Wall Street Rewrites Market Playbooks With Second Wave Looming

As the world braces for a second wave of infections from the coronavirus, stocks are priced for a booming global economy, bonds point to a protracted downturn and currency volatility is rising.

Investors are increasingly uneasy with these conflicting signals among asset classes, but they are also resigned to them, and have adjusted their playbooks accordingly.

Tried-and-tested strategies that directed buyers into stocks in good times and bonds in bad times began to unravel in the face of unconventional monetary policy a decade ago. They are being dropped now as central banks ramp up their response to the virus and governments pledge more than $8 trillion of fiscal stimulus to combat the fallout from the pandemic.

“It‘s a hard shift in markets and at the heart of all of this -- undoubtedly -- is the Federal Reserve’s efforts to revive the economy,” said Shyam Devani, chief strategist at SAV Markets in Singapore. “There are glimmers of 2008 financial crisis investing, but this time, from equities to bonds to currencies, there is a sense that stakes could be higher.”

MSCI Inc.‘s broadest measure of international stocks shows member companies trading at more than 19 times next year’s earnings. These kinds of levels haven‘t been seen since the dot-com bubble burst in 2002. And what’s worrying is they come as millions of people are cast into unemployment by what the United Nations has called the most challenging crisis since World War II.

“The fact that the central bank of the world‘s reserve currency is buying everything from government bonds to corporate debt is floating all boats,” said Devani. “The tipping point will be when there’s enough clarity on what the long-term impact of the virus is.”

Eye-Watering Equities

That point hasnt arrived and some stock investors expect eye-watering valuations for at least the remainder of 2020.

“Money pumped by central banks and governments will keep the PEs higher and we will have to work with that,” said Nader Naeimi, head of dynamic markets at AMP Capital in Sydney. “PEs correlate with excess liquidity.”

Optimists suggest earnings may rebound to support the valuations but others are unconvinced.

Covenant Capital Pte. fund manager Edward Lim has downgraded his view of stocks to neutral and is on guard for more black-swan events.

“Finding tail-risk hedging strategies and uncorrelated returns have become even more urgent for us,” said Singapore-based Lim.

Steeper Treasuries

Nowhere is the Fed‘s influence more pervasive than in the world’s biggest debt market. Its pledge to spend at least $120 billion a month on asset purchases, and a possible return to the 1940s-era policy of yield-curve control, are anchoring interest rates on short-dated Treasuries near record lows.

At the same time, expectations for the economy to normalize has led to bets for 10-to 30-year yields to rise, leading strategists from Bank of America Corp. to Morgan Stanley to recommend so-called steepener trades.

Mark Nash, the head of fixed income at Merian Global Investors in London, is taking this as a cue to look at the strategy, which profits as yields for long-end bonds climb faster than those with shorter maturities.

“Were nervous long bonds at these levels,” said Nash. “When things look better, when the macro data picks up and you can rely on it not being hit by another wave of the virus, then you start to sell Treasury bonds again.”

Asia Hot Spots

Playbooks are also getting reinvented in emerging markets -- where asset prices are shrugging off a severe contraction in many economies. Again, thats due to the role central banks are playing.

This trend is well underway in Indonesia where 10-year bonds have erased most of their losses from the coronavirus crisis. In India, the rally is even more pronounced with yields hovering near the lowest in more than a decade as the central bank scoops up bonds in the secondary market.

Both countries are projecting the worst economic growth in years, while also flooding debt markets with issuances to fund stimulus spending.

“Asia is again becoming a preferred destination amongst EM investors due to better fundamentals compared to other EM regions,” said Edward Ng, a portfolio manager at Nikko Asset Management Asia Ltd. in Singapore.

Currency Volatility

Meanwhile, swings in foreign exchange are picking up again -- another sign that investors cant decide between fear over a second wave of infections and optimism that economies are starting to mend.

Nowhere has this been more evident than the Australian dollar, which plunged to an 18-year low in March then rebounded 28% in the space of three months.

This is not the way currencies of developed economies typically move, said Jane Foley, a currency strategist at Rabobank in London.

“By the end of the year there is still significant risk of a nasty turn lower,” said Foley, cautioning that the Australian dollar could re-test 60 U.S. cents if investors recalibrate their expectations for global growth.

Old Normal？

That recalibration may be when markets return to a more normal state of affairs, and consensus forms over how to price assets in a world that has lived through the havoc wreaked by the coronavirus.

That may not come untill 2022, going by Fed projections over when it could start raising policy rates again.

“At the moment everybody is getting some sort of uplift,” said Pacific Investment Management Co.s Robert Mead. “As we move through this phase, there will be a lot more differentiation between the winners and losers.”

— With assistance by Kartik Goyal, Hooyeon Kim, and Chester Yung