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- Potential treatments/vaccines for COVID-19, policy support, and gradually reopening economies make us more comfortable adding risk over our 12-month time frame.
- However, the market’s sharp rally 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 value-oriented sectors are attractive near term.
- We think rates will stay low and find credit spreads attractive relative to government bonds.
- Downside risks include a second wave of COVID-19, a deeper and longer recession than anticipated, worsening US-China relations, and Brexit. Upside risks include reflation and US-dollar weakness.
GLOBAL EQUITY MARKETS HAVE STAGED A REMARKABLE REBOUND OVER THE PAST FEW MONTHS, retracing 73% of their COVID-19 decline as of June 22. The speed and magnitude of the risk rally is unprecedented relative to past economic shocks, so it’s understandable that investors are asking whether there’s a disconnect between the market gains and the economic fundamentals. In the short term, we think the market recovery is justified: Treatments and vaccines for COVID-19 are likely on the horizon, monetary and fiscal policy support is strong, and economies are slowly reopening (Figure 1).
However, after the initial burst of economic improvement from ultra-depressed levels, we expect a slower pace of recovery. In addition, since the fundamentals are dependent on the course of and treatments for a disease, and recovery from a unique and drastic shock, it’s difficult to have a high degree of confidence about the path of the global economy. Taking all of this into account, we think volatility will remain elevated over the next 6 – 12 months and have tilted our views only modestly in favor of more aggressive exposures, leaving us fairly neutral across asset classes.
We continue to prefer US equities given our expectation that global growth will recover slowly and to a weak level. 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 and find many areas of credit attractive. We believe the COVID-19 shock is deflationary and, consequently, think commodities could be a source of funds.
Equities: A balanced approach
Our moderately bullish view on US equities stems from the less cyclical nature of the economy and the potential for the market’s heavy growth and tech exposure to continue outperforming. While value may have its day in the sun during the initial economic recovery, we think the post-COVID-19 world could closely resemble the post-financial-crisis world, with aggressive monetary stimulus, low growth, low rates, and low inflation. Against this backdrop, we expect growth equities to outperform over the next year, despite rich valuations.
We have upgraded our view on Europe to neutral based on the region’s progress toward recovery from the virus (or at least its first wave), solid monetary and fiscal support, and cheap valuations. The European Central Bank is committed to containing sovereign spreads for at least another year, and German fiscal stimulus has surprised on the upside. However, Europe remains highly exposed to the unsettled global backdrop and must reckon with Brexit by year end.
We have also raised our view on Japanese equities to neutral as the policy response has exceeded our expectations and the country has been relatively unscathed by the virus. Despite cheap valuations, however, Japan’s equity market is very sensitive to changes in the global economy and the path there may be too bumpy to justify exposure to Japanese equities.
Emerging markets are a heterogenous asset class and country differentiation is key. We find some countries and regions attractive, including China, Russia, and Eastern Europe, but see reasons to avoid others, such as Brazil, Turkey, and South Africa. Broadly speaking, we think emerging markets may suffer the most in the second half of 2020 as weaker health care systems and safety nets are stressed by the COVID-19 outbreak. We are comfortable with a neutral stance, however, and think a scenario where a stronger global recovery or a weaker US dollar benefits EM equities is realistic, though not our base case (Figure 2).
Credit: Have spreads come too far?
Like equities, credit has had an extraordinary run this past quarter, with spreads narrowing hundreds of basis points in many cases. Despite that, spreads remain cheap and the Fed’s credit purchase programs give us confidence that they could narrow further and potentially provide attractive total returns over the next 12 months.
The Fed has the potential to become an enormous buyer of credit with its newly created Primary Market Corporate Credit Facility (PMCCF) and Secondary Market Corporate Credit Facility (SMCCF) programs. The combined US$750 billion of buying power represents 42% of the outstanding universe of investment-grade corporates with maturities of five years or less, and we think it effectively short-circuits the process of liquidity risk becoming solvency risk for stressed companies (see “The Fed’s credit-purchase programs are a game changer”). The Fed’s purchase programs also include high yield ETFs and “fallen angels.” While recessions have typically meant peak default rates in the 10% – 13% range, we believe access to liquidity could keep the default rate under 10%.
Within credit, we find emerging market debt less attractive. Valuations are more expensive and, with many large countries in the EM debt index, such as Brazil, Mexico, and Turkey, still battling rising COVID-19 case counts, we think fundamentals are likely to worsen.
The securitized market includes a broad mix of asset types and properties, so security selection is paramount. In addition, the Fed’s buying programs have bifurcated the market into “haves” and “have nots,” depending on whether an asset is included in one of the programs. To the extent one can generalize, we prefer structures in the residential property market over those in the commercial property market. We are cautious on malls and offices compared to industrial and multi-family properties. Meanwhile, housing affordability, based on home prices, income, and mortgage rates relative to household income, is high and housing supply is low. With a pickup in the housing market emerging, the credit-risk transfer market may offer a way to take advantage of these dynamics.
The biggest downside risk to our views is that the recession is longer than anticipated and risk assets correct. A disappointment on the medical front, a resumption of lockdowns in areas where there are new outbreaks of COVID-19, or a second wave in the fall could derail our base case that we are on a path to recovery over the coming year.
While the growth rate of COVID-19 is rising in emerging markets, it is declining enough in the developed world for us to consider an upside risk: the possibility that the economic recovery is stronger than our base case and the recent leadership in value persists. In that scenario, cheaper areas of the market, such as non-US, smaller-cap, and deeper value equities, could potentially outperform. Further US-dollar weakness could also be associated with a risk-on environment, especially in emerging markets.
While COVID-19 has been the number-one preoccupation of market participants, there are other risks to consider, including a potential uptick in political risks. US-China relations have deteriorated during the year. If President Trump’s reelection chances worsen as the November election approaches, the administration might pull out of the Phase 1 trade deal or otherwise increase trade tensions (Figure 3). In addition, a Joe Biden presidency would likely mean increased regulations and taxes. The pandemic and the riots that erupted after George Floyd’s death have brought heightened attention to gaps and inequities in health care, education, and opportunity, and could push Biden’s platform further to the left.
Brexit is also looming. While we think the European Union (EU) recovery fund has greatly reduced the tail risk of a euro breakup, it seems more likely that the UK and the EU won’t have an agreement by the end of the year and that there will be some form of hard Brexit.
A balanced approach to 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 risk in the near term, we have a neutral view on non-US equities.
Value for the short term — We see a short-term case for some exposure to value-oriented markets and sectors, including financials and other cyclical areas in industrials and consumer discretionary. Longer term, we think tepid economic growth could continue to make technology a relative winner, on the strength of 5G expansion and the growing demand for data, speed, and enterprise software.
Opportunities in credit — Spreads have narrowed but are still well wide of median levels. Given the Fed’s unprecedented support for credit, we think spreads will continue to grind tighter. We are less optimistic about EM debt given valuations and poorer fundamentals. Structured credit is not the target of Fed credit programs, but the market offers exposure to the improving US residential housing market.
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.