Wall of worry built on uncertain foundations

Market participants saw the glass as “half full” in May, as strong equity markets contrasted with horrendous economic data. As equities climbed a wall of worry, views on the outlook became very polarised, with some arguing that the disconnect between markets and fundamentals is unsustainable, while others believe markets are simply discounting a more positive future.   

It is very difficult to conclude which is the correct view. What we do know is, first, that the current price action is relatively rare, with the current V-shaped rally occurring less than a third of the time after market collapses, while a W has occurred 70% of the time. That suggests a test of the recent lows has historical probability on its side, although it is not a slam dunk.

Second, the economic impact of the pandemic is still in its early stages, and although the depression-like effects of economic shutdowns are not likely to be sustained, economies will still remain very subdued. Large parts of the services sector will be significantly impacted for a considerable period of time – you just need to consider when you will next be able to partake in an overseas holiday.

Third, while government policy is aiming to bridge the economic gap, it will not fully do so, as evidenced by the steady drip of layoff announcements from corporates here and overseas. The consensus view is that unemployment rates will be higher at the end of 2020 than at the start. Also, with much of the fiscal stimulus short term in nature, there is a risk that corporate stress continues to grow, and insolvencies become an issue later in the year.

However, equity markets generally discount the future and usually reach a trough three to six months before the weakest part of the recession. With the current quarter likely to record the weakest GDP quarterly growth, the recent low in equity markets is consistent with past experiences. Also, positioning data and surveys suggest that the predominant view is one of caution and that many market participants have missed this rally, pointing to a risk of panic buying as fear of missing the rally overcomes the caution.

Reasons to remain cautious

In a typical recession, past examples often provide guideposts to help with this type of dilemma. However, with pandemics being thankfully very rare, we do not have a lot of history to guide us in this case. There are a couple of factors keeping us cautious.

First, given the speed of recent events, we do worry that the full impact on corporate health is still to be realised and this may become problematic for markets. Second, while valuations have improved, they are nowhere near levels you would consider bargains, and the levels that are typically found at the depths of recessions. Last, there is a risk of multiple waves of infection and the economic damage this may entail has not been priced in by markets.

Our portfolio position

Reflecting the above, while we have been adding to our equity exposure, it has been measured.  After reducing our exposure to a low of 20%, we have ramped it back up to 28% over the past two months, still a relatively modest level. We have also taken several other steps to position the portfolio in this time of uncertainty.

First, in May we added some put protection to the portfolio. To fund this, we took profits on a sold put option position, which we entered in April, and used it to purchase September put options with a notional exposure of 3.5% of the portfolio. Second, we have been progressively selling down our holdings of investment grade credit to provide liquidity so we can aggressively add to our equity exposure when we believe markets become attractive – either because they are retesting their lows, or because the outlook has become clearer.   

Among other changes to the portfolio in May, we added Yen to the portfolio. This is to further diversify our non-AUD currency holdings with a currency that is both cheap on a valuation basis but also performs well in risk–off periods. We also rejigged the portfolio’s duration, cutting overall duration to 2 years from 2.25 years, while adding to the long end of the US curve. Since the long end is less anchored to the cash rate, it is likely to provide better returns in a falling interest rate environment.


Signs of a global slowing in COVID-19 cases and steps to reopen economies saw sentiment improve, with most equity markets rising in May. Brazil’s Bovespa was the strongest equity market in the month, with an 8.6% return. This was closely followed by the NASDAQ, which rose 6.9%, lifting the index to a positive return over the year to date. The worst performing equity market was Hong Kong’s Hang Seng, which fell 6.3% as China moved to tighten controls, leading to an increase in geopolitical fears. The Australian ASX 200 posted a positive return of 4.4%, which saw it in the middle of the pack.

While overall value (and prospective returns) across the equity universe have improved, we would prefer to see more valuation support, especially given the uncertainties about the path forward for global economies. To manage this dilemma, we have cautiously added to our equity exposure but have also added in some put protection. Australia remains our preferred market, partly because it has underperformed, but also because we are seeing more positive signs around the containment of COVID-19.

Fixed income

Global bond yields remain anchored to low levels, on the back of near-term deflationary forces and central bank QE programs. Government bond yields in Australia and the US were flat in the month, with Australian 10-year government bond yields falling 0.01% to 0.89%, and US yields rising 0.01% to 0.65%. German bond yields rose strongly in the month, increasing 0.14% to a still negative –0.45% as the European Commission announced a €750 billion, jointly funded relief plan – a major step toward fiscal solidarity and transfers, although approval by EU members is still required.

Credit markets, like equities, were well bid in May, with global spreads tightening over the month. Higher beta plays like emerging market debt and high yield corporate bonds performed strongly. While the shorter-term liquidity concerns have somewhat abated, medium to long-term solvency issues linger. We do not believe they are fully priced into markets.

With central banks holding interest rates low, we moved out along the yield curve, adding to duration in the long end of the US market. While influenced by the US Federal Reserve, it is less impacted than the short end of the curve. We also reduced our duration by 0.25 years to 2.0 years at the portfolio level.


The Australian dollar continued to rebound strongly during May as the USD rally faltered. While we still favour the USD, we switched some of our exposure to Yen in both April and May, seeing our Yen exposure rise to 3.0%. USD remains our largest currency exposure, and we think shorter term support remains strong, particularly in an environment of global uncertainty, but we do think that the upside over the longer term is limited by the lack of valuation support.

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