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- Potential treatments/vaccines for COVID‑19, policy support, and gradually reopening economies make us more comfortable taking a pro-risk stance over our 12-month time frame.
- However, the market’s rebound and the prospect of a slow economic recovery leave us only moderately bullish on risk assets.
- Within equities, we prefer the US and the growth and quality factors, though we think some higher-quality cyclical companies are attractive.
- We think rates will stay low and find some credit spreads attractive relative to government bonds.
- Downside risks include the US election, a second wave of COVID-19, a deeper and longer recession than anticipated, and worsening US-China relations. Upside risks include a faster-than-expected, safe/effective vaccine, another major dose of policy stimulus, and/or a sharp economic rebound.
The contrast is stunning: The worst economic downturn since the Great Depression has been followed by the greatest equity rebound in history (despite the recent sell-off). But we reject the theory that the market is in a bubble. The technology sector, whose rally has raised the most alarm, enjoys excellent fundamentals and we think it could continue to exceed expectations in a low-growth world.
US election risk is also top of mind with investors, as the large number of mail-in ballots is likely to mean delayed results and legal challenges, and perhaps even civil unrest. The uncertainty will be a negative for global markets, but we expect election volatility to be temporary and are more focused on what comes next. Over our 12-month horizon, the main reasons to own risk assets in our view are: progress on treatments and vaccines for COVID-19; continued fiscal and monetary support; the gradual reopening of economies; and positive demand technicals in a near-zero yield environment for developed markets (Figure 1). Our bullishness, however, is tempered by global economic indicators that remain well below pre-COVID levels, the potentially reduced fiscal and monetary oomph of future policy action, and COVID uncertainty, including a possible second wave, the path of vaccine trials and distribution, and the vaccine take-up rate.
We continue to prefer US equities given our expectation that global growth will recover slowly. The “TINA” effect (There Is No Alternative) is powerful given low fixed income yields and the potential yield, earnings growth, and relative safety that US equities may provide. Investor cash levels also remain high and could provide support for equities. We are neutral on European, Japanese, and emerging market (EM) equities, as we think less attractive fundamentals are offset by cheaper valuations. We expect interest rates to stay low given the Fed’s new policy framework and find many areas of credit attractive given the demand for yield and the Fed’s asset-purchase support. We believe the COVID-19 shock is deflationary and, consequently, think commodities could be a source of funds. The one exception is gold and other precious metals, which we think could be a complement to fixed income for diversification purposes in a period of near-zero yields.
Equities: Leaning toward growth
We are moderately bullish on US equities given the less cyclical nature of the economy and the market’s growth and technology exposure. In the post-COVID regime that we expect — low growth, low inflation, and low rates — growth areas like technology could remain attractive thanks to their potential to increase earnings and cash flow, despite rich valuations (Figure 2).
European and Japanese equities are cheap and their economies are recovering enough to potentially warrant some exposure, but equity valuations matter very little over a one-year horizon and both regions are highly exposed to the fragile global economy. To turn more bullish, we would want to see evidence that a widely distributable vaccine was on the way or that global leading economic indicators were turning more positive.
Europe has undertaken enough policy support to prevent material downside for the economy, though not enough to provide much upside. We are closely monitoring Brexit developments and prefer to steer clear of UK equities at this time. In Japan, we think new Premier Yoshihide Suga will continue the reflationary policies of his predecessor, but we fail to see a catalyst for the market to move much higher.
Emerging markets are a heterogeneous asset class and country differentiation is key. Most of the countries and regions we find attractive currently are in Asia, and China tops the list. The country has made great progress in stopping the spread of COVID-19 and our macro team expects a steady if unspectacular economic recovery. Countries we see reasons to avoid include Brazil, Turkey, and South Africa.
Credit: Still a good case for tighter spreads
It was another good quarter for credit spreads, which narrowed 20 – 100 basis points (bps), and total returns were in the 1% – 5% range with high yield among the best performers. The backdrop for continued spread tightening is positive in our view: 1) the economy is slowly improving; 2) the Fed will be on hold for years with its new average inflation targeting strategy; 3) demand for extra yield over government bonds is strong; and 4) valuations are at median levels versus history.
Within credit, we continue to favor high yield and think spreads could potentially tighten around 100 bps more over the coming 6 – 12 months. Defaults spiked in the April – July period but have already come down, and we expect a drawn-out default cycle with slightly elevated defaults relative to the long-term average of 4%. We prefer high yield to bank loans given the prospect of short-term yields staying at zero for several years. We also think “fallen angels” (downgrades from investment-grade to high yield) will remain elevated into 2021 as some companies struggle with deteriorating credit metrics. Fallen angels have historically added to high-yield returns (Figure 3).
We see securitized assets as a way to express a positive view on residential housing, though we are cautious on commercial property like malls and offices. With mortgage rates below 3%, unemployment declining, and millennials — now the largest age group in the US — creating a large source of demand, we see tailwinds for sectors like workforce housing and credit-risk transfer. We are moderately bearish on emerging market debt, especially USD-denominated sovereign debt. These economies have been hit by higher government spending and, given their export orientation, the global slowdown. We find corporate debt, with fewer sovereign-related problems, a more attractive option for EM debt exposure.
The biggest near-term risk is the US presidential election. Uncertainty surrounds the process and we think the potential for post-election civil strife is quite high. Risk markets are also likely to initially react poorly to a blue-wave scenario in which Democrats win the White House and control both houses of Congress, paving the way for higher corporate taxes and more regulation (Figure 4).
However, we are more focused on longer-term risks, including COVID-19 developments. Markets are optimistic that a safe, effective vaccine will be ready for distribution in 2021, so a disappointment on this front or a second wave of the virus in the fall or winter could derail the global recovery. In this scenario, we think more stimulus will be forthcoming.
Given our fairly balanced views, we also consider upside risk. We see three potential catalysts that could cause a definitive rotation into value-oriented sectors, which include non-US equities, deep cyclicals, commodities, EM equities, and EM currencies:
- Vaccine — If a safe, effective vaccine comes to market, distribution begins sooner than expected, and take-up is strong, growth expectations would likely rise.
- US dollar weakening — If global economic conditions stabilize and the US dollar weakens further, EM and cyclicals could outperform DM and defensives.
- Valuations — Despite the gaping valuation disparity between growth and value, we believe mean reversion requires a catalyst. Given starting valuation levels, should either of our first two scenarios come to fruition, we would expect a growth-to-value rotation to gain momentum.
Looking beyond the election — An election-related spike in volatility seems likely in the near term, but we expect the course of COVID-19 and fiscal and monetary policy to ultimately have more sway over markets.
Leaning toward growth in equities — We prefer US equities, as we think they could retain their premium given the slow recovery we expect over the coming year. Given the upside risks described above, we have a neutral view on non-US equities and see the case for taking profits in technology (but staying long) and moving into higher-quality value-oriented companies that are more exposed to a cyclical upturn within retail, financials, and industrials. Within emerging market equities, we prefer China for growth exposure.
Seeing more spread-tightening potential in credit — Spreads have narrowed but are still around median levels as of this writing. Given the Fed’s unprecedented support for credit, we think spreads will continue to grind tighter. We are less optimistic about EM debt given poorer fundamentals. Securitized assets are not the target of Fed credit programs, but the market offers exposure to the improving US residential housing market.
Diversifying with high-quality bonds — We think agency mortgage-backed securities and high-quality government bonds can potentially boost a portfolio’s diversification and liquidity if the recession is deeper or longer than we expect. We think taxable investors should consider municipal bonds given attractive valuations.
Enhancing diversification with precious metals — Given rock-bottom fixed income yields, we think precious metals can potentially play a role in boosting portfolio diversification and mitigating the effects of a stagflationary environment and geopolitical tensions.