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barometer of financial markets september investment outlook

September 2020

Barometer: A V-shaped recovery after all?

An economic recovery appears to be gathering pace. That means emerging market stocks, and some cyclical sectors, are looking more attractive.


Asset allocation: steadying economy but virus threat lingers

It’s looking increasingly like a V-shaped economic recovery. True, in some regions the bounce back has been a little less robust. But in others, notably China, economic conditions are largely back to where they were pre-Covid – in July, industrial profits were up 20 per cent year on year. Meanwhile, after reviewing its approach to monetary policy, the US Federal Reserve has formally become a much more dovish institution at the margin, though it stopped short of a radical overhaul anticipated by some in the market.

Markets have noticed. Yet after a powerful rally across all assets during the past few months – sending leading US stock market indices to record highs – we feel that prospects for further broad-based gains are limited, with greater divergence among regional markets. 

Fig. 1 - Monthly asset allocation grid
asset allocation grid

Source: Pictet Asset Management

So while governments may yet offer more fiscal stimulus, not least in the US, liquidity provision is slowing worldwide. There are also political risks associated with US elections in November. And all the while there’s Covid-19. Not only is there the possibility of a significant second wave of the virus, but there is also little clarity on how soon a vaccine might be developed.  At the same time, Shinzo Abe’s decision to step down after being Japan’s longest-serving prime minister introduces some uncertainty around geopolitics and the possibility that the world’s third largest economy will change its policy approach.

As a result, we remain neutral on all the major asset classes, though within equities we favour more cyclical sectors.

Our business cycle indicators show that the economic recovery is proving to be strong enough to warrant an upgrade to our 2020 economic forecasts. Our economists now expect full year global GDP to come in at -4 per cent from -4.2 per cent previously, but next year’s forecast has been cut to 6.1 per cent from 6.4 per cent.

In the US, retail sales have registered the strongest and fastest ever rebound after the deepest and quickest downturn in history to where they’re now – running at above pre-recession peak. Most past cycles have taken at least three years to play themselves out. This time, it’s been only a little more than three months. Retail sales are also back to trend in the euro zone.

However, it’s notable that only China’s real-time indicators are back to pre-Covid levels. Elsewhere, they’ve flattened out at between 10 per cent and 20 per cent below.

And while inflation could yet prove to be a risk if demand remains firm and supply fails to catch up, that’s not likely to be an issue until the back half of 2021.

Fig. 2 - Peak liquidity
Total liquidity flow* of major five economies
Global liquidity peak

Source: Refinitiv, Pictet Asset Management, data covering period 15.01.2010–15.07.2020 * Total liquidity flow of US, China, EMU, Japan and UK, calculated as policy plus private liquidity flows, as % of nominal GDP, using current-USD GDP weights

Global liquidity conditions remain very supportive, with new liquidity creation running at 25 per cent of GDP, but there is clear evidence that monetary stimulus growth has peaked [see Fig. 2]. At the same time, banks are tightening credit standards. And the Chinese central bank is now at neutral, while the country’s credit surge has tapered back down. 

One upside liquidity risk, though, is that US Treasury cash balances held by the central bank could be drawn down.

Our sentiment indicators paint a mixed picture. The balance of equity calls to puts suggests a degree of market complacency, and our indicators show hedge funds have crowded into a handful of concentrated positions, particularly in the largest of the large cap stocks. On the other hand, retail investors seem cautious about shares and sentiment surveys remain depressed, while fund manager positioning in the asset class is below historic trend. A “wall of cash” remains, with some recently flowing into bonds and credit – both appear overbought.

Finally, our valuation indicators suggest equity prices look stretched after a 50 per cent rally in the S&P 500 – on our models, they are at their most expensive in 12 years, trading two standard deviations above their 6-month moving average. Even relative to bonds, equity valuations no longer look particularly cheap. The gap between the global earnings yield and global bond yield is at its lowest in a decade at 4.5 percentage points. But we’re not yet into bubble territory. If current low bond yields, which have fallen 100 basis points this year, are sustained, this valuation impact on US equities exactly offsets the 20 per cent decline in earnings. Our valuation score on equities has moved from negative in January, to strongly positive in March and is back down to negative now.


Equities regions and sectors: EM well placed to outperform

Central banks may have eased up on monetary stimulus in recent weeks but the liquidity they have provided should help stabilise equity markets following their near 50 per cent rally, or at least limit the risk of a correction.

Emerging market stocks are well placed to outperform the majority of their developed peers and we therefore upgrade the asset class to overweight.

Led by China, the emerging world is enjoying an earlier and stronger economic recovery than advanced economies, a development that is not yet discounted by the market. Emerging markets’ manufacturing purchasing managers index is back into  expansionary territory above 50 and industrial production has also rebounded to pre-Covid levels.

China is experiencing a strong V-shaped recovery, with its real output in the second quarter rising 12 per cent after a decline of 10 per cent in the previous three months. Data also points to improved capital spending.

Fig. 3 - Developing world powers ahead
Real GDP,  emerging vs developed economies
EM vs DM economic growth

Source: Refinitiv, Pictet Asset Management, data covering period 01.01.2018–31.12.2021 (forecast)

Emerging economies have been more resilient than anticipated, especially when it comes to exports. Their exports are contracting at a rate of 5 per cent, better than the 12 per cent rate seen at the depth of the downturn and outperforming the industrialised world, whose exports are shrinking at a rate of 14 per cent. EM exports are likely to be further bolstered by a weak dollar, which also helps the region by reducing the cost of servicing its hard-currency debt.

We cut UK stocks to underweight as its economy, focused on services, hospitality and consumer spending, shrank by a record 20 per cent in the second quarter, the most severe contraction reported by any major economy. The UK is braced for a wave of job losses in the coming months, at a time when Brexit uncertainty is already weighing on confidence.

We remain neutral on the US, which is the most expensive equity market, while retaining our preference for Europe, whose economic prospects are improving thanks to the region’s well-coordinated fiscal and monetary stimulus. For example, the region's retail sales are back to trend after a 27 per cent rise from the trough while private sector bank loans are growing at the strongest level in at least 10 years. In Germany, business sentiment has now improved for four months in a row.

When it comes to sectors, we see brighter prospects for consumer discretionary stocks, which we upgrade to overweight despite its somewhat expensive valuation. Global retail sales are rebounding as economies emerge from lockdowns. We also upgrade industrials to neutral as we expect production and capital spending to recover in line with higher consumer spending.

In contrast, we downgrade utilities to underweight. The defensive sector underperformed in the past few weeks as investors started to price in a strong economic recovery at a time when bond yields are kept low by various central bank measures. We are no longer bullish on communications services as such stocks have become expensive.

Elsewhere, we remain underweight financials. Banks, especially in the US, are tightening credit conditions on consumer loans.


Fixed income and currencies: Chinese bonds shine

The fixed income market offers limited options for investors seeking defensive assets at a reasonable price. Yields on developed market sovereign bonds remain wafer thin while the spread offered by emerging market (EM) local currency debt has – in aggregate – fallen to 380 basis points, its lowest level in seven years.
Into the breach comes Chinese local currency debt. China’s renminbi denominated bonds are, by some distance, the most attractive fixed income asset class in an otherwise uninspiring market. Trading at a yield of just above 3 per cent, renminbi bonds offer investors a record 230 basis point pick-up over US Treasuries.
Fig. 4 - China: defence at a fair price
Differentials in China-US bond yields and CPI, percentage points
China vs US bond yields

Source: Refinitiv, National Bureau of Statistics of China, Bureau of Labor Statistics, Pictet Asset Management. Data covering period 01.01.2009–01.08.2020

That yield differential becomes even more attractive when viewed through the prism of fundamentals. Interest rates in China – which have remained high relative to those of the developed world and large parts of the emerging world – are more likely to fall than rise in the medium term.

Not only are inflationary pressures subdued but the People’s Bank of China has plenty of scope to ease monetary policy should the country’s recovery from the pandemic stall. Technical factors are also part of our thesis. With Chinese bonds now included in mainstream bond indices, investments from foreign investors should continue to gather speed over the course of the year. Furthermore, there is growing evidence that the asset class is becoming less sensitive to changes in US rates – a plus for investors seeking to diversify their portfolios.

Separately, we are also overweight US investment grade credit. In an environment likely to be characterised by low inflation and ultra-loose monetary policy, there remains scope for yield spreads on such debt to narrow further.


Global markets overview: red hot August

Global stocks surged in August as investors pushed aside worries about the second wave of the coronavirus and bet that monetary and fiscal stimulus would support a V-shaped economic recovery.

World shares rose nearly 6 per cent in local currency terms, outperforming bonds which lost over 1 per cent. Investors were also encouraged by the improving outlook for earnings – second-quarter corporate earnings have surprised on the upside and net earnings per share (EPS) revisions have turned positive.

US stocks rose 7.5 per cent in the month to be the biggest outperforming market, marking the best August in at least 30 years. The S&P 500 index hit a record high, fully erasing losses made after the virus outbreak triggered a historic plunge in February and March.

Technology shares dominated the rally with gains of over 9 per cent. Apple has risen nearly 20 per cent to surpass USD2 trillion in market value for the first time. Other tech shares including Amazon and Alphabet, which together make up more than a fifth of the S&P 500, also rallied. Consumer discretionary stocks were the best performing sector after rising more than 12 per cent in the month.

However, not all stocks have joined in on the rally. Utilities fell 2 per cent while energy, healthcare and real estate sectors posted only modest gains. In fact, only six per cent of the S&P index is making a 52-week high, while the average S&P stock is still some 28 per cent below the peak, showing the declining participation of the index constituents in this year’s rally.

Fig. 5 - From one record to another
S&P 500 index
S&P 500 rally

Source: Refinitiv, data covering period 01.01.2016–26.08.2020

European stocks also posted the biggest August gain since 2009 as the region’s economies emerged from lockdowns.

Bonds struggled across the board, especially developed world government debt. Gilts lost over 3 per cent, while US Treasuries fell over 1 per cent.

Corporate bonds fared less badly as the riskier part of the fixed income market is supported by central bank asset purchases. High yield debt on both sides of the Atlantic rose more than 1 per cent.

The dollar fell more than 1 per cent after it hit a two-year low, bringing its losses this year to 4 per cent. This helped commodities, with oil rising 3 per cent. Gold ended the month slightly down after hitting a record high earlier in the month. The precious metal is still up nearly 30 per cent since January, making it the best performing asset class.


In Brief

barometer september 2020

Asset allocation

Evenly balanced risks keep us neutral on equities, bonds and cash.

Equities regions and sectors

Upgrading EM as China leads the region's strong economic recovery; consumer discretionary stocks should benefit from higher retail spending.

Fixed income and currencies

We remain overweight US government and investment grade bonds bonds as well as emerging market local currency debt.