So, in the spirit of our Franciscan friar: unless we see another huge outbreak of Covid-19 it is likely that risk assets – and not just equities – will continue to reward investors.
This simple explanation is based on a number of sequential observations, which lead to some very interesting opportunities, especially in fixed income markets.
Governments and central banks have acted in a timely, targeted, and concerted manner to the Covid-19 pandemic by injecting huge amounts into support for financial markets and stimulus directly into the economy.
The Italian government has allocated measures totalling 53 per cent of GDP and, in all, 19 governments have allocated more than 20 per cent of their GDP to addressing the pandemic. In many cases this has surpassed the measures taken in the Great Financial Crisis of 2008/2009.
Given these actions, we believe that the global recovery is now taking shape. Initially, we expect a synchronized, strong recovery coming out of Q2 and hard into Q3 and Q4.
However, and this comes with several caveats, we would then expect a slower pace of recovery with the potential to slow more through first half 2021.
It is unlikely that we reach the pre-Covid level of GDP until late 2021. Investors should not expect the recovery to take shape quickly. Sovereign bond yields are basically anchored at zero and there is barely any inflation to speak of.
But there is a lot of liquidity. Investors are once again being encouraged to take risk and that is exactly what they will do, probably in increments.
Such a market merits a closer look at three areas.
The first is investment grade credit.
Credit spreads, a measure of the additional return available for the extra risk of lending to companies, have come in from their widest at the peak of the crisis.
With the Federal reserve now a supporter of credit, spreads should have much more room to tighten and investors should see good rewards.
The second is equities. They have not fully reflected the above recovery outcome. Earnings expectations also have some catching up to do.
Given this backdrop we believe that equities have room to further progress, led by the growth winners. The trends that existed before the Covid-19 crisis have merely been accelerated.
Thirdly, we encourage investors to look at areas of fixed income markets that have lagged the recovery until recently and have good potential for catch up.
These, sometimes complex areas can offer exceptional rewards for the related risks. We can find these characteristics in areas of structured credit, and among others in particular the US mortgage backed securities (MBS) market.
The agency MBS are created by one of three agencies: Fannie Mae, Freddie Mac or Ginnie Mae and are essentially free from default risk.
While the Fed is buying hundreds of billions of dollars of these agency mortgage pools to support prices there are two connected areas that have not been offered such support and have therefore been left behind.
One is non-agency residential mortgage backed securities. These are mortgage pools issued by private entities, and often consist of borrowers who did not meet agency standard and are not guaranteed by the US Government.
The heaviest issuance of non-agency MBS occurred from 2001 through 2007 before the housing crisis and therefore for many investors they have been unfairly ‘tarred’ with this legacy.
Another is a sub-category called “credit risk transfers” (CRT) where Fannie and Freddie, absolved of full principal guarantee on agency loans, moved them to private markets.
The loan-to-value ratios are generally over 60 per cent but still well within conforming underwriting standards. The explosion in spreads in these areas of mortgage credits was almost unbelievable in March.
This is an area in which expertise is valuable and in relatively limited supply.
There are two Ucits vehicles that invest in these assets and we currently favour Semper Capital Management’s Irish domiciled Gemcap Semper Total Return Fund.
Following a remarkable, sentiment-driven market sell off this vehicle now has the potential for distressed credit levels of price appreciation without necessarily the associated credit risk.
Keeping things simple, it seems clear that assets such as those highlighted above will continue to reward investors, even after their recent advances.
Mark Harris is head of multi-asset at Garraway Capital Management
