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Now Reading: Barometer: Corona conundrum

Barometer of financial markets August investment outlook

August 2020

Barometer: Corona conundrum

Markets have rallied sharply on unrelenting policy stimulus, but Covid-19 has yet to be defeated. Fears of a second wave and mounting political risks argue for investor caution.


Asset allocation: a fine balance

Unprecedented times call for unprecedented measures. This year, governments and central banks have certainly delivered, pulling the global economy out of a pandemic-caused slump with record-breaking volumes of stimulus. However, it is too early to break out the champagne – coronavirus cases around the world are still rising, and corporate earnings are in freefall. On balance, we do not believe that markets can rally much further in the months ahead. We therefore keep our asset allocation neutral across equities, bonds and cash.
Fig. 1 - Monthly asset allocation grid
Monthly asset allocation grid August

Source: Pictet Asset Management

Our business cycle scores offer some grounds for optimism – brighter prospects for the developed economies have enabled us to upgrade the outlook for the world as a whole to neutral from marginally negative. One key positive development has been Europe’s newly agreed EUR750 billion recovery fund. Encouragingly, 70 per cent of it is expected to be spent over the next two years.

China remains ahead in terms of the extent of its recovery, which, along with a weaker dollar, should be supportive for emerging markets and for the materials sector.

However, daily indicators, such as credit card use and traffic congestion, suggest that on a global level activity is improving slowly, potentially reflecting a fresh increase in Covid-19 cases (see Fig. 2). 

Fig. 2 - Viral economy
Economic activity and coronavirus cases
economic activity vs coronavirus cases

Bloomberg daily activity indicator, 100=Jan 2020, GDP PPP weighted. Source: Bloomberg, Pictet Asset Management. Data covering period 08.01.2020-27.07.2020.

In general, we think that the monetary and fiscal stimulus pledged across the globe should be enough to offset the uncertainty related to the pandemic. In the US, for example, government transfers now account for around a quarter of total household income – more than double the pre-Covid level. That may lead to problems further down the line if normal sources of income do not recover, but for now should provide a valuable safety net for the economy and for markets.

The global recovery so far, albeit better than previously anticipated, has been led by improving private consumption. Industrial production has remained muted, hence running down inventories. Going forward we expect inventory levels to stabilise and gradually pick up again, with increased production underpinning the next phase of recovery in growth. 

Liquidity is still extremely abundant, with all major economies scoring "double plus" in our model. Japan is the latest major developed economy to join this club following a sharp increase in loans under the government’s guarantee programme. We expect the central banks of the world’s top five economies to inject the equivalent of 14 per cent of GDP in monetary stimulus this year, almost double the post-GFC peak. But the pace has flattened out recently and a peak in the global easing cycle is likely not far off. It may even come this quarter. On our analysis, the market is already almost fully discounting the projected evolution of liquidity creation over the rest of the year – including a formal yield curve control policy from the US Federal Reserve. 

Indeed, markets have discounted so much good news that valuations are looking rather stretched. Global stocks have gained over 40 per cent since March. Now, for the first time since September 2018, they are flashing expensive relative to their own 20-year history, according to our models. The price to trend earnings ratio on MSCI All Country World Index has climbed to 16 times – close to its pre-Covid crisis levels and up from 12.3 in March. At the same time, we believe that risks to earnings are still very much tilted to the downside.

However, bonds look even more expensive, offering the worst value in two decades. Yields on US inflation linked-bonds (TIPS) and investment grade credit have both fallen to record lows.

Gold is at all-time highs in absolute terms (if not yet when adjusted for inflation). However, shining fundamentals and demand for diversifying assets suggest there is further to go. We remain overweight on gold, expecting it climb to USD2,500 an ounce by 2025, from USD1,960 currently.

Encouragingly technical charts show that speculative positioning in gold is relatively light considering the extent of the rally. Sentiment indicators, meanwhile, support our neutral stance on equities while pointing to a temporary pause in the credit rally. 


Equities regions and sectors: Europe shines but time to cut back on financials

Whether the vantage point is the economy, the political landscape or Covid-19, Europe appears to be in better shape than the US. Which is why we retain an overweight position in European stocks. EU member states’ endorsement of the Franco-German led EUR750 billion recovery fund last month and the ECB’s continued monetary stimulus put the European economy on a much firmer footing; we have consequently raised our forecast for the region’s GDP growth for 2021 by 1 percentage point to 7 per cent.

Crucially for investors, Europe’s stock markets do not yet discount the region’s improving economic prospects. Particularly when compared to their US counterparts. At current levels, the gap in US and European price to book ratios (3.7 vs 1.7) implies American corporations’ return on equity will further outpace that of European firms, widening from a differential of 5 percentage points to over 10 percentage points. Such an outperformance looks highly unlikely.

US stocks are already very expensive in any case. For US equities to maintain their current price-earnings multiple of around 24, corporate profit margins would have to remain stable. That is a stretch, particularly when factoring in the US’s continued failure to contain Covid-19, the growing regulatory backlash against Silicon Valley and uncertainty surrounding the outcome of the November Presidential election. Mindful of these risks, we remain neutral US stocks.

With an increase in consumer spending a feature of the recovery taking hold in parts of the world, we are attracted to consumer staples stocks. The sector has failed to keep pace with the broader market rally, which has been led by cyclical stocks. As Fig.3 shows, consumer staples trade at just a 10 per cent premium to the broader global market – down from over 20 per cent in March and the 10-year average of 25 per cent. Consumer staples companies' improving earnings growth suggests their stocks warrant a higher premium.

Fig. 3 - Staples diet
Consumer staples price to trend earnings per share (LHS) and relative to global equities, percentage (RHS)
Consumer  staples price to trend earnings per share and relative to global equities

Source: Refinitiv Datastream, Pictet Asset Management. Data covering period 28.07.2000-28.07.2020.

To maintain a defensive tilt in our equity allocation, we have reduced our weighting in financials to underweight. Although banks’ bad debt provisions resulting from pandemic-induced lockdowns have been largely in line with expectations, they remain acutely vulnerable to any setback to the smooth reopening of economies. Moreover, dividend payments are unlikely to recover for the foreseeable future. Regulators across the world– including the ECB, the Fed and the UK’s Prudential Regulatory Authority – have moved aggressively to either cap bank dividend payments or temporarily suspend them. This greatly reduces the investment appeal of financial stocks.

Fixed income and currencies: trimming dollar shorts

The dollar’s sharp reversal over recent weeks  has prompted us to close our relative overweight on the euro and reduce our stance to neutral. But that’s a tactical trade. Longer term, we remain bearish on the greenback.

That’s for a number of reasons. US growth prospects are no longer far ahead of developed country rivals, while interest rate differentials are also narrowing. The country’s twin deficit – US government finances and its current account position with the rest of the world – has widened to worrying levels. We estimate the double deficit to reach 22 per cent this year; the previous worst level since the 1970s was 15.3 per cent in 2009. 

And then there are political risks associated with the November elections. The polls point to a strong likelihood that Joe Biden defeats Donald Trump for the presidency which probably means a less business-friendly regime for the next four years. All of which argues against what is already an overvalued currency.

Fig. 4 - Overbought
Euro/dollar exchange rate vs relative strength index
Euro/dollar exchange rate vs relative strength index

Source: Refinitiv Datastream, Pictet Asset Management. Data covering period 25.07.2017-28.07.2020

We remain overweight gold, which continues to be the most attractive defensive asset given the inflation risks that come with vast flows of central bank liquidity worldwide, our expectations for a weaker dollar, increased geopolitical risks and the additional uncertainty of how the Covid pandemic might play out during the second half of the year – all of which are supportive of further gains. 

Although our technical indicators show that gold is overbought, there’s little sign of excess speculative positioning by institutions. Much of the demand so far has been from retail investors through exchange-traded funds. And while gold prices hit the headlines as they approached their peak set some 40 years ago, in inflation-adjusted terms the precious metal is still around 25 per cent below those record levels. Moreover, with financial repression undermining the diversification offered by bonds, we believe gold would continue to play a key role in balanced portfolios.

Our view of the greenback largely informs our fixed income positioning.  With developed market yields at rock bottom levels across the board and emerging market currencies still undervalued – our models tell us that they’re the cheapest they’ve been on a relative basis for at least two decades – EM local currency bonds remain the biggest overweight in our fixed income grid.

Corporate bonds still offer some value, notwithstanding their already low yields. Official determination to support businesses by ensuring their access to cheap finance isn’t likely to end soon. So we remain overweight US investment grade credit. 


Global markets overview: going for gold

Gold was the financial market’s star performer in July, gaining 10.7 per cent and hitting fresh record highs (see Fig. 5). Investors were drawn to the precious metal’s defensive characteristics as new coronavirus infections continued to rise around the world and relations between the US and China grew more tense.
Fig. 5 - A glittering rocket
Gold price, USD per ounce
gold price chart

Source: Refinitiv, Pictet Asset Management. Data covering period 01.01.2008-29.07.2020.

Those same two factors proved to be the US dollar’s undoing. It sagged to a two-year low against a trade-weighted basket of currencies. Coronavirus deaths in the US surpassed 150,000, accounting for nearly a quarter of the global total. Hit by the pandemic, the economy contracted by 32.9 percent in Q2 on annualised basis – the deepest slump since the 1940s.

In response, the Fed affirmed that it would use its full range of tools to support the economy and would keep interest rates near zero for as long as necessary. The pledge reverberated through the US bonds market, sending yields on both US government debt and corporate credit to historic lows.  

Other fixed income markets also rallied. European bonds responded positively plans for a EUR750 billion EU rescue plan that could pave the way not only to stronger growth and better fiscal unity, but also to a broader and more liquid bond market. Emerging market debt, meanwhile, was boosted by dollar weakness. Emerging market equities also did well, adding 8 per cent on the month in local currency terms.

Indeed, stocks held up well across the board in July as stimulus from central banks and governments around the globe and largely uneventful reopening of economies raised hopes for a sustained post-pandemic recovery. US equities took heart from the latest earnings season, where profits are down sharply but not quite as sharply as analysts had expected. 

Sectors most exposed to the economic cycle – such as materials and consumer discretionary – fared particularly well. Energy remained the notable laggard, finishing July in the red.


In Brief

Barometer August 2020

Asset allocation

Given the fine balance of risks, we remain neutral on equities, bonds and cash.

Equities regions and sectors

We upgrade consumer staples to overweight and turn more cautious on financials.

Fixed income and currencies

We reduce our position on the euro to neutral from overweight on a tactical basis after the dollar's recent slide.