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Now Reading: Barometer: Liquidity vs the virus


July 2020

Barometer: Liquidity vs the virus

Vast amounts of stimulus have underpinned the markets after the initial shock of the Covid-19 crisis. The question for investors now is whether such support can continue to offset a sharp fall in corporate profits.


Asset allocation: balancing risks

There are few certainties when it comes to investing. Take Covid-19. Just when many parts of the world looked to have got to grips with the coronavirus pandemic, the US, South Korea and Beijing re-imposed lockdowns to contain a surge in new cases. A standing reminder that virus infections could – as the World Health Organization points out – ebb and flow for up to five years. 

Still, there are some things investors can be certain of in 2020. Corporate profits will fall precipitously, and central banks will move mountains to support the economy. The task is to determine which of these will have a stronger bearing on financial markets. 

Corporate earnings prospects are clearly a concern. The consensus among analysts is that profits will decline by about 20 per cent this year following the deepest recession in more than a century. Our models paint an even more pessimistic picture. Globally, earnings could drop some 30 to 40 per cent year-on-year. 

But that does not mean equity and corporate bond markets are due a sharp fall. Central banks are committed to containing the damage. According to our calculations, the US Federal Reserve will inject another USD1.3 trillion of additional monetary stimulus this year while the European Central Bank will unleash an extra EUR1.1 trillion. 

Broadly speaking, this suggests the decline in earnings per share will be offset by a central bank-inspired expansion in price-earnings multiples. Crucially, however, stocks that trade on cheaper multiples, such as European equities, should see stimulus hold sway. Which is why we have raised our exposure to European stocks to overweight. We retain a neutral stance on most other stock markets.

Fig. 1 - Monthly asset allocation grid
July 2020
July monthly asset allocation grid

Source: Pictet Asset Management

Our business cycle indicators show large parts of the global economy are beginning to recover from the damage caused by the pandemic. China’s revival continues apace, with the daily indicators we monitor showing economic activity is running some 5 per cent below pre-pandemic levels. For Japan, the US and the euro zone, the equivalent figures are between 5 and 10 per cent. Of the major economies, Europe’s prospects look brightest. In a few short months, the region’s fiscal stimulus has increased from 2.2 per cent of GDP to about 4.4 per cent. This is triple the amount delivered during the 2009 debt crisis. What is more, the region seems to have the Covid-19 under control, and an ambitious plan to recover from its effects.
Fig. 2 - Awash
Total and average  public and private liquidity flows since 2007, % of GDP*
Total and average  public and private liquidity flows since 2007

*Total liquidity flow calculated as policy plus private  liquidity flows, for US, China, Japan, euro zone and UK  as % of nominal GDP, using current-USD GDP weights. Source: Refinitiv Datastream, Pictet Asset Managementt. Data covering period 15.05.2007-15.05.2020.

Our liquidity indicators flash green for riskier asset classes. Both the Fed and the ECB are set to deliver vast amounts of new stimulus. Bank lending is also very strong globally as banks’ capital positions are solid and government loan guarantees are helping direct credit to businesses hit by the crisis. The ECB’s targeted long-term refinancing operations (TLTRO) have proved especially effective in channelling much-needed credit to the economy. China is bucking the trend, however. With the economy recovering, authorities in Beijing will look to rein in stimulus. Interbank lending rates – Shibor – have risen by some 60 basis points over the past month to above 2 per cent.

Our valuations gauges show equities are, in aggregate, fairly valued. Compared to bonds, though, they remain cheap – provided the pandemic does not weigh on profit growth over the long run. European markets look attractive relative to others. While the discount at which European stocks trade to their US peers has narrowed in recent weeks, there is scope for it to tighten further. US bonds, while cheap heading into the crisis, are approaching expensive levels.

Our technical readings show investors have turned less bearish on stocks – the indicator has moved from oversold to neutral. That increases the scope for a correction over the near term. High yield bonds also look vulnerable to a sell-off as flows into the asset class have been unusually strong.


Equities regions and sectors: European attractions

Europe’s economy is benefiting from a loosening of lockdown restrictions and plenty of fiscal and monetary support. We have consequently upgraded European equities to overweight.

At the same time, we trim our overweight on health care, a defensive sector, with an eye to the US presidential elections in November.

Europe’s steady return to health tracks developments in Asia – the Chinese economy is almost back to normal – and the US, where economic indicators are increasingly positive. And euro zone equities have shown significant positive momentum lately. They were cheap relative to the US market before the crisis and continue to look attractive on that basis. Indeed, euro zone cyclical stocks, as a ratio to defensive equities, trade at a record discount of 50 per cent to their US peers [see Fig. 3]. This suggests that as investors' faith in economic recovery builds, European equities should have relatively greater upside potential than their trans-Atlantic counterparts.

Fig. 3 - The Great Divide
Ratio of cyclical to defensive equities in the US and EMU, 31.12.1998 = 100
Ratio of cyclical to defensive equities in the US and EMU

Source: Refinitiv, Pictet Asset Management. Data covering period 31.12.1998-24.06.2020.

Monetary and fiscal stimulus is likely to continue offering support. The European Central Bank’s TLTRO 3 programme looks to be successfully injecting liquidity into the system. Perhaps more importantly for the long term, the introduction of the region’s emergency funds bond programme offers the prospect that - at long last - a common fiscal component will be introduced to complement the single currency’s common monetary policy.

With yet more US stimulus measures in the works, it’s understandable why equity markets have been on a tear during the past couple of months. But there remain plenty of risks. Growth in Covid cases in parts of the US and flare-ups in those regions where the pandemic appeared to have been beaten down raise the worrying prospect of a second wave. A resurgence of the virus would threaten the imposition of periodic and rolling lockdowns or, at the very least, consumer retrenchment. In continental Europe, on the other side, the epidemic seems to be under control, as confirmed by the WHO this week.

At the same time, recent polls flag up the possibility of a Democrat clean sweep at November’s elections: the presidency and control of the Senate. The Covid crisis has pushed health care towards the top of the agenda and fears are that the Democrats would push to restrain costs and prices, particularly of pharmaceuticals. With this possibility in mind, we have reduced our exposure to health care stocks. The decision makes even more sense given such stocks are expensive and that a weaker dollar is traditionally a significant headwind for the sector. Our biggest equity overweights remain Swiss equities, a bet on quality growth, and materials for their exposure to China’s recovery.


Fixed income and currencies: a focus on the US

Global bond markets remain supported by unprecedented monetary stimulus. We expect the world’s five top central banks to inject a whopping USD8.4 trillion of liquidity into the financial system this year, which is equivalent to 14.3 per cent of their countries’ total GDP.1 

All bonds might look attractive against this backdrop. But central bank support must be balanced against the fact that valuations are now exceptionally high – some fixed income asset classes are the most expensive they’ve been in 20 years. Additionally, the global economy appears to be on a path to recovery, which could cause bond yields to reverse course. 

Those contrasting signals keep us neutral on fixed income overall. Drilling deeper, among sovereign debt we see the best return potential in US Treasuries. The Fed has been particularly aggressive with stimulus, and we expect it to deliver more in the coming months. This will most likely come in the form of yield curve control, which should keep liquidity abundant and Treasuries’ valuations unusually high for a long time.

The stimulus should also be good news for US corporations, which are already beginning to benefit from a pick-up in the economy. The US economic surprise index hit an all-time high in June, for example. Economically, US looks to be in better shape, which supports our overweight stance on US investment grade bonds – particularly as they have the backstop of Fed support should things dip again.

However, we are mindful that the economic recovery is still in the early stages, and there are many risks ahead, including the US election and the possibility of a second wave of the pandemic. We therefore remain underweight US high yield. Although it is the only fixed income asset class that is not expensive relative to its 20 year history, according to our model, we believe such valuations do not factor in the potential for future defaults. The market is pricing in a  default rate of just 7-8 per cent, while Moody’s expects it to reach nearly double that, at 13 per cent.

Fig. 4 - Euro value
Euro/dollar exchange rate vs equilibrium
Euro/dollar exchange rate vs equilibrium

* Equilibrium exchange rate is based on relative prices, relative productivities and net foreign assets. Source: Refinitv, Pictet Asset Management. Data covering period 01.01.1978-24.06.2020.

In the currency market, we think the euro should benefit from an improving economic backdrop, helped by increased stimulus. The ECB’s TLTRO 3 bank funding programme and the EU’s economic recovery plan are big positives. The former has seen a very good take-up and will boost banks’ earnings as well, while the latter can potentially prove a game-changer for fiscal unity within the bloc. All in all, we think the euro’s 14 per cent undervaluation against the dollar (see chart) is no longer justified, and upgrade the currency to overweight. Technical trends, such as seasonality, are favourable, too.

We also see potential for a rebound in emerging market (EM) currencies, which are extremely cheap and have lagged the broader ‘risk-on’ rally so far. That, in turn, should benefit EM local currency debt.

To guard against any renewed market volatility, we keep defensive positions in the Swiss franc (whose haven status is complemented by a strong uptick in the domestic economy) and in gold. Although gold has enjoyed a very strong run (up 15.5 per cent since the start of the year), it is still not in overbought territory according to our technical indicators, which makes it a good hedge. Indeed, we believe fundamentals – including the possibility of an inflation spike over the medium term, persistently negative real rates and the prospect of a further weakening in the dollar – more than justify the precious metal’s apparently stretched valuations.


Global markets overview: equities, gold shine

Global equity markets advanced further in June, gaining nearly 3 per cent in local currency terms and outperforming bonds as investors grew more optimistic about the prospect for an economic recovery. Encouraging data from China, Europe and other economies and continued monetary and fiscal stimulus eclipsed news of a rise in Covid-19 cases in certain parts of the world.

Within equity sectors, IT shares extended their impressive rally, gaining more than 7 per cent in the month. The tech industry has proved resilient during the pandemic as lockdown measures encouraged people to work remotely and shop online. Consumer discretionary and material sectors also performed well thanks to expectations of rising demand in China. Utility and health care shares fell after investors scaled down their bets on the top performing sectors of the past few months.

Emerging Asia and Latin American shares were the biggest outperformers with gains of more than 7 per cent. Japan failed to participate in the risk-on rally as its shares ended the month virtually flat.

Fig. 5 - Tech reign
Nasdaq Composite Index
Nasdaq Composite Index

Source: Refinitiv. Data covering period 05.02.1971 – 19.06.2020.


Bonds ended the month flat. Investors preferred riskier debt, with emerging market hard currency bonds rising more than 3 per cent. US, euro zone and Japanese government bonds ended the month little changed. Corporate bonds rose between 1-2 per cent on both sides of the Atlantic, supported by central bank asset purchases.

Oil rose more than 8 per cent in the month, helped by signs of economic recovery and a weaker dollar, which fell 1 per cent on a trade-weighted basis. Gold rose another 3 per cent to be the best performing asset class so far this year with a gain of over 17 per cent since January.


In brief

barometer july 2020

Asset allocation

The balance of risks between policy stimulus and economic impact of the virus keeps us neutral on major asset classes.

Equity regions and sectors

We upgrade European equities to overweight and trim our overweight in the Health Care sector ahead of US elections.

Fixed income and currencies

We upgrade euro to overweight versus the dollar on improved political and economic news and attractive valuation.