Following an unprecedented collapse in global GDP, the global economy has begun to recover as lockdowns have been relaxed. Global equity markets recovered much of their first quarter losses and liquidity conditions improved considerably.
The current recovery is encouraging, but it was from a very low base. While re-openings and signs of a rebound are encouraging, uncertainty over whether the recovery can be sustained beyond the immediate rebound remains.
Equity valuations, particularly in the US, are stretched by historical standards. However, equity valuation are reasonable, if not cheap, versus government bonds. The prospective equity risk premium is high by historical standards, although short-term risks are also high.
Holding cash and Treasuries almost guarantees a loss in purchasing power over the long-term. We suggest institutions consider reviewing their strategic asset allocation to test the viability of their objectives against their risk tolerance. The decline in expected returns from high quality bonds will make it more challenging to meet typical long-term return objectives.
Investors should consider asset classes that can dampen volatility with a lower opportunity cost. Hedge funds and other alpha-oriented strategies are also worth consideration. Gold tends to perform well during periods of falling real rates and provides a reasonable hedge to equities.
We retain a positive view on emerging markets. Valuations are reasonably attractive and the ability of the largest countries to control the virus and re-open their economies is positive. However, geopolitical risks remain elevated, particularly as it relates to Hong Kong and US-China tensions.
While credit spreads narrowed during the quarter, we continue to believe there is value within investment-grade corporate bonds. The combination of a more favorable macro environment and direct central bank support should continue to act as a tailwind.
While spreads on HY bonds have narrowed considerably since the end of March, current valuations remain compelling and have historically offered investors an opportunity to generate strong returns on a forward basis. We continue to prefer the risk-to-reward of high yield over equities.