Six months into this pandemic, we evaluate the investment backdrop and explore attractive opportunities. As preview, we see appeal in tech and tech-enabled businesses but remain cautious on elevated pricing; we find enough value in relatively cheap segments of public equities to justify taking measured, diversified overweights; we are broadly cautious on credit, but see pockets of opportunity in some segments less supported by central bank activity; and we are seeking opportunities that emphasize social equity and diversity.<\/p>\n
State of Affairs<\/h1>\n
As the COVID-19 pandemic spread across the globe, most countries took decisive measures to limit the virus\u2019 spread, while treating the resulting economic shock with aggressive monetary and fiscal policy. We have highlighted two critical areas to watch toward economic recovery: continued fiscal and monetary policy support to serve as a bridge until economic activity can normalize and containment of COVID-19 infections or significant advances in treatments. On the former, the global response overall has been strong. On the latter, cases continue to increase, and progress has been uneven, but medical progress has been impressive, enabling a more targeted policy response.<\/p>\n
The damage has been significant, with more than 25 million confirmed COVID-19 cases, 800,000 deaths, double-digit GDP contraction, and sharp increases in unemployment. For the first six months of the year, US GDP fell 10.2%, and Eurozone GDP, 15.2%, seasonally adjusted\u2014the worst decline since the Great Depression. The global economy bounced back sharply from April lows, but GDP remains well below pre-COVID-19 levels, even as several Asian economies have made significant strides to regain lost ground. Central banks everywhere are still committed to supporting markets for the foreseeable future. Support for fiscal policy has largely remained firm although the United States has yet been unable to pass a new stimulus bill amid political clashes. The International Monetary Fund projects that fiscal debt in advanced economies will increase from 105% to 122% between 2019 and 2021, with some countries seeing increases of roughly two times that seen in the three years following the Global Financial Crisis (GFC). Much of this debt has been monetized by central banks\u2014multiples of what was seen in the GFC\u2014raising questions about the risk of inflation. For now, inflation remains in check given excess capacity, and the risk to not acting is greater than that associated with stimulating growth. In short, policymakers have been willing to provide support to bridge the income gap, but this may change as COVID-19 lingers and the effects become more expensive to mitigate.<\/p>\n
Even as the number of COVID-19 cases continues to rise globally, the trajectory of new cases is flattening out and the world\u2019s ability to cope with the disease has improved somewhat. As various locations see spikes in cases, they have been able to use more targeted lockdowns than initially enacted, limiting the impact on business activity. Further, as our knowledge about COVID-19 treatments and therapeutics has improved, hospitalization rates and death rates have fallen. For these reasons, assuming the number of new infections keeps falling or stabilizes, economic activity should continue to improve, albeit at a gradual pace.<\/p>\n
ECONOMIC ACTIVITY IS HIGHLY CORRELATED TO MOBILITY, WHICH IS UNLIKELY TO REVISIT PRIOR LOWS<\/strong> Sources: Bloomberg L.P., Homebase, and Federal Reserve Bank of Dallas. At present, there are at least 170 vaccines and 379 therapeutic drugs in development with 47 and 293 in human trials, respectively. More than ten vaccines are in large scale human trials, making prospects for vaccine availability by early- to mid-2021 increasingly plausible. Concerns regarding production, effectiveness, and uptake of a new vaccine present challenges. Indeed, investors may be overestimating the ability of a vaccine to contain COVID-19 if the combination of effectiveness, production, and inoculations lead to immunity levels too low to create herd immunity.<\/p>\n In sum, we can expect a choppy economic recovery based on the path of the virus and responses to its path, but the worst is likely behind us. Markets remain vulnerable to a diminution in policy support and disappointment on the ability to contain and treat COVID-19, but prospects have improved.<\/p>\n The COVID-19 pandemic has accelerated technological disruption. Many tech businesses claim product adoption has advanced five years in the span of just eight weeks. While discriminating between winners and losers is best left to managers, we consider opportunities and risks in the sector to inform appropriate exposure on a look-through basis. Strong demand, persistent cash flow growth, and low interest rates have benefited tech and tech-enabled companies, as well as tech-related infrastructure and real estate. Yet, these investments are vulnerable to several factors, such as relatively high valuations, a sharper-than-expected reversal in demand trends, higher interest rates, regulatory backlash, US-China relations, and the potential for higher taxes. On balance, we continue to look for opportunities and would not stray too far from neutral allocations based on global equity benchmarks, while recognizing that tech cuts across sectors.<\/p>\n A key question is whether market pricing has gotten ahead of reality. Over the last five years, equity price appreciation has been influenced by cash flow growth. However, some stocks, including the vast majority of tech stocks and tech-enabled FAAMGs, have seen appreciation beyond that justified by trailing fundamentals indicating high confidence in the future. Indeed, the current sell-off in tech stocks following their recent parabolic ascent should come as no surprise. Over the next three years (2020\u201323), analysts forecast annualized EPS growth of 32% for Netflix, 30% for Amazon, 15% for Facebook, and 12% for Microsoft\u2014lofty expectations, but not out of historical bounds. In addition, the roughly 270 basis point (bp) decrease in US ten-year Treasury yields since late 2018 has disproportionately benefited long-duration assets, like technology stocks.<\/span> 2<\/a><\/sup> Should rates remain tame, current pricing could be supported, although there isn\u2019t much room for continued appreciation on this basis.<\/p>\n TECH STOCKS HAVE GENERALLY APPRECIATED MORE THAN FUNDAMENTALS ALONE JUSTIFY<\/strong> Sources: MSCI Inc. and Thomson Reuters Datastream. MSCI data provided “as is” without any express or implied warranties.<\/p>\n<\/div>\n A reversal in interest rates would transpire should economic prospects improve (perhaps from rapid development of an effective vaccine), central banks seek to roll back extreme measures, and\/or inflation expectations inch up. Tech stocks also face regulatory and tax risk. While a break up of tech companies seems unlikely,<\/span> 3<\/a><\/sup> we expect increased regulation. Continued escalation of US-China tensions also has potential to limit tech profits as companies reconsider supply chains and find their end markets constrained by regulations (e.g., inability of Huawei to include Google apps and Apple to include WeChat on their smart phones). Furthermore, an increase in corporate tax rates, as would be expected should Joe Biden win the US presidential election, would disproportionately crimp large tech, pharma, and biotech companies\u2019 profit margins, especially if they limit use of safe harbors.<\/p>\n Outperformance of tech and tech-enabled companies and supporting businesses has largely been justified in the pandemic. Prices for many fast-growing businesses are starting to outstrip fundamentals, while valuations remain well below bubbly peaks reached in the late 1990s. Indeed, we may be at the early stages of a tech bubble. It will likely be detrimental to meaningfully underweight tech in the near term, but risky to overweight tech in the intermediate to long term. We would limit any underweights to tech for now, seeking to expand them should greater opportunities unfold in relative value opportunities over time.<\/p>\n As discussed above, looking toward the remainder of 2020 (and beyond) investors face difficult tasks. They must assess the long-term impact of COVID-19 on companies, while also determining when the eventual economic recovery might allow some of these performance streaks to reverse. Although timing for the latter is uncertain, we believe investors should lean into opportunities that offer relative value, including non-US, small-capitalization, and value stocks.<\/p>\n US stocks have recently trounced global peers, with the MSCI US Index beating non-US equivalents by around 6,000 bps cumulatively over the past five years. This has continued throughout the pandemic. Slightly stronger macro conditions in the United States, more exposure to tech champions, and shareholder-friendly capital management have supported performance, but it is easy to overstate their impact. US earnings growth has outpaced peers, but by less than 350 bps per annum over the past five years. US stocks are now twice as expensive as developed peers, a record gap. A cyclical economic rebound could help narrow this differential, and we note the impressive policy response in the Eurozone, as well as more encouraging COVID-19 trends. Meanwhile, Asian countries like China have seen a much shallower recession and earnings hold up better throughout the pandemic, and 2021 earnings growth forecasts for EM overall are higher than in the United States. Rising political risks may also weigh on US equities, as could higher leverage levels (or political pressure), which discourage buybacks.<\/p>\n EQUITY RALLY HAS PUSHED US AND GROWTH STOCK VALUATIONS HIGHER<\/strong> Source: Cambridge Associates LLC. Small-capitalization stocks have also been a notable COVID-19 laggard, continuing a long-running trend. US small-cap stocks trail large-cap peers by more than 1,500 bps year-to-date and more than 600 bps per annum over the last five years. US small caps have been disproportionately impacted by COVID-19 given large weights to heavily impacted sectors like healthcare, financials, and real estate, and different types of companies within some buckets (notably, regional versus global banks and retailers versus Amazon). High debt levels and secular changes may mean many never recover from the current crisis. However, small caps typically outperform coming out of a crisis as valuations decompress; in the meantime, seldom has the valuation differential between small and large caps been so large.<\/p>\n The post-COVID recovery may also allow for beleaguered value stocks to rebound, which, like their international and small-cap brethren, have rarely underperformed to this degree. World growth stocks have outperformed value by more than 3,700 bps over the last 12 months, as investors have paid up for their attractive combination of yield and earnings growth amid the pandemic-related recession. Not all value stocks will stage a fierce recovery, especially if low interest rates and dividend cuts continue to weigh on sectors like financials and energy. However, the flipside is that nosebleed valuations for many growth stocks imply a robust economic rebound, which would also benefit cyclically exposed value peers, and some tech darlings are cheap enough to be included in value indexes.<\/p>\n The recent economic recovery remains tenuous and is vulnerable to forces like another resurgence of COVID-19 or diminished political appetite for more stimulus. Given the resulting uncertainty about when current sectors cede leadership positions, we suggest investors establish small overweights within equities across non-US, small caps, and value, and use momentum as a signal to further increase positions. To limit underweights to high-quality IT stocks, which could continue to outperform, investors implementing these overweights should ensure private investment sleeves have adequate exposure and\/or implement these tilts via active managers.<\/p>\n Credit assets have generated mixed performance year-to-date, with eligibility for Federal Reserve purchases, exposure to a COVID-19 related slowdown, and technical factors all coming into play. US investment-grade bonds have fared best (6.9% year-to-date), high-yield bonds are barely in the black (1.7%), and many types of structured credit have underperformed. Given in many cases an unpalatable combination of average spreads but elevated risks, investors should choose private over public credit strategies and pursue opportunistic mandates as opposed to placing all their eggs in one basket.<\/p>\n CREDIT SPREADS HAVE RECOUPED MOST OF THEIR LOSSES WITH SOME EXCEPTIONS<\/strong> Sources: Bloomberg Index Services Limited, Credit Suisse, J.P. Morgan Securities, and Thomson Reuters Datastream. Opportunities in liquid credit are greatest where the Fed is not providing direct support. Spreads on lower-rated collateralized loan obligation (CLO) paper (including BBB- and BB-rated bonds) have tightened yet remain elevated, though asset quality and deal structures vary and using skilled active managers is key. Strong tailwinds like record-low mortgage rates and limited new supply are likely to support housing related credit, including non-Agency residential mortgage bonds. There are also select opportunities in lower-rated legacy commercial mortgage\u2013backed securities, but loan delinquencies are rising and vintage, collateral type, and choice of tranche come into play\u2014some of these bonds are cheap for good reason.<\/p>\n In contrast, investors should pass on assets whose option-adjusted spreads offer little compensation for the possibility of another downturn in risk assets. BB-rated high-yield bond spreads have retraced more than 60% of their late-March widening and now yield just 3.9%, while investment-grade corporate bonds have retraced 65% and offer a historically low yield of just 1.9%. Structured credit is a similar story, with Fed support and stabilizing fundamentals meaning some AAA-rated assets now yield less than levels seen in early March.<\/p>\n Investors willing to lock up capital have more attractive alternatives. Some managers can earn attractive spreads by funding borrowers shunned by skittish banks or whose debt is ineligible for Fed largesse. Examples include lower middle-market companies targeted by direct lending funds and real estate operators looking to acquire and renovate assets. Credit opportunity funds are seeing a variety of opportunities, though massive government intervention has slowed the pace at which some are deploying capital. Looking forward, their opportunity set includes making loans to troubled companies that are unwilling or unable to tap public markets, leveraged funds needing to sell assets due to weakening collateral performance that triggers margin requirements, and ratings downgrades that trigger forced selling. In some cases, there may also be mismatches between time horizons of funds, which hold struggling corporate loans or property-backed securities, and their investors that desire more immediate liquidity, creating opportunities for those that are more patient to step in and await an asset\u2019s recovery.<\/p>\n Distressed funds are in capital-raising mode, and an extended downturn could generate significant opportunities given the combined $2.5 trillion high-yield and loan markets. Still, it is unclear whether these commitments should be the first priority. Default rates are rising but have thus far been concentrated in industries like energy and retail; a plunging distressed ratio speaks to the fading possibility of a disorderly cycle, which might offer the richest pickings for investors. There is also the possibility that a quick recovery ensues, allowing even struggling companies to squeak by given loose lender protections.<\/p>\n An opportunity also exists among social equity investments. This space is broad and deep, touching multiple thematic areas and industries: think education technology, healthcare services, and affordable housing. Investments in these areas benefit society as a whole by addressing its inequities, many of which manifest themselves along racial and gender lines. While we expect return patterns of investments in this space will be similar to other equity investments, they may diversify traditional portfolio holdings to a greater extent. Moreover, they add another dimension to success\u2014social impact.<\/p>\n The tragedy of George Floyd\u2019s death galvanized a global social movement, adding urgency to this opportunity. But data has long indicated that stark divides exist. Consider, for example, how wealth is allocated in the United States. Currently, White Americans hold 84.8% of the nation\u2019s total wealth, which represents roughly $88.4 trillion, according to the Fed. While the share of White Americans\u2019 wealth has fallen from its recent peak in 2001, it is still considerably larger than that racial group\u2019s share of the population, which is 60.1% at present.<\/p>\n WHITE AMERICANS CONTROL THE MAJORITY OF US WEALTH<\/strong> Sources: Federal Reserve and Survey of Consumer Finances and Financial Accounts of the United States.<\/p>\n<\/div>\n Long-lasting concentrations of wealth such as this have ramifications for society. To see one, look no further than health outcomes for COVID-19 patients. The rate at which Black Americans have died is 2.4 times the rate of White Americans, after accounting for population sizes, according to the COVID Tracking Project. Hispanic Americans have suffered too, with death rates 1.5 times that of White Americans. Unfortunately, these inequities aren\u2019t present in just one corner of life. Disparities occur in virtually all areas, such as financial inclusion, education, and housing.<\/p>\n But where there are gaps in investment focus, there are opportunities. We view the opportunity set in two ways. First, there are those managers that are diverse themselves or that have an explicit strategy of backing diverse-run businesses. Second, there are those managers whose investments would disproportionately benefit underlying communities in need. This approach is a bit more abstract, but consider a manager focused on fintech start-ups aimed at democratizing financial solutions or another seeking to improve access to healthcare services. Although the products of those firms may benefit all communities, underserved communities may find them particularly empowering.<\/p>\n In both approaches, we\u2019ve seen the number of manager options increase in recent years. Like any space, return expectations vary by the manager\u2019s focus and strategy, but broadly speaking, we don\u2019t expect return patterns to be structurally different than other equity strategies. Still, it does seem reasonable to expect that social equity returns may be less correlated to traditional portfolio holdings than broad equity strategies, given their integration of a different lens in investment decision-making processes.<\/span> 4<\/a><\/sup> Said differently, these strategies may help to diversify any implicit or explicit biases against these communities in portfolios.<\/p>\n The world has changed considerably over the last six months. As many markets have rapidly snapped back in response to extraordinary fiscal and monetary policy, investors must be discriminating in pursuit of opportunities. While we believe the economy has bottomed, the road ahead may be choppy. We also recognize that investors and business leaders notoriously overestimate the near-term impact of changes, while underestimating the long-term impact. Patient investors should find attractive long-term opportunities in public and private technology and tech-enabled investments given the dramatic change under foot but should limit exposures at elevated valuations. At the same time, investors should initiate small overweights to relatively cheap equities, such as value, global ex US, and small-cap equities that have considerable upside if conditions improve given their propensity to outperform during recoveries. Selective opportunities remain in credit and managers with the ability to be flexible as the opportunity set evolves should be best positioned for success. Finally, the importance of investing in social equity and diversity has been brought into sharp relief by this crisis. We expect such investments to offer diversification at competitive returns relative to the broad market.<\/p>\n <\/p>\n
\nMarch 7, 2020 \u2013 August 4, 2020 \u2022 Percent (%)<\/p>\n![\"ECONOMIC](\"https:\/\/publishedresearch.cambridgeassociates.com\/wp-content\/uploads\/2020\/09\/09-2020-VP-6-months-in-01.png\")
<\/a><\/p>\n
\nNotes: Hours worked by hourly employees, hourly employees working, and local businesses open are based on Homebase data. All Homebase rates compare that day versus the median for that day of the week for the period January 4, 2020 \u2013 January 31, 2020. The Mobility and Engagement Index is constructed by the Federal Reserve Bank of Dallas and measures the deviation from normal mobility behaviors induced by COVID-19. All data are daily on a seven-day moving average.<\/p>\n<\/div>\nWalking the Tech Tightrope<\/h1>\n
Limit underweights to tech for now, seek to expand if greater opportunities unfold in relative value opportunities over time.<\/h4>\n
\nAugust 31, 2015 \u2013 August 31, 2020 \u2022 5-Yr Trailing Annualized Average Percent Change (%) \u2022 Local Currency<\/p>\n![\"TECH](\"https:\/\/publishedresearch.cambridgeassociates.com\/wp-content\/uploads\/2020\/09\/09-2020-VP-6-months-in-02.png\")
<\/a><\/p>\nLeaning in to Relative Value in Equities<\/h1>\n
Establish small overweights within equities across non-US, small caps, and value, and use momentum as a signal to further increase positions.<\/h4>\n
\nAs of August 31, 2020 \u2022 Percentile<\/p>\n![\"EQUITY](\"https:\/\/publishedresearch.cambridgeassociates.com\/wp-content\/uploads\/2020\/09\/09-2020-VP-6-months-in-03.png\")
<\/a><\/p>\n
\nNotes: This exhibit compares current valuation levels to historical levels across a variety of asset classes. A percentile rank of 50 indicates that an asset class\u2019s current valuation level is consistent with its long-term median, while a percentile rank of 75 indicates that level is higher than 75% of historical data. The valuation levels for each asset class is determined by a metric or composite of metrics relevant to that asset class.The cyclically adjusted price-to\u2013cash earnings (CAPCE) ratio is calculated by dividing the inflation-adjusted index price by trailing ten-year average inflation-adjusted cash earnings. Cash earnings are defined as net income from continuing operations plus depreciation and amortization expense. MSCI does not publish cash earnings for banks and insurance companies and therefore excludes these two industry groups from index-level cash earnings. ACWI ex US, Asia ex Japan, US Small Cap, and World ex US Small Cap equities are cyclically adjusted by trailing five-year data. All data are monthly.<\/p>\n<\/div>\nPicking our Places in Credit<\/h1>\n
Choose private over public credit strategies and pursue opportunistic mandates.<\/h4>\n
\nAs of August 31, 2020<\/p>\n![\"CREDIT](\"https:\/\/publishedresearch.cambridgeassociates.com\/wp-content\/uploads\/2020\/09\/09-2020-VP-6-months-in-04.png\")
<\/a><\/p>\n
\nNotes: Asset classes represented by: Bloomberg Barclays US Corporate Investment Grade Index (US IG), J.P. Morgan CLOIE AAA Index (CLO AAA), Bloomberg Barclays US Corporate High Yield Index (US HY), Credit Suisse Leveraged Loan Index (US LL), ), J.P. Morgan CLOIE BBB Index (CLO BBB), J.P. Morgan CLOIE BB Index (CLO BB), J.P. Morgan CEMBI Diversified Index (EM USD [Corp]), and Bloomberg Barclays US CMBS Baa Index (CMBS BBB). Percent recovery from peak is the recovery of the option-adjusted spread from each asset’s peak. Peak dates vary for each individual asset class.<\/p>\n<\/div>\nSupporting Social Equity<\/h1>\n
Seek opportunities that emphasize social equity and diversity.<\/h4>\n
\nFirst Quarter 1990 \u2013 First Quarter 2020 \u2022 Share of Total Wealth (%)<\/p>\n![\"WHITE](\"https:\/\/publishedresearch.cambridgeassociates.com\/wp-content\/uploads\/2020\/09\/09-2020-VP-6-months-in-05.png\")
<\/a><\/p>\nConclusion<\/h1>\n
![\"OVERVIEW](\"https:\/\/publishedresearch.cambridgeassociates.com\/wp-content\/uploads\/2020\/09\/09-2020-VP-6-months-in-HV-Overview-new.png\")
<\/a><\/p>\n