There is a good reason for the current dislocation between a stunted global economy and strong equity markets according to Allen Sukholitsky, the founder of investment research firm Xallarap Advisory and ex-Goldman Sachs senior market strategist.
Government intervention has offset the effects of the pandemic and has combined with the natural end of a historic bull run to widen the gap between the flailing global economy and resilient markets, Sukholitsky explained during an interview with Investment Magazine’s Market Narratives.
“Economic growth is basically the worst it’s ever been or close to it, and yet we have markets that are off to the races,” Sukholitsky said. “But at the same time there are good reasons for the existence of the disconnect.”
The seismic shock of the pandemic has stifled the economy in countless ways, he explained, but the collective response from governments to support systems, businesses and citizens has also served to warp the natural order of things.
Asked if this dislocation has eroded or “hollowed out” the very premise of markets, the strategist said that was “probably accurate” to an extent.
“We like to use the word ‘distortion’,” he said. “There is an enormous amount of distortion because we’ve had an enormous amount of policy responses supporting areas of the economy which would go under if they didn’t have that support.”
These distortions are manifesting in several ways, he believes, including the labour market, which could mean that supported businesses are “less positioned” for a recovery.
Another example of the “distortionary economy”, he explained, can been seen with inflation.
“Inflation is distorted because prices do not rise at the same time,” he added.
The economic recovery from the pandemic, he believes, may take a while. Leading up to the pandemic, the global equities market was effectively at the tail end of the “longest expansion that has ever taken place”, he explained. Having the global markets’ positive momentum chopped down by such an “unexpected and unprecedented” event like the Covid-19 virus will likely mean the road back is a long one.
“You end up in a situation where the recovery can easily take quite a bit longer than many might expect because of those two things coinciding,” Sukholitsky said.
While valuations are obviously problematic in the current environment, Sukholitsky believes they are still useful for forecasting longer term returns. Shorter term forecasting, however, require analysis of the “channels” money flows through.
“What are the channels and the order it flows through the channels – those are big component of how we forecast different asset class returns,” he said.
The role of sentiment in forecasting shouldn’t be overstated, he explained, because it happens after capital has flowed through these channels.
“What’s most impactful in our eyes is the channels and the order the money goes through, because that’s going to create the primary impact,’ he said. “That’s why sentiment plays less of a factor than simply; ‘where is the money going?’”
Sukholitsky’s channel theory and the subsequent models it has fostered aren’t solely US-centric, either, and can be applied on a global scale.
“When we first started developing this theory that eventually got translated into the models, one of the requirements for us from a theoretical and statistical standpoint was that if there was any validity to this theory being useful than we better apply the theory to every market all over the world,’ he recounted.
“Luckily… the theory is in fact applicable to many different markets all over the world, not just in equities but in rates, and in countries that have very different financial systems and very different data sets.”
The same principles remain
While much of the composition of asset classes will depend on targets and risk tolerances, the strategist believes, a lot of the pre-pandemic principles of asset allocation remain the same.
“I would say the asset allocation that we would be recommending now is in so many ways very similar to asset allocations we would have recommended recently,’ he said.
“If you’re looking for a strategy that is going to generate better returns – which is going to come with corresponding high levels of risk – you would still want to allocate more to equities as opposed to something like fixed income,” he continued. “And vice versa is also true.”
And while it may seem elementary, Sukholitsky said it’s important to reiterate that the need for diversification is at least as important now as it was before the virus swept the world.
This is especially so for US investors, he reckons.
“In the US we have a lot of investors who for some time have been asking ‘why is it that I’ve been hearing about diversification for so long when I can just buy the S&P500 and call it a day?’” he said. “And the answer is historically diversification is not something that works every time, it’s something that works over time.”
“There will undoubtedly be stretches where being a little bit less diversified seems like the winning recipe, but it’s definitely over time a much better idea to diversify very broadly across asset classes.”