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Barometer of financial markets October investment outlook

October 2020

Barometer: Positive signs but red flags flutter

The global economy's recovery from the effects of the pandemic continues, but investors face a number of risks in the coming months.

01

Asset allocation: guarded optimism

The global economy appears to be on the road to a V-shape recovery from the Covid-induced recession.

Economic activity has been picking up in US and Europe but most rapidly in China, where our real-time indicators show output levels are back at pre-pandemic levels.1

At the same time, although monetary stimulus from central banks may be easing, it remains sufficient to support demand for now.

This is not to say all is rosy.

Investors have no shortage of risks to contend with in the coming months – a resurgence of Covid cases, fears of a new round of lockdowns in Europe and the potential for a disputed US presidential election next month.

Taking all this into account, we have retained a neutral weighting in equities and bonds. Within stocks, we like emerging market and euro zone equities yet, due to the uncertainty regarding Covid-19 and the US election, we have sought some insurance by retaining an overweight on the safe-haven Swiss franc and gold.

Fig. 1 Monthly asset allocation grid
October
Monthly asset allocation grid

Source: Pictet Asset Management

Our business cycle indicators show global industrial activity is nearly back to pre-Covid levels, while spending on services is lagging.

In the US, the recovery is being fuelled by a strong housing market, where record low interest rates have helped push existing home sales to their highest levels in nearly 14 years.

We now expect a smaller contraction in output this year than our previous forecast, which was for a for -4.6 per cent drop. We see GDP growth recovering to 5.5 per cent next year – which is just under the 2019 trend projections.

There are concerns that the forthcoming lapse in US pandemic relief benefits and grants – or what has become known as the “fiscal cliff” – could stall the recovery. But we think the high level of savings among US households, which, as a proportion of net disposable income, hit a record 33 per cent earlier this year, should cushion any shock to the economy.

Recoveries in the euro zone and Japan are modest by comparison. In the euro zone, new restrictions to halt the resurgence in virus infections threaten to derail a recovery in the services industry while retail sales in Japan also remain weak.

Emerging market (EM) economies, led by China, are recovering strongly, thanks to improving global trade – which stands at just 10 per cent below pre-Covid levels. Our leading indicator for EM economic activity has turned positive on a three month basis for the first time this year, outperforming its developed world counterpart which is still in negative territory.

Our liquidity signals are positive for risky assets, with the volume of public and private money supply remaining at a record high of 28 per cent of GDP.2

However, this is likely to represent the peak. Central banks are unlikely to boost monetary stimulus significantly from this point, which should squeeze stocks’ price-to-earnings multiples in the coming months.

What is more, bank lending standards have tightened to levels not seen since the global financial crisis. In the US, for example, a net 71 per cent of banks surveyed by the US Federal Reserve have tightened their lending standards, the highest percentage since 2008. This could spell trouble for financial markets at a time when the coordination between central banks and governments is weakening.

Fig. 2 End of PE expansion?
AA yield and PE

Source: Pictet Asset Management, data covering period 02.01.2017 – 22.09.2020

Our valuation gauges continue to show equity prices are stretched, even after the recent fall in stock markets.

The expansion of equity multiples – responsible for almost all of the total return of equities this year – appears to be over.

Historically, price-earnings (PE) ratios have had a close relationship with real yields (see chart), where the PE tends to rise when real yields fall. However, real yields, using inflation-linked bond yields as a proxy, seem to have bottomed out at a record low of -1 per cent in the US. What is more, the US Federal Reserve is unlikely to turn much more dovish than it is now.

Investors therefore are unlikely to enjoy the same level of equity gains from the multiple expansion in the coming months. Our models point to an underperformance of stocks to bonds of 5-7 per cent over the next 12 months.

Our technical and sentiment indicators have turned positive for risky assets, partly thanks to seasonality – the tendency for equities to rally towards the end of the year. Although mutual fund data show investors bought USD26 billion of equities last week, the highest weekly amount this year, investor positioning in stocks is not excessively high.

That said, we are mindful of growing political risks surrounding the November US presidential election. Judging from Wall Street’s volatility options pricing, investors are beginning to factor in the possibility of a contested election in November and political turmoil early next year.

02

Equities regions and sectors: sticking with the emerging world

Equities suffered a turbulent start to the autumn. The enormous rally that followed the pandemic lows left some expensive stocks vulnerable to correction. But even after selloffs in some formerly high-flying sectors, not least tech, valuations remain expensive. Which is why we stick to our defensive tilt on sectors and remain neutral on the pricey US stock market and IT sector.

The huge expansion of price-to-earnings ratios since March has come to an end as real bond yields have stabilised and as PEs have risen far beyond the levels usually seen at this stage of the investment cycle – 50 per cent above on a 12-month forward basis for the S&P 500 and 25 per cent for global equities.

US equities look particularly expensive. Current valuations – stocks are trading at 23 times future earnings – can only be sustained if trend growth is unchanged, profit margins remain stable at current high levels and bond yields stay at 1 per cent forever. Some long-term valuation metrics – such as market capitalisation to GDP and price to sales ratios - for the US equities are above or close to all-time highs. 

Some of that rich valuation of US stocks is reflected in the extreme rating of cyclicals relative to defensive stocks. This has been supported by positive economic surprises, but this improvement appears to be levelling off (see Fig. 3).

Fig. 3 - Peaky
Ratio of MSCI World Cyclicals to Defensive Sectors Indices vs Citigroup Economic Surprise Index 
Ratio of MSCI World Cyclicals to Defensive Sectors Indices

Source: Refinitiv, Pictet Asset Management. Data covering period 03.09.2018 to 22.09.2020.

How the coming months pan out will boil down to two key factors – the outcome of the US election and how much fresh stimulus governments and central banks are willing and able to provide. Complicating matters is whether the recovery is self-sustaining. There are plenty of indications that economies are in relatively robust good shape. industrial production has been strengthening, trade is largely back to where it was and in many corners of the world. What’s more, strength in retail sales in the US and China belies some of the gloom of sentiment surveys.

All of which is to say that central bankers will be watching closely for how much or, indeed, whether any more stimulus will be needed for fear of overegging the recovery if the coming wave of Covid proves to be less damaging than feared.

Equities have so far been supported by falling real bond yields and an acceleration of growth momentum – but with this sweet spot slowly disappearing, we stick to a neutral approach to risk taking a barbell strategy of quality defensives like Swiss equities, staples and pharma and attractive cyclicals like euro zone and emerging market equities and materials, while avoiding low-growth markets and sectors like the UK, financials and utilities.

03

Fixed income and currencies: the appeal of US high grade

The global economic recovery is looking more secure, and earnings are on balance being revised higher. That is good news for companies and – on the face of it – the corporate bond market. 

However, we believe that the benefits won’t be felt evenly, particularly in the US.

Investment grade companies are, arguably, in a stronger starting position and should continue benefiting from the economic recovery, while being better placed to secure any extra funding than their lower-rated peers. They are also subject to additional and significant support from the Fed, which began buying investment grade corporate bonds in the summer. We retain an overweight position in US investment grade credit. By contrast, we remain cautious on US high yield. Returns from speculative-grade bonds are more dependent on economic growth picking up dramatically – something we are not seeing yet. What is more, the US high yield market is heavily exposed to the hard-hit energy sector, whose prospects remain murky.

In Europe, the prospects for corporate bond markets are more balanced. The composition of the region's high yield bond market is less cyclical and less energy-heavy than in the US. The investment grade segment is, like in the US, supported by central bank buying. One difference, however, is that the European Central Bank has been in the market for much longer than the Fed, which means the effects of its intervention are arguably fully priced in. Furthermore, our macroeconomic indicators are neutral on the prospects for the European economy – which in turn supports our neutral stance across the region’s credit markets.

Within sovereign markets, we see strong potential in emerging market local currency debt, not least because developing world currencies are around 20-25 per cent undervalued versus the dollar according to our models. 

Fig. 4 - Currency potential
China-US bond spread and exchange rate, bps
China-US bond spread and exchange rate

Source: Refinitiv, Pictet Asset Management, data covering period 02.01.2006 – 11.09.2020.

China continues to lead the improvement in the global economy, largely due to successful pandemic management. That makes the 3.1 per cent yield on 10-year renminbi bonds – representing a record premium of 250 basis points over US Treasuries – look particularly attractive. All the more so, given the potential for the renminbi to appreciate against the dollar (see Fig. 4).

Furthermore, foreign investor interest is on the rise, as China’s bonds become a bigger feature of major indices. In September, FTSE Russell’s World Government Bond Index became the latest benchmark to add China to its ranks – a move which Standard Chartered estimates could bring an additional USD140-170 billion of inflows from tracker funds into what is already a rapidly-growing market.

Defensive assets remain a key part of our overall portfolio in the face of a number of risks including the US fiscal cliff, the US election and a possible escalation of the Covid-19 pandemic. These include overweight positions in US Treasuries, the Swiss franc and gold.

While we are negative on the US dollar on a five year horizon, its more near term fate is likely to be decided by the results of the US polls. A clean sweep for the Democrats would be a positive outcome for the greenback, due to domestic stimulus and a push for companies to move investment back to the US. 

04

Global markets overview: getting jittery again

Equities slipped this month, underperforming bonds as concerns about a resurgence in Covid-19 cases and uncertainty surrounding the outcome to the November US presidential election prompted investors to scale back holdings of riskier assets.

Energy stocks were the biggest losers, suffering a decline of over 10 per cent as fears of further lockdowns weighed on oil prices. Sectors which have rallied the most in the past six months, such as communications services and IT, also suffered heavy losses in the first major market correction since March.

Even after the latest sell-off, however, IT remains the strongest sector this year with gains of 26 per cent since January. Utilities, a defensive sector, managed to end the month unchanged, while materials and industrial sectors were in flat to positive territory thanks to expectations for growing demand from a recovering China.

Stock markets in Switzerland and Japan ended the month higher while the rest of Asia-Pacific and the US fell the most.

Fig. 5 Dizzing heights
Nasdaq composite index
Markets Nasdaq.png

Source: Refinitiv, Pictet Asset Management, data covering period 23.09.2019 – 22.09.2020

Bonds ended the month up by more than 0.5 per cent with UK, Swiss and European government debt faring better than their US and Japanese counterparts. Emerging market local currency and hard currency debt fell by some 2 per cent, pressured by a combination of falling commodity prices and a stronger dollar.

European investment grade corporate bonds ended the month higher, outperforming their US counterparts.

High yield debt on both sides of the Atlantic fell as concerns intensified over rising default risks at a time when banks are tightening lending standards. Moody’s expects default rates in the speculative grade corporate debt market to rise to 9.1 per cent in the US and 5.5 per cent in Europe from 8.7 per cent and 3.4 per cent respectively.

The dollar was stronger against most developed and emerging currencies, except the Japanese yen and Chinese renminbi which eked out some gains. Sterling lost more than 3 per cent against the US currency as the chances of Britain leaving the European Union without a trade deal appear to have risen as negotiations between London and Brussels continue without a clear resolution in sight.

Commodity currencies such as the Australian dollar and Russian rouble were also weak with a decline of 3-4 per cent. Gold fell more than 3 per cent as investors took profits after this year’s strong rally. The precious metal is still up 25 per cent since January.

05

In Brief

barometer october 2020

Asset allocation

We remain neutral in equities and bonds while we keep our overweight stance in Swiss franc and gold.

Equities regions and sectors

We retain a barbell strategy of holding quality defensives and attractive cyclicals.

Fixed income and currencies

Our top picks within fixed income include Chinese renminbi bonds and US investment grade credit.