Discretionary Trading Q2 2020 commentary

Market overview

In Q2 there was a historic rally in equities, with the best quarter in decades and the fastest-ever 50-day rally. Markets have almost recovered to pre-pandemic levels in the S&P 500, while we are now at all-time highs in the Nasdaq technology index. Hardly anyone expected such a recovery considering the socioeconomic reality in July is not far from what was expected in March. 

Why then are the markets at completely different levels? Some recovery was expected from lockdown levels as many parts of the developed world managed to reopen the economy, albeit at roughly 90% of potential levels as sectors most affected by social distancing still struggle. Important factors in market optimism are expectations of a vaccine and belief in science. Around the middle of May, enough scientific news had been released to assume that a vaccine is coming soon and the whole virus disruption is only a 2020 affair. From academic work we know that a company’s one-year earnings represent only 10% of a company’s market value. So from that point of view the March sell-off was overdone to begin with. 

But the March sell-off was based not only on the assumption of virus disruption, but on the belief that today’s overleveraged economy would not survive the full impact of the lockdown and disruption without intervention. Indeed, the strategy manage believes we could have faced a cascade of bankruptcies and another financial crisis if not for monetary and fiscal policy intervention. But such invention is supposed to only be a bridge back to normality, yet the consequences of the socioeconomic crisis have not even begun. 

A secondary effect of monetary policy intervention is the expansion of risk appetite in financial markets and rising valuations. Rising risk appetite and expanding valuations in the middle of a recession and speculative activity that reached even the retail sector is the biggest surprise. Usually we have that level of risk appetite when the sky is clear, not when the situation is uncertain. Some hype around technology stocks is justified as structural digitisation of commerce trends are stronger than cyclical headwinds, but the markets assume that everybody will continue to work from home, while at the same time everything will reopen, and there will be no losers from this change. It assumes that monetary supply growth is permanent but disruptions are temporary. 

Portfolio performance

(Performance figures are inclusive of transaction costs but not service and performance fee.)

It was a flat quarter regarding performance. The strategy manager’s assumption going into Q2 was that risk appetite would not come back so quickly, preventing the strategy from taking meaningful ‘long’ positions. Amid the rally, the risk of collapse was notable and the amount of optimism at the elevated prices was too high. There were opportunities on the ‘short’ side, especially in June during the resurgence of the virus in USA and Beijing. But mistiming and expectation that the trade would last until quarter-end meant the opportunity was mostly lost. 

There were very few opportunities in currency markets, with some moves in the euro driven by the Recovery Fund announcement and the eurozone’s long-term prospects. The trades of choice regarding money supply growth were in precious metals. Taking a long position in silver was beneficial, substituting for gold, which had become quite heavily priced. Bonds are for now subdued and de facto regulated by central banks, although there are long-term opportunities as public debt financing balloons. There was a spectacular move in oil markets, but market manipulation and negative prices changed regulatory requirements, adding unlimited risk to (trade) equation. And although the oil recovery was attempted in the strategy, results were lacklustre during the most promising period of the trend.

Outlook

The pandemic will surely have political consequences as a democratic blue wave in the US’s November elections is becoming more probable by the day. It will have also geopolitical consequences with stronger deglobalisation tendencies. It will impact public debt and the level of taxation, but as of now the market assumes that we live in a monetary policy primacy world and there is no problem that cannot be fixed with monetary policy.

Markets therefore are likely to start paying attention to election risks in the US. Technology stocks appear to be in bubble territory, making it vulnerable to turbulence around earnings season. The strategy manager believes there will be opportunities to play the equity market from the short side. Global investors will be mindful of EU Recovery Fund news, which can signal long-term consequences for the eurozone. The strategy will look out for the opportunities to play the euro from the long side as its share in global currency reserves rises and dollar prospects weaken. We also anticipate opportunities in precious metals as a play on rising money supply. 

We look forward to providing further comments next quarter.