Investors must brace for volatility in Q3 as 'J-shaped recovery' emerges, says Martin Currie’s Osmani

Equity investors must prepare for the possibility of increased volatility in Q3 as the V-shaped recovery we have seen so far morphs into a new phase, known as the J-shaped recovery, according to Zehrid Osmani of Legg Mason affiliate Martin Currie.

While Q2 saw economies and stock markets rebound sharply in a V-shape, Osmani said the recovery would now change as we move through the second half.

“As countries are now coming out of lockdown, the fiscal stimuli will be helping economies recover and we are likely to see some pickup in leading indicators over the next one to three months from the lows earlier in the year,” he says.
“Some of the initial improvement might appear rapid, which could give the illusion of a “V-shaped” recovery. The shape of the economic recovery, however, is still highly uncertain, due to numerous unknowns about what a post-lockdown world looks like.”
Osmani - manager of the Legg Mason Martin Currie US Unconstrained and Global Long Term Unconstrained funds - says, as a result, volatility could return in the third quarter, especially if the strong momentum for the US economy in particular is not continued.
According to the VIX index, volatility fell back in Q2 to more normal levels around 30, far below the peak in March above 80. But this could rebound next quarter, Osmani said.
“We are expecting a more gradual recovery now, and this is being factored into the forecasts for the companies we own,” he says. “There are a lot of unknowns on the speed of channelling policy stimuli into the economy, as well as pandemic relapse risk once lockdowns end, which could act as a dampener to any recovery. We don’t expect a return to normal activity levels until 2022.”
The manager expects China’s economic recovery to act as a blueprint for the rest of the world, given the country entered into recession first.
“In Q1 in China activity halved, and then it started to recover swiftly, and for now it looks like regions including the US and Europe are following in its path, albeit a whole quarter behind in terms of timescales.”
Osmani says against this backdrop of a slower, J-shaped recovery, it remained paramount to focus on businesses which were resilient.
“Given the uncertain environment, we continue to favour companies with high management quality and strong balance sheets and cash flows, and which are operating in industries with high barriers to entry and with strong market share,” he says. “This gives them pricing power, and therefore an ability to generate high returns and attractive growth profiles.”
The threat to Osmani’s outlook remains the unemployment rate globally. While moves by governments to support mass furloughs have kept unemployment rates down, the risk now is that as furloughs end, there will be more spikes in unemployment.
“While we expect a gradual recovery, there remains the potential downside impact of any negative feedback loop from the weakening jobs markets on demand. That’s the big threat to the whole recovery and therefore a major forecast risk, and that’s why we have opted for a portfolio focused on resilience.”