Principal Monthly Viewpoints (October 2020)
Q: Principal Asset Management (Asia) Investment Management Team
A: Crystal Chan, Principal Asset Management (Asia) Senior Investment Specialist
Q: What is the current global economic situation?
A: The global economy has improved significantly in the third quarter and has established a preliminary V-shaped rebound pattern. As the COVID-19 pandemic has been modestly alleviated, ultra-loose monetary policies from global central banks and the fiscal stimulus measures of global governments have been effective. Some long pent-up demand has been revived, which was favorable to the global industrial production to lead the recovery. According to PMI figures tracked by Principal, global PMI for manufacturing has rebounded to the expansion zone in September, with a reading of 53.1 in the month as compared to the low of 40.3 recorded in April. In addition, global leading industrial production index continues to improve while Economic Surprise Index continues to increase for the fifth consecutive month. A series of economic data indicates that it is unlikely for the economy to fall to trough level again.
Global central banks have been easing monetary policies since the outbreak of COVID-19, in order to offset the impact on the economy. In 2020 alone, central banks around the world cut interest rates a total of 72 times, and global financial conditions have hit record highs repeatedly. Global central banks are expected to maintain their policy stances in the fourth quarter, though the downside momentum of interest rates may slow down. Interest rate futures indicate that interest rates of G7 countries will remain unchanged in the remainder of 2020, except for Australia, which still has the room to reduce rate once more before year-end. Other developed countries are expected to keep rates unchanged at least until next year.
Under the environment of growth recovery and negative real interest rates, the need for central banks in developed markets to ease policy substantially has declined, or generally speaking, they tend to support the economy by expanding their balance sheets steadily. In fact, the growth rate of security holding in the Fed's balance sheet has slowed in recent months gradually. The overall scale has stabilized at around US$7 trillion.
On the other hand, the emerging markets have cut rates by nearly 4,000 basis points this year after a period of the most accommodative monetary policy in history. Facing inflationary pressures, the downside of policy interest rates has been limited by currency depreciation. For example, the Central Bank of the Republic of Turkey has raised rates by 2% to curb inflation and support the Turkish Lira exchange rate. Except for some Asian countries with better inflation outlook, such as China, India, Indonesia and the Philippines, which are still likely to reduce rate further in the future, there is little room for substantial rate cuts for emerging market economies.
As for the fiscal policy, in the case of the U.S., since the previous fiscal stimulus packages expired in July, the U.S. Congress and the Republican Party failed to reach an agreement on the new round of stimulus bills. It is expected that the possibility of introducing a new bill before the U.S. presidential election is remote. It may slow down the growing pace of the U.S. economy. However, taking into account factors such as high level of corporate leverage and cash flow has not fully recovered yet, it is expected that governments will continue to introduce economic stimulus packages in the following months to support households and businesses. If most of the economies can resume economic activities as the situation with COVID-19 continues to develop in the near future, the global economy may return to its pre-pandemic level as early as mid-2021. The time needed for recovery is less than the two years it took the Financial Tsunami.
We expect that the global economy will continue to improve in the fourth quarter; the growth rate, however, may be slower than the third quarter, especially for industries such as tourism and commercial real estate, which are expected to face substantial challenges. There has been an increase in the number of new COVID-19 cases globally again; the process of resuming economic activities has been hindered. In addition, there is limited room for further significant expansion of fiscal and monetary policies in the short term; it may slow down the process of global economic recovery. For example, we expect that the U.S. economic growth rate will slow from over 25% in the third quarter to about 7% in the fourth quarter.
Q: What are the risk events in the fourth quarter?
A: The U.S. election is one of the major risk events. The U.S. presidential election will be held on November 3, 2020. The investment market will remain volatile temporarily before and after the election. We believe that it doesn't matter much which candidate wins; the conclusion of the election itself will eliminate uncertainties for the market. The investors will concentrate on the market fundamentals again, which include the U.S. economy is improving, easing monetary policy remains intact, and corporate earnings is still on the path of improvement. These factors are favorable for the performance of U.S. stocks.
According to current poll results, Joe Biden, the Democratic presidential candidate, has expanded his advantage over President Donald Trump. It is widely expected that the Democratic Party will control both houses of Congress. If the election result turns out as expected, the policies proposed by Biden will have a higher chance to be implemented, including tax raises and strengthened regulatory oversight. These policies will hurt the profits of technology companies or weaken the performance of technology stocks and even the overall U.S. stock market again; the potential increase on infrastructure investment may benefit the related sectors at the same time.
The second wave of COVID-19 is another major market risk. With the gradual recovery of economic and social activities, the number of confirmed cases has continued to rise. As of October 6, 2020, there have been more than 35.75 million confirmed new cases globally. Europe is the main source of new cases recently. The second wave of the pandemic in the region continues to worsen. Some countries have declared the highest pandemic alert level and reinforced lockdown rules to control the outbreak. As the autumn and winter are approaching, there is greater uncertainty in the development of the global pandemic.
Luckily, the related death rates continue to fall while progress is being made on vaccine research. There are eleven COVID-19 vaccine candidates globally that have entered the third phase of research; and five vaccines that are produced in China and Russia have been approved for vaccination for some people. If the vaccines can be approved in the next few months, the number of new cases should be further reduced, and this may become the biggest positive factor for an upward market trend.
Besides the pandemic and the U.S. election, investors should not ignore other geopolitical risk events. The Brexit trade negotiation has entered the final sprint with the transition period that will end on December 31, 2020. If the two parties fail to reach an agreement, a "no-deal Brexit" scenario is a possible outcome. In terms of Sino-U.S. relations, the divergence between the world's two largest economies has expanded from trade to technology; and the tension may escalate and impact the market risk sentiment.
Q: What is the asset allocation for the fourth quarter?
A: Our fund managers have taken the opportunity to reduce extra stock holdings in the past few months whenever the market rose. We are still slightly bullish on stocks in the fourth quarter. Once the market hits a low level, we will further increase our stock holdings for we believe that the global economy will continue its growing trend.
Secondly, we can see that the earnings growth forecast is improving gradually. Although the EPS forecast of the MSCI Global Index for this year is still decreasing by 21%, it is likely that the figure will return to positive territory next year with the earnings growth expected to reach 28%. Take the U.S. stock market as an example. In the second quarter, its earnings performance outperformed the market expectations significantly while the earnings decline was also obviously lower than the first quarter. The corporate earnings decline for S&P 500 companies is expected to further reduce to about 20% in the third quarter.
In terms of the stock market allocation for the fourth quarter, we will favor the U.S. and China, slightly favor the Asian market, keep a neutral stance on Japan while remaining slightly bearish on Hong Kong and bearish on Europe.
As for bonds, the returns for holding cash is relatively low due to the continued low rates environment. Most of the global central banks will retain the easing approach, which will keep the capital flow into the corporate bond market. We are optimistic about the overall prospect of corporate bonds and especially prefer Asian corporate bonds. In the sovereign debt market, since there is limited room for further rate cut and the valuation is quite high, we are slightly bearish for the asset class.
(Written on 7th Oct 2020)
Senior Investment Specialist
Principal Asset Management (Asia)