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Barometer of  financial markets june investment outlook

June 2020

Barometer: Equities out of step with economy

While economies are beginning to emerge from lockdown, market hopes for a V-shaped recovery look optimistic.

01

Asset Allocation: wary about the optimism

As lockdowns are lifted and economies start to revive almost everywhere, it would be easy to assume risk assets were vindicated in rallying sharply since their late-March lows. But we think it is premature to argue that the crisis is over and that the world is heading into a V-shaped recovery. Which is why we maintain our neutral stance on the major asset classes.

Risks are balanced. For all the optimism generated by falling infection and death rates in much of the world and enthusiasm for fiscal and monetary stimulus, the possibility of a significant second wave of the Covid pandemic later in the year can’t be discounted. At the same time, businesses face carrying heavy new burdens – such as having to restructure the way they operate to meet social distancing guidelines – for some time.

Fig. 1 Monthly asset allocation grid
June 2020
June asset allocation grid

Source: Pictet Asset Management

To be sure, our business cycle indicators show that economies across the world have picked themselves off the floor. Daily activity trackers from the likes of Google and Apple show most developed countries are edging towards normality, halving the declines suffered during their March and April lows, with the euro zone now down some 24 per cent below pre-Covid levels and the US and Japan down around 15 per cent. China is back to January levels, though the country’s unique policy circumstances – both to lockdown and stimulus – mean it might not be a template for elsewhere.

Huge job losses – the unemployment rate is likely to peak well above 20 per cent – have hit US consumption. We expect a 12 per cent peak-to-trough decline in consumer spending. This, however, will be mitigated by massive fiscal stimulus. The US fiscal deficit is off the charts, and is likely to reach USD4 trillion this year, some 20 per cent of GDP, without even taking into account the various spending programmes winding their way through Congress. Some 90 per cent of that increase is being financed by the US Federal Reserve.

The euro zone has, hitherto, been more conservative in its approach. But a new EUR750 billion rescue programme (a mix of grants and loans), to be funded through a commonly issued bond, is a big first step towards fiscal integration of the single currency region. This, ultimately, could be even more important than short-term rescue measures and represents a great step forward for the single currency region, especially in light of the lack of solidarity among member countries at the start of the crisis. Even if the plan is watered down - as seems likely - the Franco-German programme could change the bloc's medium and long-term economic prospects. 

Emerging markets, underpinned by China and India, are likely to suffer less of a drop in growth than their developed counterparts, but we see world growth down 3.6 per cent this year, with a peak-to-trough drop of 8 per cent, double the global financial crisis slump.

Our liquidity indicators give very positive readings for riskier asset classes thanks both to the biggest money printing measures ever and the fact that bank balance sheets are robust enough to transmit this through to credit creation – unlike during the 2008-09 crisis. Total public and private liquidity creation is equivalent to 23 per cent of global GDP, compared to 17 per cent at the previous peak in 2016. Central banks will be providing a 13 per cent liquidity boost this year compared to 8 per cent in 2009. However, the momentum of money creation appears to be peaking.
Fig. 2 - Improving by the day
Daily activity indicators by country, % change from baseline (5-week average Jan-Feb)
Daily activity indicators by country

*Retail & recreation, transit stations, parks, grocery & pharmacy, workplaces, residential. ** Average of coal consumption, traffic congestion & property sales. Source: Pictet Asset Management, Google LLC. Data covering period 21.02.2020-21.05.2020.

Markets are pricing in a permanent decline in the cost of capital rather than focusing on income and earnings, which is boosting valuations. After a 30 per cent rally from their March lows, equities are now back to fair value while bonds are their most expensive ever. Relative to bonds, equities have some marginal upside. However, absolute valuations matter and in some markets like the US, multiples are very high, even on trend earnings, never mind the hit the Covid crisis and its aftereffects is likely to cause profits – we expect a 40 per cent decline this year, almost twice the consensus. Dispersion of valuations is extreme within asset classes, but the relative rankings of both equity regions and sectors is similar to pre-Covid levels. 

Our technical indicators suggest a possible correction for equities, while negative seasonal effects represent a headwind for risk assets. Sentiment has returned to normal levels, but it’s worth noting that retail investors had never fully capitulated, which is typical of severe bear markets. Surveys suggest widespread scepticism of this rally among professional investors, who continue to hold high cash levels.

02

Equities regions and sectors: warming to some beaten down sectors

The world economy is not out of the woods yet. But while we are lukewarm on the prospects for global equities in the near term, we have decided to raise exposure to a number of cyclical sectors that have been hit particularly hard by the market sell-off. 

In particular, prospects are looking brighter for the materials sector, which includes miners and chemicals firms. It is well-placed to benefit from the economic recovery we’re starting to see in China – where daily activity tracker levels have already returned to January levels. Crucially, we are also seeing monetary expansion which, history shows, has tended to help material stocks outperform (see Fig. 3). Given the attractive valuations, we upgrade the sector to a single overweight from neutral.

Not all beaten-down cyclical stocks look attractive, however. The financial sector, for example, is undoubtedly both cyclical and cheap. However, we don’t expect a value rally for some months to come. In the meantime, bond yields are proving stubbornly low, and in that environment rising loan loss provisions will be a big headwind. We therefore downgrade financials to neutral.

Fig. 3 - Material optimism
Global material sector performance and China credit impulse*
Material sector and China credit impulse

Source: Refinitv. Data covering period 28.05.2010-28.05.2020.

We see prospects brightening for stocks in Japan, which is one of the cheapest regions in our scorecard. Along with China, Japan is a country where a halt in tourism could actually prove a boon to domestic spending, as people switch to shopping at home rather than abroad. Authorities have also been proactive – the cabinet has just approved an extra USD1.1 trillion in stimulus. If implemented, this should boost its total economic support package to over 40 per cent of GDP, according to Prime Minister Shinzo Abe. Additionally, the government has just lifted the state of emergency as new Corona cases have fallen dramatically. As a consequence, we decided to close our tactical short position on Japanese stocks.

In contrast, we close our overweight in UK equities even though their valuations remain attractive. The FTSE 100 has a high exposure to energy – a sector that is unlikely to see a strong recovery in the near term. At the same time, with Brexit negotiations reaching a critical stage, the UK market could suffer a period of turbulence. 

Despite these pro-cyclical tweaks in our asset allocation, we believe that risks remain finely balanced overall. For us, that balance comes from retaining some defensive overweight positions, such as in Swiss stocks and in health care. 

03

Fixed income and currencies: printing presses working hard

The money printing presses remain in overdrive.

The world's central banks have provided a record USD7.5 trillion of monetary stimulus to revive the virus-hit economy, equivalent to 13 per cent of GDP. Their actions have given a strong boost to almost all fixed income asset classes, but with some areas now looking very expensive, investors will need to be more discerning.

The US remains our favourite market; we maintain our overweight stance in Treasuries and investment grade bonds.

The Fed has been by far the most expansive central bank, with its quantitative easing programme now also encompassing corporate bonds.

While benchmark interest rates are unlikely to fall below zero, we expect the Fed to adopt a Japan-style yield control curve policy if inflation undershoots its target significantly in the coming months.

The Fed’s total liquidity injection this year will amount to some USD2.4 trillion, effectively financing about 60 per cent of the government deficit, which should hit USD4 trillion by end-2020.

This should push the US “shadow” rate – which takes into account the impact of its unconventional easing – below the previous trough of -4.7 per cent in real terms by the year end from the current -3.3 per cent.

Fig. 4 - All that glitters...
Gold price in USD 
Gold price

Source: Refinitv. Data covering period 28.05.2010-28.05.2020.

We remain attracted to emerging market local currency debt. Inflation in the emerging world stands at an average of 2.5 per cent – a record low - which opens the door for further easing in countries like Korea, Russia and Turkey.

Euro zone fixed income assets are also supported by central bank stimulus, but many markets are unattractive with yields deep into negative territory. While a German-French proposal for a EUR750 billion recovery fund is a positive development, spreads on bonds issued by Italy, Spain and Portugal have already narrowed considerably, limiting the scope for a further rally. We therefore retain our neutral stance on euro zone sovereign debt and credit.

Our overweight stance on gold remains in place. Despite its recent rally, gold has room to rise further as it provides an attractive hedge at a time when tensions between the US and China are rising once more.

Aggressive monetary easing by the world's central banks also raises the risk of currency debasement in the long term, which supports the precious metal.

Elsewhere, we continue to prefer the safe-haven Swiss franc.

04

Global markets overview: stocks, oil extend recovery

Global equities extended their recovery in May, rising by more than 4 per cent in local currency terms and outperforming bonds, which ended the month flat.

Investors have grown more optimistic about the prospect for an economic rebound, buoyed by the easing of lockdown restrictions in several countries and encouraging data from China.

Japanese stocks fared especially well with gains of more than 6 per cent. Wall Street also staged a solid recovery, rising more than 5 per cent.

Emerging stocks lagged their developed counterparts, with Asian shares ending the month flat.

IT shares extended their winning streak as they rose nearly 7 per cent in the month to be the only sector alongside healthcare to be in positive territory this year.

Materials, industrials and consumer discretionary shares rose nearly 6 per cent.

Fig. 5 - Stocks powering ahead
Global bond yields % vs MSCI All Country Index 
Global bond yields % vs MSCI All Country Index

Source: Refinitv. Data covering period 28.05.2019-28.05.2020

Most developed sovereign bonds ended the month barely changed.

Emerging markets were a rare bright spot as EM local currency and hard currency debt as well as EM corporate bonds posted gains.

In developed market credit, high yield bonds outperformed their investment grade counterparts both in European and US markets.

Oil extended its V-shaped recovery from a slump in the previous months as it rose nearly 40 per cent. Commodities followed suit with a gain of 16 per cent.

Elsewhere, the dollar fell 0.7 per cent as investors grew worried about the currency’s diminishing interest rate premium and a growing fiscal deficit in the US. Sterling fell 2 per cent after speculation intensified that the Bank of England may consider cutting the cost of borrowing below zero to revive the economy.

05

In brief

barometer june 2020

Asset allocation

Caution about the scale of the stock market's rally means we remain neutral on equities and bonds.

Equities regions and sectors

We turn a bit more cyclical, upgrading materials and downgrading UK.

Fixed income and currencies

We continue to favour US Treasuries and investment grade credit, as well as emerging local currency debt. We also prefer gold and the Swiss franc.