Today’s “risk on” environment may be here for the long term

Policy responses, global management of the pandemic, and equity prices may enable investors, collectively, to remain comfortable with assuming risk.

To assess whether a prolonged “risk-on” environment has emerged, it is important to focus on what we know about market cycles. While no two market cycles are identical, they tend to follow similar patterns. This time has been no different, the global pandemic notwithstanding.

In the following commentary, we articulate what we know about the early stages of elongated market and business cycles and liken those trends to the current market and economic environment.  The inevitable near-term potential for increased volatility aside, our conclusion is that a new cycle has emerged and is providing the fundamental catalyst for a sustainable long-term rally in risk assets. 

Bear markets typically portend economic recessions rather than persist through the early and middle stages of the recovery. In the US, there have been six instances since 1930 when stocks experienced market declines of greater than 30%. In every instance, stocks were meaningfully higher 1 and 3 years after the trough, the inevitable volatility and market corrections along the way notwithstanding.1 This year, global stocks experienced a full-blown recessionary bear market in roughly 20 trading days. The market trough, as has typically been the case, coincided with extreme volatility, lopsided investor positioning, and dire sentiment globally. By early May, investors had largely capitulated with trillions of dollars seeking the relative safety of government bonds and cash-like assets.

Inevitably, at such times, policy responses emerge and financial conditions ease. If the adage for investors has historically been “don’t fight the Fed,” we can now likely expand that to include almost every other central bank in the world, as well as the European Commission and the US Congress. As has historically been the case, the beginning of cycles can be terminated with bad policy mixes. In this instance, we think the likelihood of a policy mistake is low. Expansionary monetary policy has already had its intended effect. Inflation expectations have largely recovered from albeit depressed levels, the US dollar has been weakening against a broad basket of other currencies, industrial commodity prices have stabilized, and credit spreads have compressed. On the fiscal side, policymakers, including the US Congress and the European Commission, appear poised to provide ample support to economies.

“Risk-on” periods can emerge even as broad economies remain challenged. Remember, in the aftermath of the global financial crisis, it took many years for mortgage default rates to peak, for households to de-lever their balance sheets, and for full employment to emerge. Nonetheless, stocks staged a sound advance. While there are signs of sound recoveries in certain segments of the global economy (like China manufacturing, US housing and retail sales), other segments of the global economy remain challenged. Economic conditions could potentially worsen in the near term as rising COVID-19 cases in many US states and select cities of the world could lead to renewed shutdowns and decreased human mobility. Importantly, however, we would not expect the same shut-down measures as witnessed earlier in the year. We know far more about this virus now than we did in March 2020 (the benefits of masks, social distancing, and the lower risk of outdoor gatherings) that should support the compression of cases and enable a gradual continuation of the economic recovery. Also, we would expect weak and intermittent recoveries to be consistent with extended and even advanced monetary and fiscal policy accommodation globally. As always, investors should be focused in the coming quarters not on whether economic conditions are good or bad, but rather on whether conditions are likely to get modestly better.

Finally, global equity valuations, although not necessarily cheap on an absolute basis, remain attractive to many alternatives, including developed market government-related securities. The discount rates used to determine the present value of future cash flows is near zero in much of the developed world, suggesting that investors will likely be willing to pay higher multiples of earnings over time. Equity investors should, however, be mindful of the types of businesses they want to own for the long term. Market leadership will likely come down to which businesses are the disruptors and which businesses are being disrupted. The high-flying winners in this market are disrupting the way the economy, business, and society operates. We may end up paying higher equity multiples on those businesses than for the broader market, but it seems reasonable to expect those business will grow their earnings faster than the broader market does.

Ultimately, we expect this new emerging market and business cycle to be among the longest on record, perhaps even surpassing that of the post-2008 period. A prolonged period of slow growth, low inflation, low interest rates and massive policy accommodations will likely be a period that is conducive to sound performance from credit and equities. Investors should expect volatility along the way, particularly if concerns about re-opening the economy persist, but we believe that betting long-term against credit and equities now would be akin to betting against medicine, science, human ingenuity, and the direction of monetary policy.  That is not a bet that we would be willing to make.

Footnotes:    

1  Source: S&P 500 Index returns from January 1, 1939 – July 28, 2020, with data from Bloomberg L.P. and Invesco.

Important Information

Blog Header Image: Hakan + Sophie / Stocksy

Past performance does not guarantee future results.

In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as market, economic, and political condition conditions.

The risks of investing in securities of foreign issuers include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

The opinions referenced above are those of the authors as of August 12, 2020. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.

Brian Levitt is the Global Market Strategist, focusing on North America, for Invesco. He is responsible for the development and communication of the firm’s investment outlooks and insights.

Mr. Levitt has two decades of investment experience in the asset management industry. In April 2000, he joined OppenheimerFunds, starting in fixed income product management and then transitioning into the macro and investment strategy group in 2005. Mr. Levitt co-hosted the OppenheimerFunds World Financial Podcast, which explored global long-term investing trends. He joined Invesco when the firm combined with Oppenheimer Funds in 2019.

Mr. Levitt earned a BA degree in economics from the University of Michigan and an MBA with honors in finance and international business from Fordham University. He is frequently quoted in the press, including Barron’s, Financial Times and The Wall Street Journal. He appears regularly on CNBC, Bloomberg and PBS’s Nightly Business Report.

Talley Léger is an Investment Strategist for the Global Thought Leadership team. In this role, he is responsible for formulating and communicating macro and investment insights, with a focus on equities. Mr. Léger is involved with macro research, cross-market strategy, and equity strategy.

Mr. Léger joined Invesco when the firm combined with OppenheimerFunds in 2019. At OppenheimerFunds, he was an equity strategist. Prior to Oppenheimer Funds, he was the founder of Macro Vision Research and held strategist roles at Barclays Capital, ISI, Merrill Lynch, RBC Capital Markets, and Brown Brothers Harriman. Mr. Léger has been in the industry since 2001.

He is the co-author of the revised second edition of the book, From Bear to Bull with ETFs. Mr. Léger has been a guest columnist for The Big Picture and for “Data Watch” on Bloomberg Brief, as well as a contributing author on Seeking Alpha (seekingalpha.com). He has been quoted in The Associated Press, Barron’s, Bloomberg, Business Week, Dow Jones Newswires, The Financial Times, MarketWatch, Morningstar magazine, The New York Times, and The Wall Street Journal. Mr. Léger has appeared on Bloomberg TV, Canada’s BNN Bloomberg, CNBC, Reuters TV, The Street, and Yahoo! Finance, and has spoken on Bloomberg Radio.

Mr. Léger earned an MS degree in financial economics and a Bachelor of Music from Boston University. He is a member of the Global Interdependence Center (GIC) and holds the Series 7 registration.

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