Taking profit as summer and challenges heat up

The upcoming earnings season, a recent uptick in coronavirus infection numbers and political developments in the USA create a challenging backdrop for financial markets going into the summer.

Equities remain attractive on a 3–6 month horizon, but prudence is the best guide for the time being.

In late March the Investment Committee decided to move into an overweight allocation in equities. Though a contrarian move at the time, this decision allowed us to participate disproportionately in the market recovery. Lately, however, the equity uptrend has started to falter. At this point, we believe prudence is the best guide as we move into the summer months. We are therefore taking profit and reducing equity allocations in portfolios. The following reasons drove our decision:

Navigating the volatile summer months

First, a lot of positive news now seems to be priced in. For instance, the latest European manufacturing purchasing managers’ indices surprised to the upside, in some countries even crossing the crucial level of 50, which marks a return to economic expansion. However, these positive surprises failed to reignite positive market momentum.

Second, the upcoming earnings season is likely to be difficult. While first-quarter earnings were less negative than many market participants expected, second-quarter earnings are likely to reveal the full extent of the economic slowdown of the last few months. This is likely to cause some nervousness in the market and may subject it to a reality check.

And third, there is the coronavirus itself, which has been seeing an unsettling resurgence as the number of new cases, particularly in Latin America and the USA, has increased. The world may be learning to live with the virus, but it is still there and can flare up if the necessary precautions are not taken. The uptick in case numbers will likely require renewed, if very localized, measures to contain the spread of the virus, which, in turn, is likely to raise questions about the economic outlook.

Furthermore, in the political sphere, the US presidential elections are now just a little over four months away. Recent weeks have seen Democratic presidential candidate Joe Biden open up an at times significant lead over incumbent President Donald Trump, as the latter is facing criticism over his handling of the coronavirus pandemic and his response to recent protests in cities across the USA. Given the uncertainty related to a potential change in president, the election race bears close watching.

Beyond summer, risk assets offer upside

Against this challenging backdrop, we believe that markets may well be subject to volatile trading in the summer months, and temporary setbacks are very possible. However, while the increased risks no longer warrant an overweight position, in our view, we do believe that equities continue to offer upside potential over the next 3–6 months. The economic recovery is continuing and both fiscal and monetary policy provide ongoing support. Investors whose equity allocations are significantly below their strategic targets may use setbacks as a long-term buying opportunity.

We maintain our overweight positions in credit markets, including investment grade, high yield and emerging market hard currency bonds. In our opinion, the yield advantage of these markets over treasuries still justifies their additional risk given ongoing support from central banks’ asset purchasing programs. Being physical assets, commodities should benefit from the combination of low real yields, recovering economic growth and our expectation of a weaker USD.

While we go into the summer with confidence about our now more prudent positioning, we are fastening our seatbelts for the ride ahead, and investors are well-advised to do the same.