NN IP: Looking through short-term pandemic and Brexit risks

December 10, 2020

Investors are looking beyond rising infection numbers and political uncertainty to focus on the road to economic recovery. Positive vaccine news and hopes of further US and European policy stimulus outweigh the uncertainty stemming from the US Senate runoffs and Brexit negotiations. We await the right time to reintroduce an overweight in global equities and neutralize our credit overweights.

As the first countries launch their mass vaccination programmes, financial markets continue to focus on the post-pandemic economic recovery path. Investor risk appetite remains unaffected by the ramp-up in infection growth numbers almost everywhere, especially in North America and Europe.

The economic outlook for the coming months looks rather grim, owing to prospects of further lockdowns and the diminishing likelihood that restrictions will be eased. So far, however, economic data has held up reasonably well. The consensus expectation is that the extension of existing fiscal support for the hardest-hit companies and households will alleviate pressure on business and consumer confidence.

Investors have opted to focus on bipartisan initiatives in the US for a slimmed-down fiscal stimulus package and on the expectation of further quantitative easing by the ECB. The approaching climax in EU-UK negotiations about their post-Brexit relationship and the tight Senate runoffs in Georgia create significant uncertainty, but investors do not want to worry about this for now.

The general feeling is that the positive vaccine news and the expected policy stimulus in the US and Europe outweigh the short-term threat of the virus and the economic disruption that Brexit could spark.

US Senate runoffs will determine shape of Biden presidency

With the Georgia Senate runoffs too close to call, it is difficult to say whether Joe Biden’s presidency will mean a policy U-turn on many fronts or general gridlock. The outcome of the 5 January runoffs will determine to what extent the new president can carry out his plans. These plans include heavy investment in education, infrastructure and social programmes; increased taxes for the households and companies that benefited most from the Trump tax regime; and tighter regulation to rein in big tech companies and fight climate change.

Such changes would have a huge impact on future returns for equity and credit investors. We therefore expect that shifts in the polls that offer clarity on the outcome will impact equity and credit returns as the runoffs draw near. This impact would likely be most prominent on a sector and industry level: a Republican success would support IT and traditional energy, whereas a Democratic victory would help building materials and capital goods companies involved in the energy transition. It could also impact overall risk appetite.

Pressure intensifies as Brexit negotiations continue

The other key near-term event is the end of the Brexit transition period on 1 January. The UK and EU must reach a deal in the coming weeks to avert disruption. The two sides have come closer to an agreement, but certain highly sensitive issues remain to be solved. Discussion is focused on the so-called level-playing-field provisions and the level of access that EU fishing boats will have to British waters.

The EU wants assurances that the UK will not distort future trade with subsidies or by undercutting on environmental, labour and social standards. France in particular is unwilling to accept a fast phase-out of its fishing vessels’ access to British waters.

Meanwhile, UK Prime Minister Johnson is feeling the pressure from the Brexiteers in his party to not compromise on Britain’s sovereignty. Encouragingly, the UK government has dropped its plans to abandon all clauses relating to Northern Ireland. This move could indicate increased willingness to reach a final agreement.

We still believe the UK has more to lose than the EU in a no-deal scenario. It would face more economic disruption and likely also political backlash in the form of another potential leadership crisis in the Conservative Party, the risk of renewed instability in Northern Ireland and probable strengthening of the Scottish independence movement.

Balancing UK equity downgrade with EM equity upgrade

In our multi-asset model portfolio, we have neutralized our overweight in UK equities. The British pound has weakened substantially in recent weeks, partly because of the difficult Brexit negotiations. This has helped the UK market to outperform global equities, as large-cap UK companies realize 70% of their revenues abroad. We opted to take profit on our overweight given the binary outcome and approaching deadline of the Brexit talks.

To compensate for the downgrade of the commodity-sensitive UK, we simultaneously upgraded emerging market equities to keep exposure to rising commodity prices. In addition, the rotation towards more cyclical and value-oriented markets continues.

This trend, coupled with continued US dollar weakness and the Fed’s accommodative monetary policy stance, should help emerging markets in the coming period. Chinese equities’ recent underperformance vis-à-vis global emerging markets justifies some caution, as it likely reflects rising concerns about Chinese monetary tightening and the increasing restrictions on US-China trade and on US institutional investors buying Chinese stocks.

We stay neutral on equities in our global asset allocation. Our bias is to upgrade the category, but we remain on the side lines for now mainly because of large investor optimism. The levels of the bull/bear and put/call ratios indicate investor euphoria, making the market vulnerable to adverse news. We aim to use any potential market weakness to move back to an overweight. The medium-term outlook remains strong, with earnings growth of 25% and an attractive risk premium.

Waiting for the right time to reduce credit overweights

In fixed income, we opted to keep our long positions in credits when we closed our equity overweight three weeks ago. We are now waiting for the right moment to reduce risk in this category as well. Last week, we closed our underweight in Bunds in anticipation of an ECB decision to increase its Pandemic Emergency Purchase Programme.

We had also expected yields to rise on vaccine-related recovery hopes. This failed to materialize, making us less comfortable with keeping the underweight.

Our large developed market credit overweights have served us well, but we will likely reduce these positions as we approach the second half of December, given the large exposure in our model portfolio. The year-end holidays will reduce liquidity in financial markets, which could lead to sharp price movements in the case of a correction. We do not yet see strong signs of weakness in global risky assets, so we are holding on to our overweights in investment grade and high yield credits for now.