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Weekly investment update – Is this time different?

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BNP Paribas Asset Management
 

The sharp year-end rally in stocks extended into the first weeks of the New Year. Investors are now reassessing the valuations of risk assets as the spread of COVID-19 mutations along with logistical issues in manufacturing/distributing vaccines threaten to delay the economic recovery. We are neutral on our allocation to equities and await more favourable market entry points.  

Where is the way out?

The most important basis for economic performance in 2021 is the authorities’ success in tackling COVID-19. Over the last week, there has been further confirmation that three mutations of the virus are spreading across Europe, forcing governments to impose/extend social restrictions. These new constraints on mobility along with evidence that vaccine manufacturers will struggle to deliver all the doses as scheduled are raising market concerns over a weaker or delayed economic rebound.

Economic impact of extended lockdowns

In updating its forecasts, the International Monetary Fund split the economic prospects around the world into three broad groups:

  • China and the US, which the IMF expects will quickly recover almost all of the ground lost in the COVID-19 crisis. In China’s case, this is explained by an effective curbing of the pandemic. The US has struggled to contain the virus — which continues to spread at a rapid, albeit slowing, pace — but its new government plans more fiscal stimulus than almost any other country. This decisive approach earns the US plaudits from the IMF.
  • Other advanced countries are in a middling group, with a deeper economic downturn and slower recoveries. Greater policy support would enable these countries to do better. For example, Germany, where the economics ministry is expected to cut its growth forecast for 2021 from 4.4% to 3%.
  • Emerging economies with the exception of China. These countries have been hit hardest according to the IMF and will sustain the greatest lasting damage from the crisis. Their efforts to contain the virus have not been as effective as in China. Oil exporters and tourism-based economies were hit especially hard.

Fourth-quarter 2020 US GDP growth figures will be released this week; consensus forecasts suggest 3.3% growth (seasonally adjusted annual rate) compared to the third quarter.

High-frequency survey data are pointing to COVID-19 restrictions in the US leading to an underwhelming recovery in the near-term, with Q1 expected to be the trough in growth in 2021.

It is clear that as elsewhere, Q1 GDP risks are to the downside for the US, given the severity of the new COVID-19 wave and the potential for deeper and more extended lockdowns or delays in vaccine rollouts.

Strong earnings expected in the US and Europe  

In the US, the Federal Open Markets Committee (FOMC) meets this week. It is expected to reinforce its commitment to an accommodative monetary policy stance and firmly push back against any speculation of a move towards a tapering of central bank support or a rise in rates before 2023.

Near-term risks to the outlook and long-term economic scarring are damping the likelihood of a tapering being considered this year. It is only in 2022 that we would expect policymakers to become comfortable enough that “substantial further progress” has been made towards the Federal Reserve’s dual mandate, and to move towards tapering, potentially in the beginning of 2023.

Last week, the European Central Bank re-emphasised the importance of maintaining favourable financing conditions. The ECB’s message is clear: it will pursue policies to ensure financing conditions remain supportive. Given the downside risks to the economic outlook, there seems little prospect of the ECB’s governing council making any meaningful change in policy.

Resistance to the Biden administration’s USD 1.9 trillion COVID-19 relief package appears to be rising among Republicans and it is possible that the plan will be cut to around USD 1 trillion. It looks feasible that this round of relief can be secured by mid-March despite negotiations in the US Senate over operating procedures and the looming impeachment trial of former Republican President Donald Trump.

For fourth-quarter 2020 earnings, initial reports in the US have pointed to the continued dominance of the tech sector amid the pandemic-induced shift in consumer spending patterns. Analysts expect a strong rebound in earnings per share in 2021, with annual growth expected to be above 20% in both the US and Europe, albeit from depressed levels in 2020. That said, this year’s earnings recovery appears to have been discounted well in advance with market valuations at or near all-time highs.

Exhibit 1 US equity markets

Is this time different?  

Against this background, support for equity valuations is being tested further by concern that the new COVID-19 wave could prove more severe than expected, resulting in a more protracted downturn and further pressure on company fundamentals.

In addition, there are increasingly concerns over a speculative bubble in stocks. Federal Reserve data[1] show that thanks to last year’s strong returns, equities now represent a high share of US household assets. Among the main US stock indices, the NASDAQ is up by 83% over three years. This compares to a 285% rise in the three years through March 2000 (this was followed by a 77% fall over the next two years). The broader S&P index is up by 36% over the past three years. That is a strong rally, but arguably, it is not excessive: the index rose by 93% between 1997 and 2000. The big difference today is of course the absence of yield in fixed income markets.

Central banks have remained firmly committed to locking in low bond yields and stock markets have priced in rising earnings and ample liquidity. This should underpin market valuations. Nonetheless, we are on the lookout for more attractive entry points as markets re-evaluate the way out of the pandemic.


[1] See Longest Bull Market In U.S. Stocks Bid Adieu But Not Before Flashing Warning Signs and Households and Nonprofit Organizations; Directly and Indirectly Held Corporate Equities as a Percentage of Total Assets, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BOGZ1FL153064476Q


 

Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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