl.      4.0         3.0       Under-weight still brand pruning 

Energy              6.0         4.0       Over-weight favor strong cos..

Financials       19.0       13.5        Over-weight restructuring

Healthcare      15.0       17.0        Over-weight critical delivery

Industrials       13.0         9.0        Over-weight on capex gain

Info. Tech.      21.0          28.0           Market-weight readjust HW

 

Materials          8.0            4.0          Over-weight precious metal.

REITS              2.0             2.0Under-weight retail & office     

Utilities             2.0          2.0         Under-weight – hold pipe.

Total-%        100.0      100.0         () prior weight StrategeInvest’s independent consultancy operates as Subodh Kumar & Associates. The views represented are those of the analyst at the date noted. They do not represent investment advice for which the reader should consult their investment and/or tax advisers. Any hyperlinks are for information only and not represented as accurate. E.o.e.