GLOBAL HEAD OF INVESTMENT STRATEGY
Global Market Outlook 2020 –
Q4 update: The Old New Cycle
2020 continues to surprise. A pandemic, the shutdown of the global economy, the deepest recession since the 1930s, a global equity market collapse and now, record highs for the U.S. equity market. The upcoming U.S. election is shaping as a tight contest, with the potential for more surprises and market volatility.
We’re in the early recovery phase of the cycle following the COVID-19 recession. This implies an extended period of low-inflation, low-interest-rate growth—an environment that usually favors equities over bonds. But after such a rapid rebound, an equity market pullback would not be surprising. Technology stock valuations are elevated, and the U.S. federal elections create uncertainty around tax changes, government regulations and the re-escalation of China/U.S. trade tensions. Beyond this, the market looks set for a rotation away from technology/growth leadership toward cyclical/value stocks. This also implies a rotation toward non-U.S. stocks with Europe and emerging markets the main beneficiaries.
Our cycle, value and sentiment (CVS) investment decision-making process scores global equities as slightly expensive, sentiment as neutral and the cycle as supportive. This leaves us neutral on the near-term outlook, but moderately positive for the medium-term with slightly expensive valuations offset by the positive cycle outlook.
Economic cycle vs. market cycle
It’s a new cycle for the economy, but some asset classes look decidedly late cycle in terms of valuation. Equity markets, particularly in the U.S., are exhibiting valuations typically seen after several years of strong returns, while credit market spreads look narrow for early in the cycle. In part, this reflects the speed of the market rebound. It is also a consequence of ultra-low, risk-free government bond yields and central bank asset purchases that have compressed risk premiums and boosted asset prices.
We expect that the early-cycle economy will trump later-cycle valuations for the next year or two. The turning point could occur when economies hit full capacity. This will be when unemployment has fallen as far as possible and inflation pressures start to rise. Central banks will signal that higher interest rates are on the way and bond yields will move higher. The pandemic-driven decline in U.S. bond yields below 1% has allowed equity markets to trade at more expensive valuations in terms of price-to-earnings ratios. Rising bond yields will eventually place lofty equity market valuations under pressure.
Don’t fight the Fed
The U.S. Federal Reserve’s (the Fed’s) move to target average inflation is a significant shift. We believe it should lengthen the expansion and delay the day of reckoning for equity markets from higher interest rates. The Fed will now allow an overshoot of its 2% target if inflation dips below the target for some time.
The Fed’s preferred measure of inflation, the core personal consumption expenditure deflator, rose 1.3% in the 12-month period through June 30. This measure of inflation has averaged 1.7% over the past five years and 1.6% over the past decade. This gives the Fed plenty of room to leave the Fed funds rate unchanged after inflation starts to pick up. Other central banks are undertaking similar reviews of their respective policy operations and we expect they are likely to reach similar conclusions.
The other important policy shift will be how quickly governments try to repay the debt arising from the support measures for the pandemic lockdown. Government debt levels for developed economies are likely to increase by around 15% of gross domestic product (GDP) on average. There is speculation that tax hikes will be on the way once COVID-19 has passed. We’re not convinced that governments will be in a hurry to implement fiscal austerity. It’s not a winning electoral strategy and the current ultra-low borrowing cost makes high debt levels more sustainable. We believe the debt/GDP ratio can be stabilized provided the interest rate paid on debt is lower than the growth rate of trend nominal GDP1 —which is something that holds for almost every major economy as we move into the fourth quarter. The test for governments will come only after bond yields rise meaningfully and capital markets are driven by concerns about sustaining the higher debt levels. The bottom line in our view is that fiscal austerity and tighter monetary policy are still some years away.
Three major market trends could reach a turning point over the next few quarters: the outperformance of U.S. stocks versus non-U.S. stocks, the outperformance of growth stocks relative to value stocks and the decade-long upward trend in the U.S. dollar.
The three trends are related and started around the time of the 2008 financial crisis. The U.S. market is overweight the technology and healthcare stocks that dominate the growth factor while the rest of the developed world is overweight the financial and cyclical stocks that populate the value factor. The U.S. dollar benefits from U.S. stock market inflows and the positive interest differential when the U.S. economy is performing well.
The U.S. dollar is showing signs of rolling over, in line with its counter-cyclical, safe-haven nature. It usually goes up in times of uncertainty and declines when uncertainty eases, as has been the case during the coronavirus panic and subsequent market recovery.
The surprise has been U.S. and growth stock outperformance during the rebound from the coronavirus bear market. Cyclical and value stocks—and by association, non-U.S. stock indices—usually perform well during the initial recovery phase from a recession and bear market. But not this time.
The reason has been the strong performance of the technology stocks, the so-called FAANGs—Facebook, Apple, Amazon, Netflix and Google. These stocks, plus Microsoft, comprise 25% of the market capitalization of the S&P 500® as of September 16, and they account for all the year-to-date gains in the index. Excluding these stocks, the S&P 500 would have declined by around 4% for the period.
Technology stocks received two benefits from the lockdowns. The first was from the decline in government bond yields. Investors typically regard technology stocks as long duration as they are expected to grow their earnings over the longer term. The decline in bond yields made the present value of those future earnings more valuable. The second benefit was from the boost to current earnings from the lockdown as consumers went online for purchases, made more use of video call technologies and watched streaming services.
These tailwinds should soon become headwinds. Barring a second round of lockdowns, global bond yields have probably seen their lows and the near-term boost to technology stock earnings from lockdowns has peaked. This should allow the normal recovery dynamics to resume, with investors rotating toward relatively cheaper value and non-U.S. stocks that will benefit from the return to more normal economic activity.
China was the first country to enter the COVID-19 crisis and see a downward trend in the number of new cases. High-frequency trackers of daily economic activity show that economic activity is resuming. Traffic congestion in Shenzhen and Shanghai has returned to normal levels and coal consumption by power generators is trending higher.
Government stimulus is coming. Local provinces have announced infrastructure projects, and the People’s Bank of China has cut interest rates and the reserve ratio requirement several times. Banks have been encouraged not to call in loans while there is pressure on cash flows. The main uncertainty is whether the combined monetary and fiscal stimulus will be as large as in 2015/16, which created a V-shaped recovery in 2016. We don’t think it will be nearly as large, as China’s leadership is still worried about excessive debt levels. But it will be substantial and position China for a strong rebound when the threat from the virus starts to subside.
The government’s virus containment measures mean a technical recession – negative GDP growth in Q1 and Q2 – is probable. As of 19 March, the S&P 500® Index has declined 29% from its 2020 peak, which is on par with a moderate economic recession. A reasonable amount of economic pain is already in the price.
A risk is that the sharp plunge in cash flows causes highly indebted companies to default, triggering a credit-crunch in the broader economy. This threat should be lessened by the Fed’s 150 basis points (bps) of emergency easing, asset purchases, and the resumption of an alphabet soup of crisis-era liquidity management facilities.
Fiscal policy will be important in offsetting the recession. The nature of the COVID-19 shock should force a bipartisan agreement on large stimulus measures. More immediately, though, Congress and the U.S. Treasury can put emergency funding channels in place for stressed industries facing liquidity pressures.
Tailwinds from monetary and fiscal policy should eventually promote stronger economic conditions when the virus disruption has cleared. The upside risk is that should the number of new virus cases begin to decline in Q2, the subsequent recovery will be boosted by the strongest stimulus measures in more than a decade.
Europe is the worst-affected region outside of China by COVID-19. It has high exposure to global trade, particularly China, the ECB has little monetary policy firepower and the rules around fiscal policy in the Eurozone make stimulus measures difficult to implement. Italy is in quarantine and strict containment measures have been put in place in France and Spain. These seem likely to be adopted by other European countries.
The combination of these factors means that the Eurozone stock index has been the hardest hit of the major bourses, down more than 35% as of mid-March.
The Eurozone is likely to experience a deeper recession than the U.S. but should also experience a bigger economic bounce when the virus subsides. It will be one of the main beneficiaries of the rebound in global trade. Eurozone equities are now very attractively valued, and we would look for the European stock market to be one of the best performers in the recovery.
The UK economy has two main advantages over Europe:
- The Bank of England, unlike the ECB, has been able to cut interest rates by 65bps , taking its policy rate to the effective zero-lower-bound.
- The ability to quickly implement fiscal easing. The UK government has announced over 1% of GDP in stimulus measures.
The FTSE 100 Index has been hit by a trifecta of challenges: Brexit uncertainty from the end-2020 deadline for an agreement, the large exposure to multinational firms with profits based overseas, and the high weighting to energy companies that have been hurt by the oil price collapse. The UK equity market has already been a poor performer, hit by three years of Brexit wrangling following the 2016 referendum. The COVID-19 declines take the FTSE 100 into exceptional value territory. It has a trailing PE ratio of under 10-times and a dividend yield pushing towards 7%.
Japan’s economy was weak at the end of 2019, weighed down by the October value-added tax (VAT) increase and a natural disaster caused by the largest typhoon in half a century. The COVID-19 disruption has almost certainly pushed the economy into recession. Japan faces an extra virus-related risk as the Olympia games, scheduled for 24 July to 9 August, has now been postponed.
Stimulus measures are underway. The Bank of Japan has limited firepower, but has increased its purchases of government bonds, corporate bonds, and equities via exchange-traded funds (ETFs). The government is likely to announce emergency fiscal measures. Japan’s structural weaknesses in terms of weak monetary policy and persistent deflation mean it will likely remain an economic laggard relative to other developed economies.
The twin shocks of the COVID-19 outbreak and the collapse in the oil price has complicated what was already a lacklustre economic outlook for Canada. Economic growth is at risk of falling below the 1.0% lower-end of our forecast range. The Bank of Canada has responded with 100bps of easing and increased liquidity provisions, with more likely to come. Prime Minister Justin Trudeau recently announced plans to roll out a stimulus package valued at roughly 3% of Canadian GDP. Beyond the immediate concerns around the virus, the structural watchpoint will be the collateral damage inflicted on highly indebted households.
Australia & New Zealand
The Australian economy was already soft under the weight of a cautious consumer and slowing housing market and the COVID-19 threat will accelerate this trend. The Reserve Bank of Australia has made two emergency rate cuts totalling 50bps that take the cash rate to 0.25%. It has implemented its first steps into unconventional policy by setting a target of 0.25% for the three-year government bond yield. Quantitative easing through government bond purchases is not far away.
The government has announced a fiscal stimulus package worth 1.2% of GDP, and the Australian dollar is fulfilling its traditional shock absorber role by depreciating and softening the blow on export-exposed industries. Australia’s outlook appeared promising heading into 2020 with its biggest trade partner, China, about to be boosted by a phase-1 trade deal with the U.S. The virus outbreak has substantially delayed this outlook.
New Zealand entered the COVID-19 pandemic in a slightly better economic position than 2019, helped by the Reserve Bank of New Zealand’s (RBNZ) accommodative policy. The risks around growth have clearly escalated, and the short term outlook has been downgraded. Both fiscal and monetary policy have come to the fore ─The New Zealand government has announced stimulus worth 4% of GDP, and the RBNZ has cut rates to 0.25% and are embarking on a bond buying program. The bond buying program will put pressure on the New Zealand dollar, given the high level of foreign ownership, but should contain bond yields.
Asset class preferences
Our cycle, value and sentiment investment decision-making process has a moderately positive medium-term view on global equities. Value is slightly expensive, with the expensive U.S. market offset by fair value in the rest of the world. Sentiment is neutral. The cycle is supportive of risk assets for the medium-term. The recovery from the recession means a long period of low-inflationary growth supported by monetary and fiscal stimulus.
- We prefer non-U.S. equities to U.S. equities. The second stage of the post-coronavirus economic recovery should favor undervalued cyclical value stocks over expensive technology and growth stocks. Other major markets are overweight cyclical value stocks relative to the U.S.
- We like the value in emerging markets (EM) equities. China’s early exit from the lockdown and stimulus measures should benefit EM more broadly.
- High-yield and investment-grade credit were very attractive in late March when spreads were wide. Spreads have since narrowed and at the beginning of the fourth quarter only adequately compensate for the likely rise in default rates following the recession. We have a neutral view.
- Government bonds are expensive. Low inflation and dovish central banks should limit the rise in bond yields during the recovery from lockdowns. U.S. inflation-linked bonds offer good value with break-even inflation rates well below the Fed’s targeted rate of inflation.
- Real assets: Real estate investment trusts (REITs) sold off heavily in March, with investors concerned about the implications of social distancing and online shopping for shopping malls and office buildings. Sentiment appears overly bearish, while value is positive. These should be a pandemic recovery trade.
- The U.S. dollar should weaken into the global economic recovery given its counter-cyclical behavior. The dollar typically gains during global downturns and declines in the recovery phase. The main beneficiaries should be the economically sensitive commodity currencies—the Australian dollar, New Zealand dollar and Canadian dollar. The euro and British sterling are undervalued. The euro should gain if a second virus wave is avoided and a recovery is sustained. Sterling, however, is likely to be volatile around Brexit negotiations uncertainty.
1 Nominal GDP is an assessment of economic production in an economy but includes the current prices of goods and services in its calculation. GDP is typically measured as the monetary value of goods and services produced.
2 The Nifty 50 is an informal designation for 50 popular large-cap stocks on the New York Stock Exchange in the 1960s and 1970s that were widely regarded as solid buy-and-hold growth stocks. These stocks are credited by historians with propelling the bull market of the early 1970s, while their subsequent crash and underperformance through the early 1980s are an example of what may occur following a period during which many investors, influenced by a positive market sentiment, ignore fundamental stock valuation metrics. Most have since recovered and are solid performers, although a few are now defunct or otherwise worthless.
The tech stock market bubble was caused by excessive speculation in internet-related companies in the late 1990s, a period of massive growth in the use and adoption of the internet.
FAANG is an acronym referring to five large technology companies: Facebook, Amazon, Apple, Netflix and Alphabet (formerly known as Google). Together, the FAANGs make up about 15% of the S&P 500. This large influence over the index means that volatility in the stock price of the FAANG stocks can have a substantial effect on the performance of the S&P 500 in general.
3 The targeted longer-term refinancing operations (TLTROs) are Eurosystem operations that provide financing to credit institutions. By offering banks long-term funding at attractive conditions they preserve favorable borrowing conditions for banks and stimulate bank lending to the real economy.
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