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BAROMETER OF FINANCIAL MARKETS JULY INVESTMENT OUTLOOK

July 2021

Barometer: An unfavourable mix of slower growth and rising inflation

Slowing growth, rising inflation and less expansive monetary policy could act as a dampener on equity markets and riskier corporate bonds.

01

Asset allocation: strong growth, but strong inflation too

The global economy is expanding at a solid pace. Developed countries are responsible for much of that growth thanks to the rapid vaccine rollout and the lifting of lockdown measures.

But economic momentum is beginning to ease as central banks prepare themselves to scale back monetary stimulus in response to rising price pressures.

A less favourable mix of growth and inflation, tighter liquidity conditions and high valuations for riskier asset classes lead us to maintain our neutral stance on equities.

Within equities, we are underweight economically-sensitive sectors - including consumer discretionary stocks – while in fixed income we are underweight riskier bonds such as US high yield debt.

At the same time, we continue to hold overweight positions in defensive assets such as US Treasuries and Chinese local currency bonds.

Fig. 1 Monthly asset allocation grid

July 2021

asset allocation grid

Source: Pictet Asset Management

Our business cycle analysis shows price pressures are becoming more visible in the US.

The country’s consumer price index excluding food and energy is increasing at a 3-month annualised pace of 8.2 per cent, the highest since 1982.

Core PCE, the US Federal Reserve’s preferred measure of inflation, also rose 3.4 per cent to hit its highest level in nearly 30 years.

However, we believe the bout of inflationary pressure is transitory, owing to supply distortions and a surge in demand for items that were most affected by the pandemic, such as used cars.

Stripping out the impact from these Covid-sensitive items and the base effect, our analysis shows inflation is still stable at around 1.6 per cent.1

The Fed now appears set to hike interest rates as early as end-2022 after it unexpectedly upgraded this year’s growth and inflation projections in June.

Higher interest rates could come even sooner if wage inflation picks up from the current 3 per cent year-on-year pace – which will in turn pressure corporate profit margins.

Fig. 2 - On the dot
FOMC’s interest rate projections to end-2023 in dot plot. Median dot indicates two rate hikes in 2023 now, compared with zero in March
 
FOMC interest rate projections

Source: Refinitiv, data covering period 01.01.2003 – 24.06.2021.

In Europe, economic conditions are improving rapidly as the bloc’s vaccination programme and business re-openings gather pace.

Further improving the region’s prospects, euro zone countries will soon begin receiving funds from the EUR750 billion recovery fund, which is expected to boost growth by at least 0.2 percentage points both this year and next.

Economic momentum in emerging countries is levelling off as Chinese growth cools after a strong rebound. We think domestic demand will replace exports as the main contributor to economic growth, which will in turn boost retail sales and fixed asset investments.

Our liquidity indicators support our neutral stance on risky asset classes.

Liquidity conditions in the US and euro zone are the loosest in the world, thanks to continued monetary stimulus from central banks.

In contrast, China’s liquidity conditions are now tighter than before the pandemic as Beijing resumes its crack down on debt after a 2020 boom in lending among small and medium enterprises.

However, a further slowdown in the world’s second largest economy may prompt the People’s Bank of China to switch to easier monetary policy later this year. This will see the central bank intervene in the foreign exchange market to weaken the renminbi currency.

Our valuation models suggest equity valuations are at their most expensive levels since 2008. Tighter liquidity conditions and a further increase in real yields are likely to pressure global price-earnings multiples, which we expect to decline by up to 20 per cent in the next 12 months.

Our model suggests that corporate profits should grow globally around 35 per cent year-on-year this year. We think consensus earnings growth forecasts for the next two years -- at around 10 per cent -- are too optimistic as that would take EPS clearly above the pre-Covid trend, which is unlikely given that profit margins are already stretched.

Our technical indicators remain moderately positive for equities. Within fixed income, Chinese government debt – in which we are overweight – is the only asset class for which technical signals are positive.

02

Equities regions and sectors: buy British

The UK is the cheapest equity market according to our valuation metrics. For instance, it is trading 13.1 times forward earnings, according to MSCI, against the euro zone’s 17.3 times and 21.8 times for the US market. On our combination of valuation metrics, UK stocks have historically been cheaper only 17 per cent of the time.

Britain’s high vaccination rates – two-thirds of the population had had at least one dose by the end of June –  suggest the economy will be able to escape the worst effects of the Covid delta variation that is beginning to cause concern in other economies. This should help with a full reopening of the economy scheduled for July. Also, the market offers a favourable mix of value oriented and high quality defensive stocks which we believe would perform best in the current phase of the cycle.

Europe is also increasingly attractive. The post-pandemic growth relay has shifted from China to the US and now to the euro zone. Economic prospects and liquidity conditions for the region are better than elsewhere while equity valuations are reasonable. What is more, investment inflows into the region’s equity markets have remained strong even as they have started to tail off in the US. However, European equity markets have tended to disappoint – they’ve underperformed for years and every rally has proven temporary, so we have held off going overweight for now and await further data confirming these positive trends. 

We believe that Asia ex-Japan equity markets appear attractive from a strategic stand-point. The region is forecast to grow at twice the rate of the rest of the world over the next five years with a lower inflation rate. Also, the relatively conservative monetary and fiscal response to the Covid crisis means that economies in the region have more policy headroom. Undervalued currencies and equity valuations that appear reasonable when adjusted for superior growth should help Asia stocks outperform in the coming year.


Fig. 3 - Winning markets
Equities regions and sectors, YTD total return
equity returns chart

Source: Refinitiv, MSCI, Pictet Asset Management. EM expressed in USD terms. Data covering period 01.01.2021-23.06.2021.

We remain underweight in US equities given valuations – the US market has only been more expensive than it is currently 16 per cent of the time – and lingering question marks over the persistence of the post-pandemic inflationary spike.  It remains to be seen whether inflationary pressures will prove transitory or continue to overshoot expectations. At the same time, it is not clear whether inflation expectations will remain elevated. 

Such uncertainties leave the market vulnerable to unanticipated hawkish shifts in central bank policy.

Our worries are reinforced by a recent strengthening of the relationship between Fed policy and market moves. There has been a 90 per cent correlation between Fed net liquidity – the additional amount of money the central bank provides the economy for investment and spending – and the performance of the S&P 500 since the latest wave of quantitative easing was launched.

Across equity markets more generally, price to earnings ratios have pulled back some 10 per cent from their peak last September. In the absence of any additional increase in corporate profit margins, the catalyst for a further rise in equities would have to come in the form of faster economic growth. 

We remain overweight financials and real estate – the latter looks particularly cheap on valuation grounds – and are underweight consumer discretionary, a sector that performed strongly but is now starting to lag.

03

Fixed income and currencies: cautious on credit

In a world where yields are already ultra-low (and often negative), attractively-priced bonds are in short supply. Take speculative-grade fixed income. 

For the first time ever, the yield on US high-yield bonds is below inflation. It is also below US stocks’ earnings yield for the first time since 2014. This is why we continue to be underweight US high yield credit – currently the most expensive fixed income asset class in our model. 

Such a high valuation is particularly concerning because – despite strong US economic growth – we now see limited upside for corporate earnings forecasts. The US I/B/E/S consensus forecast for year-on-year profit growth has caught up with our own estimate of 35 per cent for 2021, and looks too optimistic for the following two years.

US inflation-linked bonds – or TIPS – are also too expensive. 

In the wake of strong investment inflows into inflation-linked bonds in recent weeks – totalling some USD3.3 billion in the three weeks to June 16 – valuations for such bonds are now hard to justify, particularly given the Fed’s more hawkish tone.

Fig. 4 - Curve of opportunity
US Treasuries yield curve (10Y-2Y, ppts)
US yield curve chart

Source: Refinitv. Data covering period 31.05.2019-23.06.2021.

In contrast, we are more optimistic on US Treasuries, which look attractive relative to other developed market government bonds. We expect the US government bond curve to continue to flatten – the yield gap between 10-year and 2-year Treasuries is 26 basis points smaller than it was three months ago (see Fig. 4). This trend could create some interesting investment opportunities.

We see the most potential, however, in Chinese government bonds. The asset class is enjoying significant inflows, which are set to accelerate as authorities allow foreign investors greater access to the market and as Chinese debt becomes a bigger feature of global bond indices. 

It is particularly good time to invest in the asset class as real rates are high (at 1.9 per cent, versus US’s -0.8 per cent) and as economic momentum across China appears to have peaked. All six of the key activity indicators we monitor – industrial production, retail sales, car sales, construction activity, fixed asset investment and nominal exports – are now lower than they were a few months ago. While we expect PBOC to maintain the status quo for now, its next move is likely to be towards more accommodation as inflation is unlikely to reach its target by the end of the year. 

China is also the only sovereign bond market to score positively on technicals according to our model.

Elsewhere, we are broadly neutral on major currencies versus the US dollar. The one exception is sterling, where we are underweight following its recent surge.

04

Global markets overview: relentless equities

Equities continued to climb during June with the S&P 500 routinely setting new record highs as the US economy’s steady  re-opening feeds through to strong earnings. Globally, equities gained 2.2 per cent on the month in June for a total year to date performance of 13.6 per cent in local currency terms.

The US and Swiss markets were particularly strong performers during the month, up 2.8 per cent and 4.9 per cent respectively. The greenback was up 2.7 per cent on the month against a basket of currencies, boosted by a slightly more hawkish outlook from the Fed.

Bonds recouped some ground during the month, but remain down 2.6 per cent since the start of the year in local currency terms. There’s a growing tension between investors worried that above-target inflation will become increasingly embedded in consumer expectations and those who see current price pressures as a purely transitory phenomenon, largely down Covid-related distortions.

Within credit, the higher risk parts of the  markets on both sides of the Atlantic remain supported by the same forces boosting equities, with the US high yield up 1.4 per cent on the month and euro zone high yield up 0.6 per cent in local currency terms.


Fig. 5 - Shining less brightly
Industrial metals prices versus the US dollar index
industrial metals and dollar chart

Source: Refinitv. Data covering period 31.05.2019-23.06.2021. 

Oil has been a particularly strong performer so far this year with economies bouncing back smartly from where they were a year ago and supply discipline among oil producing nations’ cartel remaining strong. Oil prices were up another 9.3 per cent taking them up nearly 50 per cent since the start of the year. That fed through to energy stocks, up 4.4 per cent for a 30 per cent gain on the year.

Industrial metals have however rolled over from their recent peaks. The unwinding of speculative positions in metals and signs that economic growth may have peaked have contributed to the move, as have a tempering of inflation expectations and a stronger dollar [see Fig. 5].

The latter two factors have also led to gold prices losing ground on the month, down 4.3 per cent.


05

In brief

barometer july 2021

Asset allocation

We maintain our neutral stance on overall asset allocation, preferring to hold defensive assets such as US Treasuries and remaining underweight cyclical sectors and credit.

Equities regions and sectors

We remain overweight UK equities on favourable valuations and Pacific ex-Japan on strategic grounds.

Fixed income and currencies

We see the most potential in US Treasuries and Chinese renminbi debt, while taking a more cautious stance on credit markets.