Economic data releases – broadly – continue to surprise on the upside, with surprise indices near record highs. China is benefiting from its first in / first out status, with exports showing surprising resilience throughout Q2, even if domestic demand has been slower to recover. US data has been particularly strong and will likely need to remain buoyant in order to support sentiment. In Europe, data has steadily improved, but remains below pre-crisis levels. Crucially, though, the agreement on a EUR750 billion Recovery Fund that will see common debt issued by the European Commission and grants to the worst-hit European countries is a game-changer for the longer-term prospects of the Old Continent. The next step toward further cooperation and integration has been taken. US “Phase 4” negotiations are moving slowly, but an agreement is expected – and necessary for the recovery and for sentiment.
In our view, even if it is bumpy, as long as the recovery continues, markets should manage to grind higher. Admittedly, a number of hurdles are on the path ahead, but we believe they will be overcome, likely with higher volatility, but with limited corrections. Indeed, sentiment and positioning remain bearish, cash levels are elevated, and fiscal and monetary support is set to continue. Most investors missed the rebound so far and are likely to see corrections – as we do – as better entry points for the longer term, suggesting the downside is more limited.
Moreover, none of the risk scenarios ahead should completely derail the recovery. We do not expect new broad lockdowns, as cases appear to be peaking in a number of southern states in the US, but mostly because hospitalization levels remain manageable. We believe that rising tensions between the US and China will remain contained and not lead to significant economic consequences and the US election is likely to bring higher volatility as it nears, but not a sharp sell-off. In addition, Q2 earnings, so far, have proven better than expected. As such, we are constructive on equities.
Conversely, we expect bond markets to remain “boring,” with low for longer sovereign yields thanks to central bank actions. As equity markets move higher, credit spreads should also resume their downward path. We maintain a preference for investment grade (IG) credit over high yield (HY) where default risk persists, although selective opportunities exist. We continue to see opportunities in emerging market debt, particularly in the less volatile hard currency corporate space, where spreads have yet to recover meaningfully.
We believe that sentiment is likely to break out on the upside, as better news has continued to come through and appears to be winning the battle against fears of a second wave. Yes, plenty of hurdles remain, including US/China tensions, US elections, Q2 earnings and US fiscal negotiations, and volatility is likely to rise, but we believe the most important driver is the continued economic recovery. As long as we can continue on the path, markets can gradually move higher.
Valuations have risen, but should not be a hurdle to market advances as long as risk appetite remains supported by the economic recovery and monetary and fiscal stimulus. Nonetheless, we will keep an eye on Q2 earnings season, though so far results have held up better than expected.
The agreement on a EUR750 billion European Recovery Fund, while already mostly priced in, should help European assets continue to play catch-up to the US, as the prospects of further fiscal cooperation and integration have virtually eliminated the risk of a euro breakup. European financials should additionally benefit from European Central Bank support and continue their recent bounce.
We remain underweight emerging markets given concerns surrounding the COVID crisis in many large economies, and have a preference for emerging Asia.
Central bank actions continue to make the bond market rather boring, with sovereign bond yields set to remain low for a very long time. We maintain our preference for credit over sovereigns, as there is potential for spread compression to resume with improving risk appetite. However, we believe that peripheral yields will continue to fall thanks to the European Recovery Fund and the upcoming European Commission issuance of common debt. We therefore have an overweight to Italy and Spain.
We remain overweight US and European investment grade credit for enhanced carry, but remain more cautious on high yield as the extent of the damage from the crisis is still unknown and default risk remains elevated. In addition, if markets become disorderly again, central banks are expected to favor protecting IG over HY.
We see select opportunities in emerging market debt, particularly in hard currency corporates that have more potential for spread tightening and are typically less volatile. However, given difficult situations in many countries, selectivity is key. We believe emerging market currencies should benefit from dollar weakness, but on a selective basis as well.
The US dollar continues to slide, breaking through long-holding resistances on trade-weighted indices as dollar demand recedes following the crisis and the euro strengthens thanks to the European Recovery Fund and improving risk appetite. Sterling could see more volatility as the crisis has not been handled well and fears of a hard Brexit may come back since little progress has been made on trade negotiations with the European Union. Emerging market currencies should benefit from a weaker USD, but idiosyncratic risks remain.
Oil prices have benefited from the nascent economic recovery, but are still likely to be capped given ongoing oversupply and a slow pick-up in demand. Over the medium term, prices should rebound further as supply and production balance out, but we still expect supply to remain ample. Gold should continue to see underlying demand as a safe haven, given inflation expectations and central bank QE1 programs.
We continue to see a place for alternatives in portfolios, as we look for de-correlating and diversifying strategies to complement traditional asset classes. We believe that real assets can also help provide income in a lower for longer world.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed are as of July 23, 2020 and may change based on market and other conditions.
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