SGR Monthly Dashboard July 2020 – “Are We There Yet?”: Donkey in Shrek 2
By Dimitri Triantafyllides
July 1, 2020
When the characters in Shrek 2 undertake their very long journey by horse and wagon, from the very beginning, the hilarious Donkey played by Eddie Murphy, keeps asking “are we there yet?”. In a similar way, just a month after the beginning of lifting of lockdown measures in most US states and globally, the market has kept rallying in anticipation of the end of the pandemic journey. While it is true that the equity market discounts future events, and as a result is probably one of the better leading indicators, from where we stand today, it is hard for us to jump on the enthusiasm bandwagon.
In the last three months, the equity market has risen 19%, with the more economically sensitive sectors leading the rally (discretionary up 35%, tech up 27%, materials up 24%). The equity market P/E ratio is back over 20x as the earnings yield has dropped from 5.3% to 4.7%. During this time rates have remained steady at the new normal (with the 10 year comfortably below 1%). As we noted in last month’s letter, the Fed’s rapid and massive response to the pandemic lockdown has flooded money that has been forced into assets. This is beginning to feel like a financial game of musical chairs in which as long as the music is playing, each time the Fed throws money to the problem it removes a “risk chair”, forcing each market participant to move up to a slightly higher “risk chair” than the one they previously occupied. If you were a Treasurys-only investor, you now must buy agency debt to earn what you used to in Treasurys. If you are an agency debt investor, now you have to buy high-grade corporates. The high-grade corporate investor now has to buy BB junk bonds. The junk bond investor has to now buy equities. The equity investor must now trade volatility. It is no surprise therefore, that the volatility proxy, the VIX, has remained elevated (currently at 33%).
As every kid knows, musical chairs ends with a single winner, and even the winner may doubt the game’s worth given the stress of playing. In a backdrop like this, where risk is elevated but return increasingly diminished, we believe a defensive stance is warranted.