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- The global equity market rally was mainly driven by liquidity which in turn, pushed company valuations to levels last seen during the dot-com bubble.
- With a lack of corporate guidance, stock markets currently carry a high level of risk due to a large dispersion in earnings estimates.
- We expect range-bound trading for markets in Q3, which has led us to place more emphasis on thematic investing and alpha generation instead of pure beta exposure.
Overall, we remain bearish on global equity markets which is reflected in our underweight equity positioning. The main factors which contribute towards our conviction are the over-stretched valuations for global stocks, lack of guidance from companies and the fragile economic recovery. The main risk factors for our view are bearish positioning of market participants (which is a strong short-term bullish signal) and the ‘whatever it takes liquidity’ that has been injected into markets.
Our underweight view is driven in part by the highly associated risks embedded within equities. The number of companies issuing quarterly guidance was an order of magnitude lower relative to the usual average number. This lack of pivoting points has led to a rise in dispersion for corporate earnings estimations for the next 12 months. With Q2 earnings season imminent, we anticipate that companies will provide sufficient data to generate a base case scenario for future corporate cash flows. This removal of the ‘unknown’ should help to decrease risk – although if guidance is lower than currently expected this could result in a negative equity market reaction. We anticipate that this reduced risk should form a more appealing investment case for certain stocks on a risk-adjusted basis.
“As a base case scenario we expect global stock markets will be range-bound during the third quarter.”
A buy and hold strategy is likely to be less successful in Q3 as it was in Q2. For our model portfolios, we continued to increase exposure to more alpha generating ideas through thematic stocks and sector convictions with a much smaller allocation to equity beta.
Given our expectations for a weaker US dollar, as James Gutman writes about in the macro section, from a geographic perspective we prefer Europe, UK, and Japan to the US. While as we are cautious with regard to debt levels nominated in foreign currencies, namely in USD, EMs remain our least preferred markets.
Sector wise we still consider the IT industry and particularly those companies which are engaged in sectors that are either new or have been substantially accelerated by the virus outbreak already existing structural changes in the economy as an attractive investment. Possible cross-asset switch between equities and fixed income makes attractive a set of high dividend-paying stocks from non-cyclical industries. Among recovery stocks and industries, we prefer stocks of Global major oil producers not engaged in the US shale oil industry as best exposure to rising crude oil prices and a set of stocks from the European car manufacture industry as exposure to the recovery in car sales.
The US government delivered the most aggressive fiscal response to the crisis globally, in excess of 13 per cent of national GDP and more than twice the size of the response delivered during the global financial crisis in 2008/09. The ‘Paycheck Protection Program’ will be spent out in July which provides an additional $600 per week in unemployment benefits will end on 31 July. With the federal deficit reaching 23 percent of GDP we remain concerned due to the amount of future spending that is being brought forward through government expenditure. US stocks are expensive relative to their historical average with the next 12-month forward price-to-earnings is equal to 21.8 vs 15.3 an average since 2010.
The main upside may come from sentiment and technical indicators. Speculators remain net short of S&P500 futures contacts. According to American Association of Individual Investors as of 2 July, there were almost twice as many bears than bulls. Overall, it shows that risks are well understood and reflected in current positioning. When positioning is underweight equities and sentiment is bearish, as it is today, stocks are more likely to go up than down.
From a purely technical perspective, the S&P 500 continues to look very bullish on a longer-term timescale. The index (currently above all major moving-averages) is up close to 20% in the second quarter of 2020 and has been consolidating in what appears to be (yet another) bull flag between 3000 and 3150 – a break of which could spark a trend change to the downside or target the previous all-time closing high of 3383 to the upside. Momentum indicators are not flashing any warning signs.
We pointed out at the end of Q1 that the FTSE 100 Index is heavily skewed towards financials, energy, materials, and industrials which account for more than half of the index. This set of sectors got hit the most during the recession. Consistent with this view FTSE 100 was up a modest 9.6 percent versus 19.6 percent for MSCI World in the second quarter. We do not expect this underperformance to continue as the energy, materials and industrials sectors should catch up with the global business cycle having bottomed.
With GBP fixed income instruments offering increasingly less attractive returns, we also like UK utility producers as they are paying high stable dividends with relatively inelastic revenue streams and enjoying low variability of their financials.
Similarly to Europe we remain negative on UK banks. With the Bank of England having lowered the base rate by overall -0.65 per cent to 0.1 percent in March 2020, they will struggle to generate sufficient net interest margins in this interest rate environment. Given the recessionary environment and the impact of the virus we also anticipate ongoing credit portfolio impairments.
Valuation wise UK equities remain expensive, but in contrast to their peers from the US and Europe the next 12-months forward price-to-earnings ratio for FTSE 100 at 15.9 is much closer to its 10-year average value of 12.7. Sentiment indicators show that risks are also well understood and reflected in current positioning.
Technically, similar to the SX5E, the FTSE 100 has still not managed to break above its 200-day moving average. Immediate trends appear to be pointing down, but a break above 6340/45 could change that and spark buying into 6500/10, a break of which targets 6750/60 and then the March high of 6850/55.
Staying underweight equities overall, we prefer Europe relative to the other equity markets. In the Eurozone, Germany – known for its austerity – delivered the second largest (as a percent of GDP) fiscal stimulus package globally. Excluding loan guarantees, it amounts to €0.44 trillion or 12.9 percent of GDP. Other European countries delivered a much less ambitious fiscal stimulus with figures not exceeding 4 per cent of GDP. On top of that situation with the virus remains much more manageable compare to other parts of the world.
We favour a set of stocks from the European car manufacturing industry with a focus on operational efficiency and a strong balance sheet as selection criteria. We also considered and subsequently invested into stocks of European listed global major oil producers as an optimal exposure towards the ongoing oil price recovery. On the opposite side of the spectrum, we prefer to avoid European bank stocks. A negative/zero interest rate environment is especially harsh for banks to make consistently strong net interest margins.
With the next 12-month forward price-to-earnings staying at 18.7 vs 12.9 10-year average European stocks do look expensive relative to the history. While sentiment indicators show that risks also are well understood and reflected in current positioning. The Eurostoxx 50 has been rangebound for over 2 weeks now between 3150 and 3300. Price continues to look very strong but remains below its 200-day moving-average of 3368. The immediate trend is on watch as it appears to be flipping and pointing down.
The Bank of Japan has been a pioneer in implementing unconventional monetary policy. The low cost of borrowing has negatively impacted investment returns and the Nikkei 225 has been traded range-bound for almost two decades. Now, it remains close to the top of the range which we do not expect it to break out of anytime soon.
Japan announced the third largest (as a percent of GDP) fiscal stimulus package globally. Excluding loan guarantees, it amounts for JPY 63.5 trillion or 11.4 percent of GDP and similarly to Germany it is multiples of the size delivered during the global financial crisis.
Valuation wise, Japanese equities with a next 12-months forward price-to-earnings ratio of 19.9 remain close to the peak of the 10-year range. Sentiment indicators also show that risks are well understood and reflected in current positioning. When positioning is underweight equities and sentiment is bearish, as it is today, stocks are more likely to go up than down.
Technically, The Nikkei 225 has been consolidating for more than two weeks now, trading between 21900 and 22700. Immediate trends are on watch as they appear to be slipping lower, but longer-term timeframes continue to look very strong with price above most major longer-term moving-averages, including the key 200-day moving average A break above 22700 could quickly see a run towards 23200, after which, this market is only a stone throw away from new all-time highs above 24000
Emerging markets remain our least preferred area for exposure – primarily due to local central banks and fiscal authorities limited ability to implement policy responses. High debt levels denominated in foreign currencies, mainly US dollars, are heavy constraints for emerging market economies. Overall, the value of monetary and fiscal responses is nowhere close to developed market peers. The monetary stimulus will lead to currency depreciation and capital outflow. We have already seen that, with the exception of China, quarantine measures have been much more limited in emerging markets than in comparison to developed markets. Looking forward we like the technology sector given the focus of helping some developing economies overcome their infrastructural hurdles.
Valuation wise the MSCI Emerging Market Index trades at 14.7 for its next 12-months forward price-to-earnings ratio versus a 10-year average of 11.3. While sentiment indicators show that risks are well understood by market participants and reflected in their current positioning.
The technical picture for emerging markets as shown by the MSCI Emerging Market Index looks very strong. Most major moving-averages continue to point upwards. Like most other equity markets, the price has been consolidating over the past 2-3 weeks and is now sitting right around its 200-day moving average. A break below 988/89 could spark an immediate trend change and target the rising 50-day moving average at 949/50. Conversely, a strong break above 1015/20 could see us target the 1100 area.
Past performance is not a reliable indicator of future returns. Forecasts are not a reliable indicator of future returns. If the information is not listed in your base currency, then the result may increase or decrease due to currency fluctuations.
If not otherwise indicated, all graphs are sourced from Dolfin research, July 2020.
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