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Now Reading: Barometer: A recovery we can believe in

Barometer of financial markets January investment outlook

January 2021

Barometer: A recovery we can believe in

As the rollout of Covid-19 vaccines continues apace, equity markets look set to enjoy strong support in 2021.


Asset allocation: equities ripe for a rally

The Covid-19 vaccines allow us to look beyond the pandemic and focus on the strengthening economy, which remains supported by substantial flows of emergency fiscal spending. 

This benevolent macroeconomic backdrop is a boost to corporate profits, and should offset any decline in stocks’ price-earnings multiples caused by a wind-down of monetary stimulus. 

At the same time, the risk of a policy mistake or a fresh jump in bond yields such as happened in 2013 when the US Federal Reserve decided to taper its asset purchases is low over the next six months. So although equity valuations and investor sentiment are both unusually high, the prospects of a near-term correction look limited. For these reasons, we have decided to upgrade equities to overweight from neutral and reduce cash to underweight.

Fig. 1 - Monthly asset allocation grid
asset allocation grid

Source: Pictet Asset Management

Our business cycle indicators are positive for riskier assets. We expect 2021 economic growth to beat current market expectations – our forecast is for global real GDP to expand by 5.8 per cent this year against a consensus of 5.1 per cent. China is firing on all cylinders, with nearly all of the country's key economic activity indicators running at well above the levels seen 12 months ago. This, in turn, is helping support the rest of Asia.

We also expect the US and Japan to fare well: fiscal support will be significant while the pandemic’s winter wave will, we believe, have only a mild impact on both economies.  Business investment in the US should also rise as companies, buoyed by signs of rising demand, start to deploy the cash they have amassed in recent months.

The outlook is more challenging for Europe and the UK, even if the the Brexit deal agreed at the very end of 2020 reduces some of the risks threatening the region. For now, inflation shouldn’t be a concern, given substantial unemployment and the fact that monetary policy operates with significant lags. Price pressures are more of a concern for 2022.

Liquidity remains plentiful and continues to support financial markets – the volume of monetary stimulus may be down from the summer’s unprecedented levels, but it is still around pre-pandemic peaks, according to our indicators, which measure both private sector liquidity and that provided by the five major central banks.

However, the downward trend will eventually matter for investors. We expect global liquidity supply to start contracting by the second quarter of 2021, led by Asia. This could trigger a material reduction in equities’ price-earnings multiples, much as happened during the global financial crisis.

Fig. 2 - Earning its way
MSCI All Country World constituent earnings: past and  projected, % change year-on-year
MSCI All Country World constituent earnings: past anD projected, % change year-on-year

Source: Refinitiv Datastream, IBES, IMF, Pictet Asset Management. *Calendar year % change in EPS. Data from 31.12.1992 to 20.12.2020.

Valuations appear high in all the major asset classes. Not only has ultra-easy monetary policy driven bond yields to record lows but investors anticipate a strong economic recovery. Equities are at their most expensive since 2008 according to our models. Simply put, markets aren’t factoring in the prospect of any bad news for 2021. Global equities trade at 20 times 12-month forward earnings, while for US equities that ratio is now 23 times. Although we expect price-to-earnings ratios to contract next year, this should be offset by strong corporate earnings, which we see growing by 25 per cent in 2021. 

Our technical indicators aren’t showing any reason for concern, apart, perhaps, for the corporate bond markets. Generally, our charts suggest riskier assets have further to run, seasonality is supportive, and the rally has moved beyond just the leading tech stocks. Although inflows into equities have recently been significant, some of that is down to investors making up for under-investing earlier in the year. Some sentiment indicators of investor sentiment are starting to flash red as they highlight near historic levels of bullishness, which, in the past, have foreshadowed a market sell-off.  


Equities regions and sectors: recovery benefits emerging markets and Asia

Having emerged from a tumultuous 2020 with gains of nearly 15 per cent, global stocks are set to build on their rally in the new year.1

Aggressive fiscal and monetary stimulus around the world has helped engineer an economic recovery, encouraging investors to move cash into stocks. Some USD133 billion have flowed into the equity market in the past five weeks, a record in nominal terms, according to data compiled by EPFR.

While the pace of central bank money printing is likely to slow, a V-shaped economic rebound, led by China, will boost corporate earnings growth.

Corporations and households should also begin to deploy their cash and support growth once the rollout of Covid vaccines starts to lift confidence. Illustrating the scale of the cash hoarding, US bank deposits have swollen to a record USD16 trillion, or 13 per cent of GDP – compared with the 45-year average of just under 3 per cent.

This doesn’t mean that equities will rise as strongly in 2021, however.

One constraint is high initial valuations. According to our proprietary valuation models, equities are the most expensive since mid-2008. The risk of a third wave of infections causing economic damage is also a threat.

Equity issuance is booming with the value of global initial public offerings hitting a record USD361 billion from January to mid-December.

We expect stocks to rise around 10 per cent at a global level this year, compared with a gain of 20 per cent typically seen at the end of a recession.

Emerging economies, especially in Asia, continue to benefit from a strong recovery in China, where economic activity has now rebounded to pre-Covid trend levels and nominal exports are more than 10 per cent above a six-year trend.

Japan will also capitalise on Asia’s strength and a recovery in global trade. The country’s latest USD700 billion fiscal stimulus, its third such package in a year, should also boost consumer demand. We maintain our overweight stance on emerging economies and Japan.

Fig. 3 - Blooming EM
MSCI emerging market equity index (total return, USD)
MSCI emerging market equity index

Source: Pictet Asset Management, Refinitiv. Data covering period 01.01.2007 to 21.12.2020

With cyclical sectors likely to lead the markets higher in 2021, we believe it makes sense to scale back investments in defensive stocks.

We have consequently cut Swiss equities to neutral. Swiss equity markets have the highest share of defensive companies among major economies – representing some 60 per cent of the Swiss benchmark index’s market capitalisation.

We remain neutral on European stocks. Many of the region’s economies are reintroducing strict lockdown measures. This raises the risk of a technical recession, which we believe is not priced into consensus expectations for corporate earnings for 2021. UK stocks also have Brexit-related uncertainties to contend with, despite being relatively cheap.

Our underweight stance in the US remains unchanged. US stocks are looking more expensive with a 12-month price-earnings at 23 times – levels last touched in 1999. Wall Street has seen particularly strong equity issuance with IPO values standing 122 per cent above 2019 levels – which suggests markets are at risk of overheating. What is more, as the global economy emerges from lockdowns, the defensive and tech-heavy nature of the US market will be negative.

When it comes to sectors, we prefer those that are exposed to the recovery which we expect to see in trade and capital spending, such as industrials and materials.

We are not enthusiastic about prospects for the tech sector after last year’s stellar performance. Regulations look set to tighten in the US and elsewhere. In the UK, tech giants could face fines of up to 10 per cent of their global revenues under new competition rules, while Europe is threatening to break up those that repeatedly engage in anti-competitive behaviour.


Fixed income and currencies: emerging market bonds to take centre stage

USD18 trillion. The market value of global bonds now trading at a negative yield has hit a new record high. That’s more than the GDP of any single country in the world, bar the US.

It is a tough environment for fixed income investors, particularly with inflationary pressures also on the horizon. But there are still opportunities to be found – whether the aim is to reduce portfolio risk or boost income. 

For the latter, emerging market bonds in general – and Chinese renminbi debt in particular – stand out as among the few remaining sources of positive real yield. Recent data confirms that China’s economy is firing on all cylinders, with all sectors basically back to pre-Covid levels of activity and exports surging (China’s world export share is at an all-time high), while inflation remains low. Add to this Chinese bonds’ historically high yields spread over US Treasuries, and investors have a strong case to build investments in renminbi debt. 

At the same time, emerging market currencies remain very cheap – according to our models, they are some 20 per cent undervalued versus the dollar. Currency appreciation should provide a lift to emerging market local currency debt over the coming months, supporting our overweight stance on the asset class.

In developed market corporate bonds, the outlook is more nuanced. On the one hand, we expect liquidity conditions to become less accommodating over the medium term and corporate debt – a key beneficiary of ultra-loose monetary policy – could suffer as a result. Valuations are expensive, with spreads against government bonds well below average. Technical readings, meanwhile, suggest investor positioning is excessively bullish. 

On the other hand, advanced economies are recovering – albeit more slowly than their emerging peers – and corporate earnings are on the rise. Taking the technical and fundamental into account, we see the most potential in US investment grade debt, which we believe is well-placed to benefit from fiscal stimulus and continued Fed support. We are confident that a new fiscal package will be announced soon, and that this will prove sufficiently generous to offset the inevitable negative short-term impact of surging Covid cases. 

At the same time, we continue to be very cautious on high yield corporate bonds. Some credit aftershocks are not unusual at this stage of the cycle and the volume of new bond issuance has been significant – as of the end of November 2020, some USD390 billion of high yield bonds have been issued in the US, 51 per cent more than in the whole of 2019, according to the Securities Industry and Financial Markets Association. 

Fig. 4 - Less than zero
Swiss government bond yield, aggregate index, %
Swiss bonds

Source: Refinitiv Datastream, MSCI, Pictet Asset Management. Data covering period 01.01.2019 to 18.12.2020

In sovereign debt, we downgrade Swiss bonds to underweight as the average yield has fallen to -0.6 per cent, the level it hit in mid-March at the height of the economic and health crisis (see Fig. 4). We believe the situation on both fronts is now much improved, and such pricing is not justified.

To hedge against the possibility of further economic turbulence, we hold overweight positions in US Treasuries (which also offer a higher yield than peers and are supported by the open-ended nature of Fed’s quantitative easing programme) and the Swiss franc. 

While we expect the dollar to weaken against emerging market currencies, we believe the greenback should hold up better against sterling, the yen and the euro. Against these major developed world currencies, the dollar looks oversold.


Global markets overview: a risk-on year end

The boom in risk assets continued through December. Investors focused on fresh rounds of monetary and fiscal stimulus, while the launch of Covid vaccines allowed them to shrug off news of  new coronavirus variants and increasingly severe waves of the pandemic.

Global equities – as measured by the MSCI All Country World Index – gained another 3.9 per cent on the month in local currency terms, for a near-15 per cent gain on the year,  an extraordinary performance given the severity of the economic crisis and the state of the world back in the spring. Bonds were broadly flat on the month, but the JP Morgan Global Bond Index was up 5.6 per cent on the year.

Although equities continued to rally everywhere – the US market gained 4 per cent on the month for 21 per cent on the year – the emerging world was the standout performer, particularly EM Asia, up 6 per cent on the month in local currency terms and some 26 per cent on the year. 

Fig. 5 - Bouncing back
Bloomberg spot commodity price index
Bloomberg spot commodity price index

Source: Refinitiv Datastream, Bloomberg, Pictet Asset Management. Data covering period 01.01.2014 to 18.12.2020 

For all that, there was considerable dispersion in sector performance during 2020. IT stocks gained 44 per cent on the year and consumer discretionary was up 35 per cent, while energy was down 28 per cent amid severe volatility in oil prices, while real estate and financials were down 7 per cent and 5 per cent respectively.

Bonds gained ground too – both risk free sovereigns and the highest risk corporate borrowers. Despite lagging slightly during December, US government bonds gained 8 per cent on the year, with the 10-year Treasury yield down nearly 100 basis points to 0.9 per cent. UK gilts did even better, up 9 per cent on the year after picking up another 1.6 per cent in local currency terms during December on optimism about the Brexit deal that was eventually struck on the eve of the holidays. 

Emerging market corporate debt was up 1.3 per cent on the month for 7 per cent on the year, boosted by the more optimistic outlook for global growth in 2021 and solid corporate fundamentals. Elsewhere, stand-out performers were US investment grade and high yield bonds, up nearly 10 per cent and 6 per cent on the year respectively, lifted by various Fed measures designed to protect corporates as well as by massive amounts of fiscal stimulus from the US government.

A strong rebound in Asian economies, led by China, was a significant boost to commodity prices in the second half of the year (see Fig. 5). From its wild gyrations back in March, when prices went negative, oil added to its rebound in December, picking up another 8 per cent on the month, though it was still down more than a third on the year. Gold continued to benefit from its status as a haven from inflation and political risks, gaining 7 per cent in December and up a quarter on the start of the year. Industrial and agricultural prices surged too. Overall, commodities were up 6 per cent during the month.


In brief

barometer january 2021

Asset allocation

Bullish economic fundamentals and the rollout of Covid vaccines prompt us to upgrade equities to overweight from neutral and cut cash to underweight from neutral.

Equity regions and sectors

Emerging markets remain a bright spot while defensive stocks could suffer if the economic recovery gathers steam.

Fixed income and currencies

In fixed income, we like emerging market local currency debt, US investment grade and US Treasuries, while staying cautious on high yield credit.