barometer of financial markets march investment outlook

The head of steam building up behind the global economy is becoming ever more evident. As vaccination programmes allow Covid-related restrictions to be lifted, growth looks set to jump, with the economy likely to recover much of last year's losses.

Bond yields have risen on doubts about central banks' ability and willingness to remain accommodative in the face of strong growth, the impact of President Joe Biden’s additional USD1.9 trillion stimulus package and because inflation expectations appear to be already broadly in line with official targets.

But we think these concerns are premature. Any overshooting of central bank's inflation objectives is likely to be only temporary, given large amounts of spare capacity in the economy. We don’t see underlying inflation picking up for at least the coming year. All of which leads us to maintain our overweight bias on equities and our neutral stance on bonds.

Fig. 1 - Monthly asset allocation grid

March

Our business cycle indicators show that momentum remains strong, prompting our economists to once again raise their real GDP growth forecasts for 2021 . We now expect the global economy to grow by a real 6.4 per cent this year against a market consensus of 5.1 per cent, with emerging economies, spearheaded by China and India (seen growing by a respective 9.5 per cent and 13.1 per cent) leading the way.¹ But the US is also poised for a robust 6.5 per cent expansion, according to our forecasts, more than making up for last year’s 3.5 per cent contraction. That’s underpinned by a surge in retail sales – it looks like Americans are beginning to spend their stimulus cheques – and a robust response by industry to fill that demand.

Base effects are likely to push inflation temporarily higher. It’s worth remembering that oil prices were briefly negative a year ago - now they’re roughly back to where they were before the Covid crisis. Meanwhile, as economies open up, we think the services sector will respond quickly to absorb pent-up demand and we’re likely to see few of the bottlenecks that typically give rise to underlying price pressures. In the US, any inflationary overshoot caused by excessive stimulus isn’t likely to appear until 2022/23, which should allow the US Federal Reserve to avoid tightening policy for the next 12 months or so. 

Our liquidity indicators show that the pace of monetary growth is slowing substantially. The rate at which money supply is rising is still above average, but well down from last year’s peaks. Over the near term, liquidity provision should continue to support riskier assets. In the US, for instance, money creation is off the chart, with the M1 money supply measure expanding 76 per cent on the year and M2 up 28 per cent. But on the other side of the Pacific, there are signs of restraint. The Bank of Japan is slowing its quantitative and qualitative easing programme, its yield curve control policy seems to have been relaxed somewhat. In China, the growth in the volume of credit flowing through the economy has slowed and the central bank has indicated a tightening bias.

Fig. 2 - Earnings boom

Delivered and forecast EPS growth, year-on-year, %

Our valuation indicators show most riskier asset classes trading at or near record highs. Valuations for stocks in the MSCI World index are at their most expensive since 2008 according to our models, with the market pricing in a return to pre-Covid rates of economic growth but with permanently lower interest rates.

We expect around a 20 per cent fall in the global price-to-earnings multiple as real yields start to rise and excess liquidity begins to dissipate. However, we also see a big jump in earnings per share growth (see equities section and Fig. 2) as both sales and profit margins benefit from a normalisation of economic conditions and generous fiscal support. The combined effect suggests around a 10 per cent upside for US equities from here.

As for fixed income, the recent rise in yields means that government bonds aren’t trading far away from their fair value for this stage of the economic cycle. For the first time since the pandemic struck, US 30-year real yields are in positive territory. But that rise in yields also makes equities look a little more expensive.

Technical indicators remain supportive for riskier assets, but they also flag up warnings that conditions are looking frothy. Seasonal factors are positive for equities. But investor sentiment is extremely bullish and fund manager cash levels are at 14-year lows and flows into the market are surging – at some USD180 billion, they’re at record year-to-date levels. 

Global equities have attracted investment inflows of as much as USD180 billion so far this year, the largest ever haul for this two-month period as investors, anticipating a strong economic recovery, switched out of money market and government bond funds and into stocks.

Ample monetary and fiscal stimulus and hopes for a successful Covid vaccine rollout are underpinning expectations for strong growth. This, in turn, has brightened the outlook for corporate earnings.

We expect profits to grow by more than 30 per cent this globally this year, with sales and profit margins improving as businesses reopen and consumers spend the savings amassed during lockdowns. US companies are now registering positive earnings growth on a year-on-year basis after three consecutive quarters of contraction.

While there are warning signs in the shape of record levels of new equity issuance and frothy valuations, we believe stocks have the potential to extend gains in the coming months.

Fiscal stimulus and high levels of household savings could translate into further inflows from individual investors, who account for an increasing share of ownership and trading activity, especially in the US stock market.

Another source of funding may come from a number of blank-check firms -- popularly known as SPACs – which are waiting to deploy the cash raised in blockbuster IPOs last year.

With the economy now emerging from the shadow of the pandemic, equity investors should expect to see a change in the pattern of returns across countries and sectors, with cyclical and value stocks likely to lead the market higher. Indeed, should bond yields continue to rise due to expectations for tighter monetary policy rather than out of fear of higher inflation, the earnings multiples of ‘growth stocks’ will likely come under greater pressure than those of their ‘value’ counterparts. 

In an environment of strong growth and gradually rising bond yields, financial stocks should be able to increase their earnings. Financial stocks have started catching up with other cyclical sectors as the yield curve has steepened in recent weeks (see Fig. 3). We see room for further gains as investors are yet to price in the potential for substantial upgrades to banks' earnings forecasts. Our stance is now overweight. 

Fig. 3 - A catch-up

Relative performance of financial stocks vs changes in yield curve 

We downgrade healthcare to underweight. The sector, with defensive characteristics, faces a challenging environment as the global economy experiences a post-Covid boom. Unlike other defensive sectors such as consumer staples, healthcare stocks are trading at an excessive premium among defensive peers on a cyclically-adjusted basis. Investors should also beware of potential regulatory risks in the US.

Elsewhere, we remain overweight economically-sensitive materials and industrial stocks. 

When it comes to regions, while emerging market equities have rallied in recent weeks as the region, led by China, enjoys a strong economic recovery, valuations remain fair, especially in Asian markets, where effective management of the pandemic and structural reforms should help boost corporate earnings growth in the medium and long term.

We also keep our overweight stance on Japanese stocks, which should benefit from a recovery in global trade. We expect Japan’s corporate earnings to grow an impressive 33 per cent this year, faster than emerging markets and the global average.

We remain underweight US stocks, which trade at a rich valuation of 23 times forward earnings against the long-term average of 15.

Particularly concerning is that the US market is overly exposed to technology stocks, the most expensive sector on our scorecard and which accounts for a fifth of the S&P 500 index. Tech stocks are also most vulnerable to a continued rise in bond yields.

We remain neutral European stocks, where valuations are unattractive at a time when the region’s economy is making an only slow recovery from the Covid lockdowns. After months of negotiations, Europe has finally agreed on a EUR750 billion pandemic relief package, but the fund is unlikely to flow to the economy before summer.

A stronger global economy and the spectre of rising inflation aren’t particularly welcome signals for bonds. 

However, we remain sanguine. Monetary stimulus, while fading, remains sufficiently strong to support certain parts of the fixed income market. Total public and private liquidity across US, China, the euro zone, Japan and UK stands at 13.9 per cent of GDP according to our models – down sharply from a peak of 28.1 percent in mid-2020, but still comfortably above its long-run average of 11.1 per cent.²

Inflation is rising, but we expect it to remain modest for this year at least. Because of this, the recent sell-off in bond markets has served to increase the appeal of US Treasuries and emerging market local currency bonds. We hold overweight positions in both. 

With 30-year nominal US bond yields having risen above 2 per cent, real yields on 30-year paper have turned positive for the first time since the start of the pandemic. Demand for longer-dated debt among pension funds should rise in response. Furthermore, market pricing now seems to be in-line with the likely path of US interest rates. The US curve implies a terminal Fed fund rate of 2 per cent – not too far away from the US central bank’s own forecast of 2.5 per cent. Inflation expectations, as indicated by the interest rate swaps market, also appear fairly realistic in the US (see Fig. 4).

Fig. 4 - Pricing in price rises

US 5Y5Y inflation swap, %

We also continue to favour emerging market local currency bonds in general and Chinese renminbi debt in particular. 

Data from Institute of International Finance shows emerging market debt attracted USD44 billion of capital in January, with over a fifth of that heading to China. The People’s Bank of China maintains a wait-and-see stance as economic growth shows signs of slowing but we think there is room to provide fresh stimulus if needed, which would underpin fixed income markets. 

Despite growing investor interest in the world’s second largest bond market, Chinese renminbi-denominated bonds remain the cheapest asset class in our scorecard. What’s more, a likely appreciation in the renminbi provides an additional source of return for fixed income investors. The Chinese unit should continue its ascent against the greenback as the US’s money supply is expanding at a faster rate than China’s. 

According to our analysis, the greater the gap, currently 55 percentage points year-on-year and highest in at least 14 years, the greater the renminbi’s appreciation potential. 

Elsewhere, we are cautious on US high yield bonds, whose valuations look extremely stretched. Their yield advantage relative to equities has now shrunk below 1 per cent, compared to 10-15 per cent typically seen after a recession. Furthermore, with yield spreads having fallen to pre-pandemic levels, we believe the market is under-pricing default risks. 

Among currencies, we downgrade the Swiss franc to neutral from overweight – a tactical move after its 10 per cent rally versus the dollar over the past year. We remain negative on sterling as the UK economic recovery continues to lag, hampered by lockdowns and the fallout from Brexit. 

More broadly, even though we think the dollar is headed for an extended period of weakness, it could be supported in the near tern by strong US growth.

The first two months of 2021 has seen financial markets continue to discount the possibility of a brisk pick-up in inflation. With the US breakeven – the yield gap between nominal and inflation-linked bonds and a gauge of inflation expectations – reaching 2.2 per cent by the end of February, attention turned to central banks and the growing prospect of a winding down of the monetary stimulus that boosted stocks since the onset of the pandemic.

The yield on the 10-year Treasury ratcheted up to a one-year high of above 1.6 per cent. Oil prices, meanwhile surged some 18 per cent on the month, capping their best ever start to the year.
The prospect of an acceleration in price pressures has grown as governments – particularly in the US and the euro zone – have committed to large amounts of public spending to support sectors hit the pandemic and boost employment.

With the vaccine rollout gathering pace in many parts of the world, the worry is that policymakers, especially in the US, risk over-stimulating the economy and stoking inflation. Bond markets ended the month sharply lower. Most major government bond markets ended the month with losses of between 2 and 5 per cent in local currency terms.

Fig. 5 - Rising yields

10-year US Treasuries yield, %

 

The rise in bond yields also fed through to stock markets, giving added momentum to the rotation from ‘growth’ to ‘value’ orientated sectors Equity sectors that have fared well during lockdowns – such as technology – trailed cyclical stocks that are expected to benefit from a return to more normal economic conditions.  Fuelled by a surge in oil prices, energy stocks rose 13 per cent in US dollar terms, followed by financials, which gained some 8 per cent as bond yields rose.  Materials and industrials each gained more than 4 per cent. Tech stocks carved out gains of just over 1 per cent in US dollar terms while the defensive health and utility stocks declined.

Expectations of a strong broad-based recovery should at some point see investors lower the premium they pay for ‘growth stocks’ – data from FactSet, for example, shows that shares in S&P 500 companies whose fourth quarter earnings beat expectations stayed largely flat in the two days following the release of the figures.