Barometer of financial markets November investment outlook

On the eve of what’s potentially one of the most consequential US Presidential elections in living memory, a second wave of the Covid-19 pandemic is ripping through the developed world. Compounding the uncertainties facing investors are question marks over how much more fiscal and monetary stimulus might yet be delivered, and where. As a consequence, we maintain our neutral stance on the major asset classes, awaiting clarity on at least some of these matters. 

Democrat presidential candidate Joe Biden has established a strong lead in the polls. Should he win, there’s the prospect of USD2.2 trillion of further stimulus – and a more aggressive approach to containing Covid-19. That more needs to be done is underscored by the strength of the second wave, which in some countries has already exceeded the first one. With winter only just starting in the Northern Hemisphere, there is a growing likelihood of strict lockdowns in disease-wracked countries. So far, it doesn’t look as though the measures will be quite as severe as they were in the spring, but it would be a leap of faith to say they won’t happen.

For all this, a Democrat victory is by no means certain. President Trump remains a formidable campaigning force while Biden's lead in crucial swing states is, according to some commentators, overstated by the polls. The upshot is that the range of outcomes to this bitterly contested election is unusually wide – all of which tempers some of the recent good economic news.

Fig. 1 - Monthly asset allocation grid

November

Our business indicators highlight China’s robustness, where most metrics are running at above last December’s levels. This underscores the benefits of Beijing's relentless response to the pandemic and of hefty doses of policy stimulus. Indeed, China is doing so well, that it’s starting to wind down some of its efforts (see below). China’s strength is lending support to the wider region, not least Japan.

Elsewhere, government support for workers and ultra-low interest rates have underpinned retail consumption and residential investment demand.

A Biden stimulus would further boost the US economy, although much will depend on the nature of his public health measures, how soon he might seek to implement his tax hike proposals and the degree to which consumers choose to save government support rather than spend it.

Our liquidity indicators show that China has already started to reverse its previous stimulus and is now neutral on our indicators. The US’s liquidity provision is also down on the recent past. The European Central Bank continues to be very accommodating – stimulus is running at some 30 per cent of the single currency region’s GDP – but there the limiting factor isn’t so much monetary as fiscal policy. As a result, the volume of global monetary stimulus has come off its peak after expanding strongly for five consecutive months. 

Fig. 2 - In sickness and in health

Relationship between new Covid-19 cases and daily activity rates

Our valuation metrics show that while equities remain expensive, they’re not as expensive as bonds – though that’s been the case for some time now. Emerging market equities have outperformed their developed peers in recent weeks, which means their valuations are less compelling than they were earlier this year. Indeed, looking through the prism of 6-month rolling average valuations, it is difficult to identify an asset class that looks particularly over- or under-priced 

The outlook for equities will be determined by how earnings pan out. So far, some 80 per cent of US companies have beaten earnings expectations during the latest reporting round. Intriguingly, though, companies doing well aren’t being rewarded, while those posting poor numbers have been punished.

Finally, our technical indicators show moderately positive trends for both equities and bonds; the picture for commodities, in contrast, looks negative. Technicals favour Asian emerging market stocks over other EM equities and currencies. Overall, surveys show investor positioning in equities is more bullish than it has been in recent months. But while optimism has been rising, it’s not yet stretched and flows into equities continue to lag the market rally.

Covid-19’s second wave has left European governments scrambling to impose fresh restrictive measures to contain the rise in infections, raising fears that the continent’s economy will slide back into recession.

The euro zone purchasing managers’ surveys show that services activity, which accounts for around two-thirds of the bloc’s GDP, has contracted, while banks are tightening lending standards as they brace themselves for a rise in bad loans.

With the euro zone’s ground-breaking EUR750 billion pandemic relief programme not expected to kick in until mid-next year, the region’s near-term prospects have become more uncertain.

Against this backdrop, we have downgraded our stance on European stocks to neutral from overweight.

In contrast, the outlook for Asian equities is brightening, thanks largely to China. 

China’s economic activity has almost fully recovered to pre-pandemic levels, with strong export demand driving the country’s manufacturing PMI to the highest level since January 2011.

While retail sales have lagged the strong recovery seen in other sectors, we believe there’s more room for private consumption levels to rise as the economy heads into 2021.

We therefore retain our overweight stance on emerging market stocks, and also upgrade Japanese equities to overweight. 

Given its exposure to international trade, the Japanese economy is especially well placed to benefit from Asia’s recovery. 

The world’s third largest economy saw its real exports expand for four months in a row, while household spending is expected to pick up thanks to strong and well-coordinated fiscal and monetary stimulus.

What’s more, expectations for continued corporate reform under Prime Minister Yoshihide Suga and attractive valuation of Japanese firms will mean the country’s stocks are well placed to attract more inflows in the coming months. Another positive for Japan is that, much like its North Asian neighbours, the country is managing to control the Covid-19 virus better than Europe and the US. 

Fig. 3 - Japan's trade gain

Japan exports to China and Europe (% yoy, 3m avg)

We remain neutral US stocks, among the most expensive of the asset classes we invest in. 

We also stick to our underweight stance on UK, equities as the economy is facing a double whammy of a resurgence in Covid cases and the risk of a no-deal Brexit.

When it comes to sectors, we maintain our positive stance on materials and consumer discretionary stocks – both are attractively priced economically-sensitive sectors.

Among defensive sectors we prefer healthcare and consumer staples.

We remain neutral on IT stocks. Clouds are hanging over the prospects for US tech giants as there are growing calls for regulatory oversight of the sector. A16-month enquiry by a Congressional panel has concluded the companies wield monopoly power and stifle competition; it has proposed antitrust reform which could potentially see them break up.

As the mountain of negative-yielding debt grows, the attractions of local currency Chinese bonds hove into view. 

The USD14 trillion market, the world’s second largest, has seen record net inflows of RMB300 billion in the first eight months of the year alone thanks to such bonds' attractive yield, low volatility and diversification benefits. 

Testifying to the asset class’ growing strategic importance, FTSE Russell followed other global bond benchmark providers to include Chinese government bonds in its flagship WGBI index from next year, a move that could trigger an estimated USD125 billion of inflows. What’s more, continued strength in the renminbi gives investors an additional source of return. The RMB is close to a 18-month high against the dollar and we expect the currency to appreciate further as Beijing increasingly opens up its capital market.

China’s 10-year bond trades at an attractive yield of 3.3 per cent and offers a record high spread of 250 basis points over US Treasuries.

We continue to express our preference for Chinese onshore bonds with an overweight stance in emerging local currency debt.

We also like US Treasuries, which offer a reasonably priced way to hedge a diversified portfolio at a time when a worsening pandemic and uncertainty over the US presidential election weigh on risky assets and elevate volatility. What is more, as Fig. 4 shows, inflation is unlikely to undermine US government bond markets any time soon. 

We remain neutral on all other government bonds.

Fig. 4 - Anchoring real rates

US and euro zone inflation expectations, % change year on year

In credit, the only market in which we hold an overweight position is US investment grade bonds, where the US Federal Reserve’s bond buying continues to underpin prices. In contrast, we remain underweight US high yield debt as we believe valuations under-appreciate default risks. Moody’s expects US speculative grade default rates to rise to 9 per cent from the current 8.6 per cent, with issuers in advertising, printing and leisure sectors remaining particularly vulnerable.

In currency markets, we like gold and the Swiss franc as safe-haven assets.

October was a tricky month for global equity markets. Reported new cases of Covid-19 hit a record high around the world, prompting a number of countries to introduce new restrictions – with potentially hefty economic consequences.

Uncertainty over the outcome of a looming US presidential election added to the overall cautious mood. In aggregate, global stock markets lost more than 2 per cent in local currency terms.

European equities saw some of the steepest losses, dropping some 5 per cent as economic data showed continued deflation and a rise in jobless numbers. Germany, France, Belgium and Greece all unveiled plans for a second lockdown in October. The UK followed suit a day after month-end.

US stocks, meanwhile, held up a little better thanks to a third-quarter earnings seasons which proved to be less gloomy than expected. With nearly two-thirds of S&P 500 companies having reported, earnings per share are around a fifth higher than analysts’ forecasts, according to FactSet.

Nonetheless, uncertainty remained high, with the VIX index, dubbed “the fear gauge”, approaching the 40 mark – double its long-run average. Increased likelihood of a “clean sweep” for the Democrats in the election raised the prospect of higher taxes which could prove negative for equities.

At the same time, investors see a victory for Democrat Presidential candidate Joe Biden as the catalyst for a potentially more constructive relationship between the US and China – a possibility which has helped support Chinese stocks in particular and emerging market equities more broadly  (see Fig. 5).

Fig. 5 - Chinese leadership

MSCI China versus MSCI All Country World, US$ terms, rebased 25.10.2019 = 100

Among sectors, energy stocks sold off steeply as oil prices dropped 11 per cent on the month. Further lockdowns are likely to cap production and further reduce demand for crude.

Communications services and utilities were the only two sectors to finish October in positive territory.

The risk averse environment was generally more positive for fixed income markets than for equities, but here too performance was patchy. In aggregate global bonds were broadly flat on the month.

A sell-off in US Treasuries pushed yields on benchmark 10-year paper to a four-month high of 0.85 per cent as investors adjusted positions ahead of the election and braced for the possibility of more fiscal stimulus.

The US dollar gained ground versus the euro, but saw losses elsewhere – including versus the Chinese yuan and the Mexican peso. The Turkish lira was overall the weakest currency, losing over 8 per cent against the greenback to hit a record low amid concerns of excessively loose monetary policy stance.