Cast your mind back to March 2020. News headlines are dominated by the spread of a deadly and contagious disease whose method of transmission and treatment are unknown. Hospitals are struggling to cope. Governments are closing borders. Individuals are shunning public transport. And non-essential workers are being told to stay at home. It is in this context that most asset classes hit their lows in the second half of that month.
Of course, policymakers responded to this threat with admirable speed and aggression. Monetary policy was rapidly loosened, and significant fiscal stimulus was provided to the economy. Meanwhile, vaccines have been developed and deployed with unprecedented speed. As a result, the 2020 bear market was remarkably short-lived, particularly in developed markets.
Fast forward to today and investors are grappling with significant uncertainty regarding the macro outlook. Will tightening monetary policy trigger a recession? Or will policymakers be able to tame inflation without choking off demand?
Benchmarking current asset values against the March 2020 lows, when there was universal fear of a global recession, can help us to gauge the current investor mood and identify where the biggest opportunities lie.
At the asset class level, what we see is that more defensive assets are at similar levels to March 2020, suggesting that they are once again pricing in a sharp macro slowdown. But riskier asset classes are substantially higher than before, even after recent weakness.
Credit markets can be much better at calling the economic cycle than equity markets. Due to the skewed payoff profile of credit instruments (capped upside), investment outperformance is typically determined by avoiding banana skins; investors have a laser-like focus on spotting downside risks.
For equity investors, the payoff profile is more balanced, and so their attention is spread much more broadly. For example, during the 2008-09 sell-off, US corporate bond valuations bottomed out several months before the US equity market.
What does this mean for investors today? From a risk-return profile, it may mean that defensive asset classes offer a better risk-reward profile, as they are less elevated versus their 2020 lows. Within credit, this means staying closer to higher quality but, surprisingly, longer-duration credits.
Within equities, China seems to be the standout opportunity by geography, with consumer staples, telcos and utilities looking better at the sector level. Commodity-linked names appear more exposed.
And in terms of gauging the investor mood, bulls should probably pay more attention to credit assets, and bears to equities and commodities. The recent small recovery in credit asset valuations is a case in point. Note, however, that in 2008-09, equities fell a further 30% (over four months) even as credit markets rallied.