Equity markets saw a sharp bounce back in April, supported by the continued roll out of support packages and programs from governments and central banks; and the slowing of new COVID-19 infections and related deaths in many countries. By month end, the US market (as measured by the S&P 500) was up more than 30% from its March lows and losses for the year had been trimmed to less than 10%. The US has fared considerably better than its developed market peers, in particular those in Europe, which still lag around 25% lower for the year. With the economic backdrop and outlook for the virus (and associated effects) still deeply uncertain, we favour caution as we approach the summer months.
Part of the reason for such huge differences in market return between the US and Europe lies in the structure of the market in these different countries, in particular the dominance of tech in the US. Clearly, technology focused assets are not only relatively immune from the current climate but can also grow within it. The five largest companies (Microsoft, Apple, Amazon, Alphabet, Facebook) represent 20% of the S&P 500 index – a higher level of concentration then in the Dotcom boom – compounding the effect.
At the moment, investors are focused on the very near-term effects of Covid-19, which will undoubtedly be deflationary. However, it is quite possible that long-awaited inflation may be around the corner, and aggressive in nature. Whilst we believe energy prices have likely bottomed – around the point of the flash move below $0, for the May contract, in April – inflationary pressures will likely come more from other factors: When stay-at-home restrictions are removed, demand is likely to come flooding back. But the recovery in demand will likely be much swifter than the recovery in supply. It may take some time for dislocations in global supply chains to be resolved. Service providers will be keen to capitalise on the return of their customers and recoup the losses of the first half of the year and a competitive advantage may arise if competitors have not made it through the shutdown. To combat this, some bias in portfolios to inflation sensitive assets (e.g. Index-linked bonds, gold and infrastructure) appears prudent. These assets have an additional characteristic – being defensive in nature, to a further growth shock.
Markets (the US in particular) are pricing in a swift return to normal, which seems unlikely. However, market timing is notoriously hard and opportunity cost is a real cost – therefore defensive portfolio characteristics at this point in time serve the dual purpose of participation and a degree of protection.
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