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The View from the Outer

View from the Outer: Moving too fast

Max Casey Tim Rocks Peter Dragicevich
14th May 2020

Moving too fast

We are reducing our recommendation on international equities to underweight.  Given the strength of the bounceback since late March and elevated levels of risks, we view it as sensible to build cash levels in case there are opportunities created by future periods of volatility. 

Risks remain extremely elevated at present, including:

¡  Health risks are rising as countries start to emerge from lockdowns. 

¡  Macro risks remain extreme.  The hit to labour markets has been severe and bankruptcies and bond defaults are starting. The removal of lockdowns has also not resulted in a quick return of activity in some jurisdictions. 

¡  The damage to government finances will result in ongoing problems in a range of vulnerable countries particularly EM and peripheral Europe. 

Given such elevated risks, our view is that equity markets should trade at a discount to fair value to provide some cushion for investors, but this is no longer the case.  Analysts are assuming a quick bounce in earnings in 2021 and investors appear to be paying a full price for those earnings.

We also note that valuations have changed most aggressively for quality stocks, so there is less opportunity now to buy quality companies at good prices.  Quality stocks have bounced back quickly since the market low. 

Recommendation

We recommend investors reduce exposure to international equities to an underweight position. 

We would prefer to raise this cash from equity markets where cyclical vulnerabilities are greatest.  Internationally this is in Europe and Emerging Markets.  These are most vulnerable because listed companies are in more cyclical sectors, direct government stimulus has been less and sovereign debt vulnerabilities are highest.

We retain our neutral position on Australian equities for now.  Most of the concerns raised in this note also apply in Australia, but it is better positioned given the scale of the policy response, position of government finances, strength of its financial system and effectiveness of the health response.