Vast amounts of stimulus have underpinned the markets after the initial shock of the COVID-19 crisis. The question for investors now is whether such support can continue to offset a sharp fall in corporate profits. Below, Pictet Asset Management (Pictet AM) shares their views on fixed income and currencies:
A focus on United States of America:
Global bond markets remain supported by unprecedented monetary stimulus. Pictet AM expects the world’s five top central banks to inject a whopping USD 8.4 trillion of liquidity into the financial system this year, which is equivalent to 14.3 per cent of their countries’ total GDP (1).
All bonds might look attractive against this backdrop. But central bank support must be balanced against the fact that valuations are now exceptionally high – some fixed income asset classes are the most expensive they’ve been in 20 years. Additionally, the global economy appears to be on a path to recovery, which could cause bond yields to reverse course.
Those contrasting signals keep us neutral on fixed income overall. Drilling deeper, among sovereign debt Pictet AM sees the best return potential in US Treasuries. The Fed has been particularly aggressive with stimulus, and Pictet AM expects it to deliver more in the coming months. This will most likely come in the form of yield curve control, which should keep liquidity abundant and Treasuries’ valuations unusually high for a long time.
The stimulus should also be good news for US corporations, which are already beginning to benefit from a pick-up in the economy. The US economic surprise index hit an all-time high in June, for example. Economically, US looks to be in better shape, which supports their overweight stance on US investment grade bonds – particularly as they have the backstop of Fed support should things dip again.
However, Pictet Asset Management is mindful that the economic recovery is still in the early stages, and there are many risks ahead, including the US election and the possibility of a second wave of the pandemic. Pictet AM therefore remains underweight US high yield. Although it is the only fixed income asset class that is not expensive relative to its 20 year history, according to their model, they believe such valuations do not factor in the potential for future defaults. The market is pricing in a default rate of just 7-8 per cent, while Moody’s expects it to reach nearly double that, at 13 per cent.
In the currency market, Pictet AM thinks the euro should benefit from an improving economic backdrop, helped by increased stimulus. The ECB’s TLTRO 3 bank funding programme and the EU’s economic recovery plan are big positives. The former has seen a very good take-up and will boost banks’ earnings as well, while the latter can potentially prove a game-changer for fiscal unity within the bloc. All in all, Pictet AM thinks the euro’s 14 per cent undervaluation against the dollar (see chart) is no longer justified, and upgrade the currency to overweight. Technical trends, such as seasonality, are favourable, too.
Pictet AM also sees potential for a rebound in emerging market (EM) currencies, which are extremely cheap and have lagged the broader ‘risk-on’ rally so far. That, in turn, should benefit EM local currency debt.
To guard against any renewed market volatility, Pictet AM keeps defensive positions in the Swiss franc (whose haven status is complemented by a strong uptick in the domestic economy) and in gold. Although gold has enjoyed a very strong run (up 15.5 per cent since the start of the year), it is still not in overbought territory according to their technical indicators, which makes it a good hedge. Indeed, Pictet AM believes fundamentals – including the possibility of an inflation spike over the medium term, persistently negative real rates and the prospect of a further weakening in the dollar – more than justify the precious metal’s apparently stretched valuations.
Notes:
(1) Data for US, China, euro zone, Japan and UK. Policy liquidity flow is calculated as net central bank liquidity injection over preceding 6 months as percentage of nominal GDP, using current USD GDP weights.
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Information, opinions and estimates contained in this document reflect a judgment at the original date of publication and are subject to risks and uncertainties that could cause actual results to differ materially from those presented herein.
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