Mid-year outlook: Asset class views
Although there has been a remarkable economic rebound since mid-April, suggesting a V-shaped recovery on the back of policy support and easing lockdowns, the positive reopening momentum may be experiencing its first setback. Rising new COVID-19 infections being seen across certain states in the U.S. raises concerns that these regional spikes could be accompanied by a new round of social distancing measures or lockdown restrictions.
As we enter into the second half of the year, focus will remain on the spread of the virus and how economic activity responds. As a follow-up to our recent mid-year outlook, this week’s Top Market Takeaways will dig into a Q&A on our high-level asset class views.
Equities: Stay cautious, be selective
Q: We went from all-time highs in February to the swiftest bear market decline by March, as investors lost foresight into how corporate earnings might hold up. What is our overall U.S. equity view?
A: Equity markets price off two inputs: earnings expectations, and what investors are willing to pay for those future earnings (i.e., the multiple). Global lockdown measures in the first half of the year froze demand, inevitably dragging earnings lower. As such, we expect 2020 earnings for the S&P 500 to come in around -17% lower versus 2019.
Importantly, the market already accepts that 2020 is going to be a horrible year – and thus investors are now looking through it and thinking farther ahead to determine what they’re willing to pay for stocks. As economic activity resumes, we expect earnings to recover back to around 2019 levels in 2021. We don’t expect the recovery to be linear, but we do assume that there’s no widespread re-imposition of lockdowns, combined with the arrival of a vaccination program in 2021, and therefore, the avoidance of more permanent economic damage.
On multiples – there’s pushback that valuations are too high right now (the long-term average is 16.3x the next twelve month earnings, and we’re at 21.8x right now). But consider the bigger picture: the Fed has said it will keep policy rates at zero through 2022, we’re still seeing high levels of cash flow generation, and shareholder yield dynamics are positive.
Putting that together, we think the S&P 500 could end the year around a level of 3,250 – 3,350. For context, Friday’s closing level was 3,009.
Q: Looking outside the U.S., where do we see a compelling risk/reward profile?
A: Beyond the U.S., we also like markets in France, Switzerland, China, and Germany. The common denominator is a more positive view of the consumer, technology, and healthcare sectors as they benefit from the “new normal”.
This is a realization that consumers have pent-up demand for goods, will spend on their work-from-home environment, and purchase goods online. Businesses will adjust to the impacts of the health crisis and external stimulus, accelerating spending on digitization and cybersecurity. Meanwhile, we expect rising valuations for innovative healthcare products and solutions as we conquer this crisis.
Q: Given expectations for moderate broad market returns, what sectors offer more upside opportunities?
A: Focus on three key areas:
- Digitization and innovation: Believe it or not, the data suggests that e-commerce penetration in the U.S. is only 17% and has grown over 50% since the start of the pandemic. Also, healthcare innovation has been focused on large end markets like diabetes, oncology and cardiovascular disease. The focus on treatments and a vaccine for the COVID-19 virus highlights the need and opportunity for innovative technologies.
- “Home is where the heart is”: The virus has forced everyone to spend more time at home. Record high consumer savings rates of ~33% in April (+13% vs. March) combined with the aging of millennials into family-hood, potential suburban migration, and exceptionally low borrowing rates are helping to create a societal change. Spending in the home category is surging and we think will be sustained given low interest rates and continued new home supply shortages.
- Catch-up trades: Selection is key here, and we suggest a tactical approach. We think the pandemic has delayed (rather than destroyed) a lot of spending. We think this could lead to the recovery of things like transportation, home buying, semiconductors, consumer lending, personal travel, and elective healthcare procedures that were postponed during the crisis.
Q: What are the risks, and what areas of the market should we stay away from?
A: One of the biggest risks, of course, is that second waves of the virus overwhelm healthcare systems and force economies back into lockdown. We’re also keeping a close eye on the U.S. election.
In terms of what we want to avoid: we’re looking to trim exposure in certain cyclically-exposed areas of the market as they rally, including Energy. Sure, we could see a recovery into 2021, but current valuations seem too high for the risk associated with the highly levered, structurally disadvantaged group. Longer-term, fossil fuels look challenged by renewables, which are being supported by improving technologies and more conscious consumers. Airlines are another segment to avoid as business travel, which represents 65% of industry profitability, will be slow to return to 2019 levels. Balance sheets will need time to heal. Finally, a look at positioning suggests that investors have overpaid for safety, so we are less positive on Staples and Utilities, which are currently trading above their historical averages.
Fixed Income: Neither a borrower nor a lender be? We don’t agree.
Q: If the zero rate environment is here to stay, where can investors find yield?
A: With policy rates pinned at zero around the world and asset purchase programs seem set to keep sovereign yields low for a long time, the hunt for yield is on. Anything with spread looks more attractive to us than risk-free rates. We like upper tier high yield the most, followed by investment grade and select emerging markets. Cash is certainly not king. Policy rates in the developed world will likely be pinned at zero (and in negative territory) for the next few years.
Q: How can investors take advantage of low rates?
A: Borrowing costs have fallen across maturities, and the Fed’s commitment to reducing spreads is powerful. Three-month LIBOR has fallen below 30 bps for the first time since 2015, and 30-year mortgage rates are at all-time lows.
Investors looking to augment yield could consider adding modest leverage to fixed income portfolios. Using this level allows investors to meet a yield target without adjusting either credit or interest rate risk. In particular, investors could consider levered carry trade opportunities as the majority of credit spreads are above a conservative estimate of credit cost. Leverage certainly isn’t for everyone, but it can be a powerful tool to use in this environment.
Currency and Commodities: Diversifying away from the U.S. dollar
Q: After a period of strength, what is our view of the US dollar?
A: We think this period of U.S. dollar strength is finally coming to a close. Dollar strength over the better part of the last ten years was driven by relatively high sovereign yields and the fact that the U.S. offered relatively strong economic growth during the uneven recovery. Now that the Fed has cut rates to zero and U.S. Treasury yields have dropped to secular lows, the yield advantage after adjusting for inflation has disappeared. Importantly, as the global recovery from the COVID shock gains traction, we believe that risk sentiment will improve, and capital that was seeking a safe-haven will flow towards more compelling yield and return opportunities than USD cash. Multi-currency investors should consider hedging their exposure to U.S. dollars, and we believe that the Euro in particular has room to appreciate, especially if the fiscal transfer scheme that the Germans and French are proposing becomes a reality.
At the same time, commodities that are quoted in dollars look attractive. Gold could be supported by U.S. dollar weakness and low real yields, and oil could continue to be supported by the ongoing supply adjustment.
All market and economic data as of June 29, 2020 and sourced from Bloomberg and FactSet unless otherwise stated.
For illustrative purposes only. Estimates, forecasts and comparisons are as of the dates stated in the material.
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