Andrew Pease

GLOBAL HEAD OF INVESTMENT STRATEGY

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.

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.

The main risks are broadly unchanged from our previous quarterly report: a second wave of COVID-19 virus infections that causes renewed lockdowns and the November U.S. federal elections.

• Infection rates are picking up and the advent of the northern winter could trigger a more meaningful second wave. Offsetting this, death rates have remained low in most countries despite the rise in infections, and vaccine development news has been promising.
• U.S. election odds are tightening. A contested election, with destabilizing implications for markets, is becoming a risk.
• The re-election of U.S. President Donald Trump would likely benefit U.S. stocks (tax hikes averted, more protectionism) but a victory by Democratic presidential candidate Joe Biden would benefit non-U.S. shares (more harmonious foreign and trade relations).
• The negotiations in Congress over further U.S. fiscal support have become deadlocked. This would result in a hit to consumer income equal to around 4% of GDP if an agreement is not reached.

We expect that a second round of meaningful lockdowns will be avoided. Prospects for additional U.S. fiscal stimulus have dimmed and could need to wait until the next Congress is seated in January. There is enough uncertainty heading into the U.S. elections to generate some episodes of market volatility.

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.