NN Investment Partners: Regulating risk in a whirlwind week

October 8, 2020

The week’s news flow has been a storm of mixed headlines, ranging from weak global macroeconomic data, worrying virus developments and stalled Brexit negotiations, to dovish central bank commentary and hopes of fiscal stimulus. Amid the commotion, NN Investment Partners maintain a cautious approach to risk in our model portfolio. Within our neutral overall equities position, we are overweight in the Eurozone and underweight in the UK.

Since our last Houseview, we closed our overall commodities overweight while maintaining overweights in gold and Brent oil. In fixed income, we have reduced our overweight in developed market investment grade credit and closed our overweight in emerging markets hard-currency sovereign debt. We remain cautious, for the headlines can easily change the narrative in financial markets from one day to the next.

Politics will dominate the headlines in the short run

The main market-moving news of last week concerned US President Donald Trump, who while in full campaign mode became infected by Covid-19 and was hospitalised for a few days. The incident has fuelled the existing uncertainty, as its impact on the campaign and on voter preferences is unclear. Joe Biden leads in the polls by a wide margin, but previous elections have shown this is no guarantee of victory. Election news will remain prominent in the coming weeks’ headlines, but we do not expect a big market impact until the winner is known. Once that happens, if history is any guide, we may see a relief rally, irrespective of the outcome, as election uncertainty is priced out. Markets will adapt to the outcome and take their cue from developments in economic data and policies.

Ongoing policy support will drive markets into year-end

After a lacklustre September on the monetary policy front, global central banks are hinting towards more stimulus before the end of the year. The European Central Bank has been sounding more dovish following President Christine Lagarde’s press conference last month. ECB officials have commented on the weak inflation outlook and the strong euro, which has been mitigating the positive effects of the current stimulus packages. Across the pond, the Federal Reserve has made a strong dovish shift since announcing its new 2% average inflation target. Fed Chairman Jerome Powell emphasised in his speech this week that more fiscal stimulus is needed. Meanwhile, Trump told his team to halt the stimulus talks with the Democrats until after the elections but shortly thereafter pushed for a partial package focused on assisting airlines and small businesses. Financial markets are clearly betting on policy stimulus, and these headlines will continue to dominate market movements in the short run.

Investor sentiment warrants some caution

The prevailing uncertainty has adversely affected investor sentiment. The bull-to-bear ratio remains in contrarian “buy” territory. The put-to-call ratio, which in early September was still indicating some exuberance, especially in the large-cap technology names, has fallen back to neutral levels. Other sentiment indicators also signal more caution among investors. The third-quarter earnings season kicks off next week, starting with some of the major US banks. We expect a strong beat, for two reasons. First, economic data throughout the quarter came in consistently better than expected. Second, the weakness of the US dollar will have contributed to US profits, primarily through positive translation effects of earnings realised abroad. The analyst community shares this optimism, as the ratio of upward versus downward earnings revisions shows (see figure). We are still positioned for a divergence in regional equity performance, with the Eurozone outperforming the UK.

We pared back some exposure in the commodity universe

We reduced commodities to neutral in response to increased volatility, higher risk aversion and a lack of short-term catalysts. Within commodities, we keep a moderate overweight in Brent as we await an update by OPEC later this week. Speculative positioning is low and supply discipline is good. We also keep our overweight in gold, an asset that acts as a hedge during the current uncertainty. The biggest risk for gold would be a rise in US real yields.

Central banks will support fixed income

Following the recent weakness in equity markets and the uncertainty regarding the US fiscal deal, the US presidential elections and the worrying virus developments, we reduced our risk exposure in our model portfolio. The continued equity market weakness was starting to find its way into credits as well, and amid the uncertainty, the dollar strengthened and US real yields started to climb. This also led to weakness spilling over into emerging market hard-currency sovereigns, pushing spreads wider. US and Eurozone money markets, meanwhile, have been showing no major signs of troubles. Central bank emergency measures have completely saturated financial markets with liquidity, ensuring that strains such as those experienced in March wouldn’t materialise. This indicated that a full-blown crisis isn’t on the cards and that the correction would be relatively confined to the equity universe. We maintain a moderate overweight in developed market credits, where we are still constructive over the medium term.

Risk sentiment has improved over the past few trading sessions, most noticeably in global rates. US Treasuries sold off significantly in response to Trump’s recovery, the prospects of a US fiscal deal and, probably more importantly, the growing likelihood of a clear Biden win. An increasing chance of either candidate winning lowers the probability of a contested outcome and the uncertainty that would bring. We are maintaining a constructive but not large position towards risk. Our preferred avenue into risk in the current environment would be mainly via rates.

In rates, Bunds are still expensive at current yield levels, and if risk sentiment improves further, they will be a good candidate for a small underweight. US Treasuries might have room to sell off further, but we are not yet convinced. From a fundamental perspective, little has changed. With markets betting on a US fiscal deal before the elections and Trump halting stimulus talks until after, Treasuries have shown some volatility.

An agreement on the stimulus bill would indeed be a positive catalyst for risky assets, but it wouldn’t be a game changer for the medium-term US economic outlook. More stimulus would be needed for inflation to pick up. Given the Fed’s forward guidance and the disturbing virus developments, the typical rate-hike cycle that market participants normally extrapolate with an improving macroeconomic outlook is looking less likely to materialise.