House Views - September 2020 - Treading carefully
After an initial fillip to activity driven by the easing of lockdown restrictions across developed economies, recent economic data have painted a mixed picture. Some sectors – such as housing in the US – look strong while others – such as high levels of continuing jobless claims – point to more weakness ahead. With the coronavirus continuing to spread across the globe and many industries facing extended uncertainties – for example, aviation and aeronautics –we expect that the next stage of the recovery will prove more sluggish. However, governments will be reluctant to reimpose nationwide lockdowns, meaning that the recovery should last.
Output gaps – the difference between actual and potential activity levels – remain very wide across developed economies while high numbers of workers are still unemployed or receiving furlough support. This suggests that central banks will remain more preoccupied by deflationary risks than by rising prices. With key rates and government bond yields sharply negative in real terms, we expect thatthe Federal Reserve (Fed) and European Central Bank (ECB) will continue to focus on asset purchase programmes as the best way to deploy monetary policy. And if activity looks like losing steam, we believe they would not hesitate to increase their quantitative easing.
Asset purchase programmes by central banks serve to maintain government bond yields at extraordinarily low levels while simultaneously keeping high-quality corporate bonds spreads (the yield differential over sovereigns) at very tight levels. We see more opportunity now in emerging market sovereigns, where we believe the risks are adequately rewarded by the attractive spreads on offer. We continue to prefer equity markets over other asset classes but await further policy easing before adding to positions. The recent strong rally in EURUSD leaves little additional upside in the near term. Gold recently reached our long-term price target and we suggest taking some profits.
We maintain a broadly diversified, balanced approach to asset allocation. Much of the recent rally in equities has been driven by a small number of internet and tech giants, especially in the US, and we would balance exposure to these leaders with other sectors and markets. Overall, we remain Neutral on equities with a preference for the euro zone, which should benefit from a period of sideways trading in EURUSD. Within fixed income, we have upgraded emerging market sovereigns to Neutral while maintaining a preference for Investment Grade (IG) corporate bonds over other segments. After a strong run, we have brought gold exposure back to Neutral.