Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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EM equities outperform as growth outlook improves
Peter Garnry
Chief Investment Strategist
Summary: Equity markets continue to rise as further evidence from OECD suggest the economy is rebounding led by Asia. Our current allocation view is to remain overweight Europe and EM equities, and underweight US equities. The earnings season starts this week and while EPS y/y will be another negative print investors will focus more on the outlook. We expect the technology sector to be the best performing sector in this earnings season.
We started the year with several predictions in 2020 and our current allocation view. One of our key views is to be overweight emerging market and European equities, and underweight US equities while staying selectively overweight the US technology sector. This allocation is based on two assumptions, 1) that equity markets behave according to history when the economy is a recovery phase and, 2) Europe will benefit more than the US from the rebound in Asia. So far, we have been right on EM equities outperforming US equities while European equities are a little behind. The rebound trade got more support today with South Korea exports y/y improving more than expected although the nominal figures are flat q/q.
Adding to the positive equities vs bonds trade is the OECD leading indicators released today revising some prior months data. The indicators are now suggesting that the growth momentum in the global economy bottomed in August last year and has been rebound ever since. This observation fits with this machine learning recession probability model that we are tracking. However, despite the recession probability has declined it still remains at 32% for the US economy within the next 12 months. But it looks increasingly like governments and central banks avoided a recession again. The cost short term looks small but the fallout will be a more leveraged system which imply a harder reset when the economy one day runs out of steam.
Equity valuations on the MSCI World Index rose to one standard deviation in December eclipsing the high from January 2018 and are now on par with the levels in 2007. US equity valuations are now at 1.2 standard deviations and now moving in on the levels observed during the dot-com bubble. What we are likely observing is the effect of investor expectations anchoring at very low interest rate levels in the long term. In this scenario, even a low growth economy, stable cash flows from stable companies will be bid up massively in price mimicking a bond with a credit and recession risk spread implied in the free cash flow yield.
While we do acknowledge various dangers to the equity market our view is that momentum remains strong. Implied equity volatility suggest more positive equity returns in the near term and investors are adding the least protection in option markets to protect the downside. This is positive short term but it also comes with the risk of a much larger drawdown when the equity market naturally resets temporarily.
The earnings season starts week and will be the fourth quarterly EPS decline y/y for US companies but the market is looking beyond that. As long as company outlooks start to improve and macro data on balance improve then equities will hold the line. We expect the technology sector to be strong during the earnings season together with financials and health care stocks.
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