Introduction and review of our prior outlook
It was more difficult than ever to achieve a firm result from our meeting last week. Certainly, it is not easy to predict events due to the virus, but we also needed to predict not only the result of the US elections, but whether the market would have conviction of its result in the third quarter. Of course, we are not US political experts, but the experts recently have often been wrong and nearly all the investors are not experts either. So, in the interest of our clients, we make the best decision we can. Similarly it is with our credentials as epidemiologists.
On that latter point now, perhaps most importantly, we decided in late March that the odds were very high that the virus would dissipate in the developed world in a reasonably expeditious manner from a mid to late April peak. Indeed, new cases have declined in the OECD overall, while deaths have declined sharply. Unfortunately, in order to achieve such, the damage done by lockdowns, including to political and social systems, and the ability to recover from it, is still being discovered and was the main decision of our meeting. Political and social systems naturally clearly includes the US elections, as well as overall geopolitics and issues like Eurozone cohesion and China’s difficult relations with most of the developed world these days.
As for March’s meeting, we were correct to expect a strong risk rally, but MSCI World greatly exceeded our forecasts for June. Indeed, returns mildly exceeded our 29% estimated gain for next March, so in effect, all our projected annual gains were achieved in one quarter. It is hard to imagine anyone expecting equity markets to rally as much and as quickly as they did. Our forecast that 1H GDP would greatly undershoot consensus globally was mostly correct, though China is indicating it will be surpass such, as were our predictions that the USD would be slightly weaker, inflation would remain low, geopolitics would be basically under control and that the market would not be able to predict the US election as of end-June. Our prior view that fiscal and monetary stimulus would basically peak out in the 2Q seems mostly accurate, but there will likely be a bit more follow-through on such. Our view that commodity prices would decline in 2Q and stabilize thereafter was not correct, as OPEC successfully restrained production, while such in the US fell naturally due to low prices.
As always, our Global Investment Committee members have immense amounts of experience as leaders of our equity, fixed income and multi-asset teams around the world, so we hope to provide as solid advice as humanly possible. This time, we must be particularly humble by not placing a high confidence factor on our forecasts.
The global economy’s recovery should continue below consensus
In our new outlook, we assume that the virus remains basically under control in developed countries with a mild second wave and moderate social distancing rules, and although we look for a decent recovery, the G-3 and Chinese economies should moderately disappoint consensus in 2H20, and greatly undershoot consensus in 1H21. We also still believe that the recovery should have a disinflationary tenor globally.
For the US, GDP should be -1.0% Half on Half Seasonally Adjusted Annualized Rate (HoH SAAR, as used in all references below) in the 2H20 and 1.5% in the 1H21, vs the +0.2% and +5.5% consensus estimates. A decline of1.0% HoH doesn’t sound like a 2H recovery at all, but this is due to January and February providing a high base. Assuming 2Q consensus is correct at -34%, this would place the 3Q QoQ SAAR at around 13.5% (vs consensus of 15%) and the 4Q at +6% (vs +8% consensus). Thereafter, the 1Q21 and 2Q21 should return to normal growth of 2.0% QoQ SAAR. Personal consumption should continue to recover, while private capex will likely remain quite subdued, as pre-crisis projects finally get completed and new projects are less aggressive due to economic uncertainty in most business sectors. Government spending should contribute to growth, while net foreign trade will likely subtract moderately. Related to both demand and re-certification, the uncertain future of Boeing’s aircraft production will likely be a major factor for the amount of growth.
Eurozone GDP plunged the most in the 2Q, so its 2H rebound should look strongest among the G-3, but, at +5.0% HoH SAAR, it should trail the 5.9% consensus and its 1H21 should rise 3.0% vs the 6.5% consensus. Meanwhile Japan’s will likely be -3.0% and +1.0%, vs consensus estimates of -1.4% and 4.1%. The components of growth for Europe and Japan should be similar to that in the US, but the prospects for net foreign trade is a bit better. For CY20, growth for the US, Eurozone and Japan should be -5%, -8% and -6%, respectively. Lastly, China’s official GDP should be +18% HoH SAAR in the 2H20 and +5% in the 1H21, with CY20 GDP at +1%. China’s 2H is better than the G-3 because its crisis started early in the 1H. Overall, these G-4 GDP results should disappoint risk markets and keep fixed income markets relatively encouraged.
Non- economic factors remain a concern
There remain good reasons for concern about many geopolitical issues, especially regarding China and the Middle East. In times of crisis, leaders often turn to nationalism, and some countries may feel the West is pre-occupied with economic issues and will not respond to aggression. Although partially in a temporary truce, relations between the West and China remains fraught with danger. Meanwhile, the Middle East is even more a powder keg than usual, with Iran becoming increasingly desperate and Turkey involved in a strange form of proxy war in Syria vs Russia.
As if this was not enough to worry about, the economic impact of the virus crisis will greatly influence the US election. Although the public reaction to US President Donald Trump’s performance during the crisis is mixed, as it has been during his entire tenure, the market will likely continue to believe in the 3Q that there is an even chance that he will win the election, as the polls are likely unreliable. We believe, although not with much confidence, that he will lose but that the Senate will remain Republican. If Joe Biden cannot perform as a viable candidate, he will likely be successfully replaced after the convention by a different mainstream candidate. Even if the Senate remains Republican, a Democratic president would need to satisfy a very angry left wing via important cabinet positions and hyperactive executive actions and regulatory mandates. In such a case, the only thing a split Congress could prevent is major tax increases (although some moderate GOP senators may vote for mild tax increases and major additional fiscal spending), so the net result of political change should make risk markets and business leaders wary.
Central banks: Still all-in
The Fed’s massive, multi-pronged stimulus has likely peaked in intensity, but will likely remain very high, especially under a Democratic administration, in which fiscal deficits would likely remain at record levels, if not increase further. The ECB and BOJ are similarly all-in, although partly using different mechanisms. Perhaps the question now is what will the Fed not do? We do not expect negative rates, but there is a significant chance that it will adopt Yield Curve Control, pegging the 3-year bond around 0.3% in the 4Q20, hoping, like Japan’s case, for a gradually increasing yield curve in later durations. Whether US and foreign investors will conform to Fed YCC as successfully as Japan’s unique experience, remains very much to be seen, but that is a topic to be addressed beyond September.
There also remain many questions as to how fully high yield bond and credit markets, will survive, especially in the U.S. with its oil sector’s great reliance on such. The US shadow banking system also has a large reliance on risky credit markets. The economic ramifications of trouble from high risk credit markets will likely be large for the US, but much less so for Europe and Japan. China has a huge shadow banking system and its largest property companies have high leverage ratios and borrow in immense size, including in foreign currencies. Some of this will be resolved with government help, but not likely without significant pain to some of the companies and their creditors. At least property prices seem to be holding up well in China recently. In sum, globally, central banks are fully committed and are likely comfortable even being over-committed.
Flat USD and G-3 bond yields
We expect US and Eurozone bond yields to remain flat because they are pinned down by low central bank policy rates and continued QE. Also, while the global economic recovery should be negative for bonds, it will likely disappoint consensus. For US 10-year Treasuries, our target for end-September is 0.85%, while those for German Bunds and 10-year JGBs are -0.30% and 0.05%, respectively, with virtually no change through December. Regarding forex, we expect the yen and euro at 108.5 and 1.13, respectively, at end-September and end-December. This appears to be too little volatility for forex markets, but such is the trend in recent quarters and each region seems to be reasonably content around current levels.
This all implies (coupled with our forex targets) that including coupon income, the FTSE WGBI (index of global bonds) should produce a -1.3% unannualised return from our new base date of 12 June through September in USD terms, and -0.6% through December. Thus, at this stage, we have an unenthusiastic stance on global bonds for USD-based investors. For yen-based investors, this index in yen terms should return +0.1%, and +0.8% for those periods, with JGBs returning -0.2% for both periods.
Our Brent oil price forecasts are USD 41 at end-September, USD 43 at end-December and USD 52 next June, which contribute to our forecast of the U.S. CPI of 0.4% YoY in December and 1.8% next June, with Core CPI at 0.5% and 1.5%, respectively. Thus, at least regarding the CPI, the global recovery will be dis-inflationary in our view.
Global equities likely stalling
As the global economy looks disappointing globally, equity prices will likely decline slightly in the coming quarters. The 3Q is unlikely to be affected by concerns about the U.S. election, as the prospects will remain unclear, but in the 4Q, concerns will increase regarding the new Democratic Administration, although perhaps not at a high level until there are signs of GOP Senators compromising on higher taxes. Higher taxes, however, likely means additional US fiscal and, thus, monetary stimulus, which should help cushion the blow for global equities, with the BOJ and ECB likely matching additional US monetary stimulus. The likely surge in anti-business regulations and executive actions, however, will hardly be good for sentiment and potential profits or dividends.
Also of concern for markets will likely be disappointing 2Q earnings season and 2020 guidance globally. Although related declines may occur in June warnings season, the pressure should be significant in the 3Q, as there will likely be more negatives than positives. Even if no 2020 guidance is provided, 2Q warnings will likely negatively affect both CY20 and CY21 consensus earnings estimates.
In sum, we move to a slightly negative view on global equities, especially given the high risks and market valuations, at least in the US. Aggregating our national forecasts from our base date, we forecast that the MSCI World Total Return Index in USD terms will decline 2.8% through September and 0.5% through December (-1.4% and +0.9% in yen terms, respectively). Given all the risks present, this suggests a neutral or slightly underweight stance on global equities for both USD and yen-based intermediate term investors.
In the US, the SPX’s PER on its CY20 EPS estimate is now about 24, and 19 on CY21 EPS, which is expensive even given extended low interest rates. Furthermore, dividends are likely to continue to be cut in order for many companies to preserve their investment-grade rating (and even more so for high yield companies). Buybacks have greatly diminished and are unlikely to return in many sectors, but enough will remain to provide at least some support to some major parts of the market. Besides the continuing improvement in the global economy, one positive factor is that even a moderate rise oil prices will help aggregate earnings growth and the economies of producing regions. In sum, given disappointing 2Q earnings season (including warnings season) and CY20 guidance, we expect the SPX to decline to 2,918 (-3.5% total unannualised return from our base date) at end-September, before partially rebounding to 2,997 at end-December (-0.4% return), with yen-based returns being -2.1% and +1.0%, respectively.
European equities should perform worse than the US, despite the 2H rebound from its deep economic plunge. Europeans have lower confidence in their intermediate term economic future, while the global economy disappointing consensus will also hurt investor, business and consumer sentiment. The PER on CY20 EPS is high, at 21, and far from low at 15 times CY21 EPS. Importantly, dividends here too are likely to be cut quite a bit, especially as there are many Fallen Angel risks and high oil industry exposure, at least in the UK and the Netherlands. The downfall of one of Europe’s highest profile fintech companies due to apparently long-term fraud hardly helps sentiment either. We expect the Euro Stoxx index should fall to 330 at end-September, and FTSE to 5,700, which translates to returns of -3.8% (unannualised from our base date) for the MSCI Europe through then in USD terms (-2.4% in Yen terms). Returns through December should worsen, at -6.0% (-4.7% in yen terms) in our view, with the EuroStoxx and FTSE at 320 and 5,500, respectively.
Japanese equities have performed well but underperformed MSCI World since our last meeting. Year to date, they have outperformed, however, as the lockdowns were less severe, the BOJ has been supporting equities, valuations are low and leverage/credit excesses are minor. Valuations are reasonable, with TOPIX at 18 times CY20 EPS and 13.7 times CY21 EPS (although we believe that consensus earnings are somewhat too high) consensus earnings, while dividends, as we predicted in March, have not been cut much overall, so the market’s dividend yield is highly attractive, even by global standards, and is even more so in financials and some other sectors. Improvements in the global semiconductor and smartphone cycles (which previously hit Japanese semiconductor product equipment, electronic components and supplies very badly) and better Chinese demand for capex goods, especially for 5G infrastructure stimulus, should boost earnings and thus incentivize investors, especially foreigners, to return to Japanese equities. The auto sector, however, is a major concern, so that will have to be watched closely. Due to disappointing global factors, we expect TOPIX only to hit 1,585 at end-September and 1,598 at end-December, for total unannualised returns of +0.2% in USD terms (1.6% in yen terms) and 1.7% (3.1% in yen terms), respectively, from our base date through those periods. These are higher returns than the US or Europe, so Japan should be overweighted by global investors, and these projected returns should be particularly attractive for domestic investors.
Developed Pacific-ex Japan MSCI: the improvement in China’s economy should clearly help this region, although Hong Kong’s political challenges remain a headwind. At least in the short-term, we are positive on both the Hong Kong and Australian markets, with the Hang Seng at 25,516 and 26,731 at end-September and end-December, respectively, and the ASX at 6,271 and 6,647, respectively. In sum, we expect the region’s MSCI index in USD terms to rise 8.5% through September and 15.5% through December (+10.1% and +17.1% in yen terms), so this region should clearly be overweighted.
Investment strategy concluding view
Despite all the troubles and potential risks, the solid upward equity market trend has been very hard to disrupt and investors and central banks seem happy to drive returns up more sharply than even we predicted. In some segments, irrational bubble behavior based only on monetary financing has occurred. Economic growth will disappoint, in our view, even with a moderate additions of fiscal and monetary stimulus, and negative earnings guidance should drive CY21 EPS consensus estimates lower and, thus, tame markets. Thus, as both global equity and global bond indices are likely to show small losses, we suggest that medium to long-term global investors should be neutral or slightly underweight on both, but with major overweights to the Asian region. We admit, however, that we do not have a high confidence factor in our forecasts, and there is a significant chance of major equity swings on either side. If investors agree with our US election forecast and are particularly concerned about conditions after a Democratic administration, they should underweight global equities more fully. Lastly, as always, if any reader wishes to see the targets related to the other six scenarios, in which Trump wins or other factors, they are welcome to contact us.