As the calendar rolled over at midnight on New Year’s Eve many looked forward to the “Roaring 20’s.” Just a few months later...
As the calendar rolled over at midnight on New Year’s Eve many looked forward to the “Roaring 20’s.” Just a few months later and we are looking at a changed world due to the COVID-19 coronavirus. Many have suffered immeasurable personal loss, many small businesses are struggling to survive, and social tensions are elevated. However, many advanced economies are starting to reopen and the world will gradually shift from hurting to healing. It’s against this backdrop that we discuss how to invest in this new economic cycle.
There are tentative signs that the global economy may be on the mend. This is an engineered economic collapse that will likely generate an extremely deep, but brief global recession in order to save human lives. With over 100 COVID-19 vaccines in development, we believe that a vaccine could be delivered by early 2021 and lead to a sharp rebound in global growth — from a 3.5% contraction in 2020 to a 5.5% surge in 2021.
The recovery in financial markets may look much more “V-shaped” than the recovery in the broader economy. Some service sectors like leisure and hospitality and international travel may take longer to recover. This bifurcation has led to a divergence in equity market performance with “stay-at-home” stocks like cloud computing and home entertainment outperforming more cyclical “leave-my-home” stocks like banks, industrials, and travel-related stocks. We think these beaten down sectors will eventually catch-up as the economy recovers over the next 12 to 18 months.
We acknowledge that the outlook is more uncertain than usual. The prospect of an increase in infections remains real and political tensions between the U.S. and China could cause volatility as the U.S. election approaches. However, in our view, central bank stimulus and government fiscal stimulus have significantly improved financial conditions. We see no reason to think that this support will be removed while unemployment remains elevated. We think it’s unlikely that we retest March’s stock market lows.
Global Economy: On the Mend?
There are early signs that growth may be stabilizing
The unexpected spread of the COVID-19 virus drove most advanced economies to purposefully shutdown in order to “flatten the curve” and to save human lives. Now many economies are beginning to reopen as quarantines and social distancing measures have led to a reduced burden on regional health care systems. However, a great deal of uncertainty remains with many advanced economies wondering what the path forward looks like (see figure 1).
Our outlook for the remainder of this year is uncertain, but we are basing it on the premise that a vaccine is eventually made widely available and that the world’s increased knowledge of the virus has likely reduced the odds of a second wave that parallels the first wave. Combined with waning political will, we think this reduces the odds of renewed nationwide shutdowns and limits the odds of a global “W-shaped” recession even as infections have begun to rise in states that reopened early.
Citi’s economists believe that global gross domestic product (GDP) should be well on its way to recovery by 2021 (see figure 2). Though absent a vaccine (or disappearance of the virus), a full recovery will likely take time and past peak GDP levels (not rates) may not be reached for one to two years from now. If we have to assign a letter-shape to the U.S. recession, we would label it a “lazy-V” with the recovery likely to be sharp, but not quite as sharp as the decline (see figure 2).
The rebound may be sharp, but a full recovery may take time
We expect many advanced economies to experience sharp rebounds in the third quarter of this year. The annualized rate of decline is likely to be shocking in the second quarter, but so will the rebound, with the U.S. economy likely to see an annualized rate of growth in the third quarter that is north of 20.0%. Our base case is that the global economy will experience a very deep, but brief recession (see figure 3).
Global Stocks: Accelerated
The collapse was swift, but so was the recovery
At the end of 2019, many stock market benchmarks were either at or near record highs. A few months later and the whole world looked different with a global pandemic striking fear in the hearts of many citizens globally. By mid-March, many advanced economies appeared to be in a death spiral along with stocks. However, that likely marked the bottom as central banks and governments across the world unleashed powerful monetary and fiscal stimulus. In the United States, the Federal Reserve expanded its balance sheet by about $3 trillion in just three months. By comparison, during the Global Financial Crisis, it took the Federal Reserve nearly six years to expand their balance sheet by a comparable size (see figure 4).
It is our view that this stimulus has been instrumental in driving equity markets sharply higher since the market’s potential bottom on March 23rd. As figure 4 shows, between January 2010 and December 2015, the U.S. stock market and Federal Reserve balance sheet moved together about 98% of the time. Combined with early signs that there is pent-up consumer demand with high frequency data suggesting that consumers are already starting to fly, dine, and drive more, the S&P 500 has recovered much of its initial losses and is down just slightly year-to-date (see figure 5).
“Stay-at-Home” stocks may give way to “Leave-my-Home” stocks over the next 12 months
Aside from stimulus support, the nature of COVID-19 has accelerated trends that were already in place. So- called “Stay-at-Home” trends like cloud computing, telemedicine, teleconferencing, and in-home entertainment were already in demand, but are now in even higher demand. The stocks associated with these trends were key drivers of the market rally for several months. Now, investors are seeing a bit of a rotation into “Leave-my-Home” stocks with shares that are most sensitive to the economic cycle like airlines, casinos, industrials, and banks rapidly getting a bid (see figure 6). We expect that rotation to continue with beaten-down sectors playing “catch-up” as the economy reopens over the next 12 to 18 months. However, it may be a bumpy ride as any news of rising infections could push investors back into the “Stay-at-Home” complex or to de-risk in general.
We also believe that U.S. small-cap shares may outperform as the economy reopens. Not only do they tend to do well when an economy is coming out of a recession, but they are less exposed to rising U.S. – China tensions as most sales are domestic. Although many small businesses may fail due to the ongoing COVID-19 healthcare crisis, we think that many will survive and perhaps even gain market share. We would focus on companies with strong credit ratings and solid balance sheets in order to mitigate some of the risk.
Global Fixed Income: Lenders of Last Resort
A range of lending and asset purchase programs have backstopped markets
Central banks have stepped up as lenders of last resort for not only banks, but also financial intermediaries, and even nonfinancial corporations. Combined with a reduction in interest rates and large-scale purchases of government bonds (see figure 7), the actions have helped financial conditions to recover rapidly.
This liquidity not only supports financial conditions, but it also aims to address corporate solvency issues. In the United States, having the Federal Reserve as a buyer of last resort of corporate bonds has enabled many large corporations to raise capital by issuing debt. This should help them to remain solvent until business activity returns to more normal levels...either through society’s willingness to live with the virus (so-called herd- immunity) or via a vaccine (hopefully the latter). With most countries starting to reopen, we are seeing some signs of pent-up demand with the number of people flying, driving, and dining starting to rise steadily. As we will discuss in the next section, risks of a second wave of infections presents challenges, but Citi’s proprietary U.S. economic surprise index, which measures whether economic data releases are beating or missing expectations, suggests that the recovery may occur more rapidly than originally anticipated. This could imply an eventual drift higher in sovereign bond yields as yields tend to follow the path of nominal GDP rates as well as inflation (see figure 8). North of 1.00% on a 10- year U.S. Treasury seems feasible over time.
When stocks fall sharply, high quality fixed income assets have typically risen
Typically, when stock prices fall sharply, high quality fixed income assets tend to outperform. In this past market sell-off, U.S. investment grade debt posted positive gains as stock valuations tumbled. With yields expected to remain fairly low, fixed income assets may be more of a risk hedge than a source of income, but we believe that they still belong in a portfolio.
In the U.S., the Global Investment Committee maintains an overweight on short- and intermediate-duration Treasuries, but is neutral on long-duration. Although the Committee did recently reduce the size of its overweights in short- and intermediate-duration U.S. Treasuries, investment-grade corporate bonds, and cash in order to fund an overweight position in global real estate investment trusts (REITS), U.S. residential REITS, and commercial mortgage REITS. The GIC remains neutral on municipal bonds.
Risks: A Second Wave
COVID-19 is the biggest risk, but there’s also an election
Researchers around the world are developing more than 135 COVID-19 vaccines. Under normal conditions, vaccines can often require years of research and testing before reaching a clinic, but given the severity of this global pandemic (see figure 9) scientists are racing to produce a safe and effective vaccine by early 2021. Some have suggested that a vaccine may be available to healthcare workers by this fall.
However, until then, it seems unlikely that international travel and commerce will return to the same pace that it experienced prior to COVID-19. Importantly, our base case scenario was premised on a second (though less severe) rise in infections along with a vaccine being widely available by early 2021. Though we acknowledge that there are clear risks.
Though much of the focus of financial markets has been on the widespread virus and its ramifications, the U.S. is quickly approaching the 2020 Presidential election with candidates President Trump and former Vice President Joe Biden seeking the nation’s support. Historically, positive economic conditions have led to the reelection of the incumbent. As figure 10 shows, the public’s view of the government’s stewardship of economic policy has been quite important with incumbent Presidents Carter and President Bush Senior both running for re-election during in recessionary environments and losing. That may be the case again, but we would note that our forecasts are for more favorable economic data in the third quarter as the country recovers. Third quarter GDP could easily rise by an annualized rate north of 20.0% and is released on September 30 – just before the November 6 election.
It is possible that “this time is different” with many voters suggesting that the economy is not the main driver of their voting intentions, but history suggests to us that calls for extreme market movements due the election are as likely to be misplaced as they were in 2016. Calls for dismantling the Tax Cuts and Jobs Act of 2017 seem unlikely to be carried through if the U.S. unemployment rate remains elevated – as we suspect.
Likewise, the elimination of more progressive candidates has lessened the market’s view that dramatic (market- moving) changes will be instantly implemented. A risk-off tone heading into the election seems plausible as investors assess the post-election landscape, but a severe pullback in markets seems unlikely. The primary risk remains COVID-19 for the foreseeable future.
We think that the economy is the primary driver of market performance, not Washington.
Asset Class Views (Stocks)
|Asset Class: Equities||View||Investment Rationale|
|U.S. Large Cap||Neutral||Significant and rapid policy steps by the Fed and U.S. congress have helped stabilize markets after a 35.0% drop. Sentiment is likely to continue to ebb and flow alongside headlines. Valuations are no longer cheap, after having recovered over half their losses from crisis levels.|
|European Large Cap||Neutral||We have closed our underweight and are now neutral on both developed and emerging Europe as we believe the European Union appears increasingly likely to rally behind a stronger fiscal expansion in the coming year.|
|Japan Large Cap||Neutral||Japanese large cap stocks sold off along with global markets, but have rebounded more sharply, likely as a result of seemingly lower levels of virus spreading and less extreme economic shutdown measures as well as ample stimulus.|
|Developed Market Small and Mid-Cap (SMID)||Overweight||Our thematic preference remains in healthcare and the “digital economy” over the longer term. This favors U.S. large cap equities. However, their strong outperformance YTD suggests more limited gains ahead. In a 1-2 year timeframe, we would expect US SMID to catch up some in performance.|
|Emerging Asia||Overweight||As China continues to gradually climb out of the economic declines seen in February, equities in Asia are likely to remain somewhat more resilient. We remain long term optimistic on Asian consumption, technology and healthcare themes.|
|Emerging EMEA||Neutral||While not particularly unappealing, we believe Asia (and Latam) ranks higher as a regional opportunity in EM equities vs markets in EMEA. In our view, commodity prices may rebound from depressed levels, though remain low. This is likely to weigh on middle east and other oil producing nations such as Russia.|
|Emerging Latin America||Overweight||Valuations have improved sharply after a deep selloff. Given the severe underperformance relative to other markets, we would expect the region to perform well when the global rebound comes. The correction has adjusted real exchange rates to levels not seen since the 1990s. This will provide a good cushion to economies and should help equities rally. However, we maintain a cautious long-term outlook beyond the potential global equity rebound. The region will have to deal with the aftermath of having very limited policy space.|
|Asset Class: Fixed Income||View||Investment Rationale|
|U.S. Sovereign Bonds||Overweight||Global “risk off” sentiment around the coronavirus has seen U.S. yields drop to record low levels, before stabilizing some at higher levels. Large scale fiscal packages have temporarily put a floor in long-dated yields, while the Fed has cut short- rates to zero, steepening the curve. Renewed asset purchases may limit how far yields can ultimately rise, though we expect some rebound in rates in a cyclical recovery.|
|European Sovereign Bonds||Underweight||Central bank policies are expansive though it’s possible we could still see more to come. Policy rates in Europe are unlikely to change for the foreseeable future; Italy concerns likely to grow and we remain deeply underweight|
|Emerging Market (EM) Sovereign Bonds||Overweight||External debt: Fundamentals have deteriorated, but a lot has been priced in. We favor geographical diversification, but tactically find a regional barbell with Asia (low beta) and Latin America (high beta) attractive. Local bonds: Yields have fallen to lowest levels on record, though EM FX remains volatile. Unhedged returns may eventually benefit from Fed cuts and USD weakness.|
|Corporate Investment Grade||Overweight||U.S. IG: Credit valuations have improved from the March lows, but remain cheap with some of the best relative value found between 5-7 years to maturity. We continue to avoid cyclicals, while we favor Consumer Discretionary, Communications and Technology. Euro IG: Yield differentials versus the U.S. have narrowed and look regionally attractive, especially when compared to negative sovereign bond yields. We maintain a relatively constructive view on high quality European credits.|
|Corporate High Yield||Neutral||U.S. HY: Spreads are cheap, though we may not have seen the end of market volatility. History suggests a long-term opportunity, though we favor an up in quality bias amid a likely rise in defaults. Euro HY: Spreads are cheap, though regional growth is expected to contract severely, especially compared to the US economy which is also seeing a contraction. ECB purchases could end up supporting prices, though we remain cautious in the near-term.|
Forecasts, Indicators, and Returns
|Region||GDP Growth||CPI Inflation||10-Year Yields||Exchange Rate vs. USD|
|Global: Based on PPP Weights||3.0||-3.0||5.8||3.2||2.5||3.2||N/A||N/A||N/A||N/A||N/A||N/A|
|Early Returns (%)||Valuations||Dvd Yield|
|Equity Index||Level||2015||2016||2017||2018||2019||Month to Date||Quarter to Date||Year to Date||Price to Earnings||12-Month Forward P/E Ratio||Current (%)|
|Fixed Income Returns (%)||Other Key Rates|
|Bond Index||Yield to Maturity||2015||2016||2017||2018||2019||Month to Date||Quarter to Date||Year to Date||Instrument||%|
|Global||0.79||0.9||3.3||2.1||0.5||7.1||0.4||2.2||3.8||10 Year U.S.||0.69|
|U.S.||1.24||0.5||2.7||3.6||0.0||8.9||0.5||2.8||6.0||Treasury 30 Year U.S.||1.46|
|Europe||0.27||1.1||3.3||0.5||0.5||6.0||0.8||2.2||1.0||Treasury 1 Year CD Rate||0.51|
|EM Sovereign||4.89||0.6||9.6||9.8||-4.1||14.8||3.2||12.1||-2.5||30 Year Fixed Mortgage||3.40|
|U.S. High Yield||7.12||-5.6||17.8||7.0||-2.1||14.1||2.6||11.4||-3.2||Prime Rate||3.25|
|Region / Index||Year-to-Date Return|
|U.S. Investment Grade||6.0%|
|Euro Investment Grade||1.0%|
|EM Government Bond||-2.5%|
|U.S. High Yield||-3.2%|
|United States (S&P 500)||-4.1%|
|Emerging Markets (MSCI)||-10.2%|
|Euro (Euro STOXX 50)||-13.0%|
|Economic Sectors||Year-to-Date Return|
- The Citi Emerging Market Sovereign Bond Index (ESBI)
- includes Brady bonds and US dollar-denominated emerging market sovereign debt issued in the global, Yankee and Eurodollar markets, excluding loans. It is composed of debt in Africa, Asia, Europe and Latin America. We classify an emerging market as a sovereign with a maximum foreign debt rating of BBB+/Baa1 by S&P or Moody's. Defaulted issues are excluded.
- The Citi U.S. Broad Investment-Grade Bond Index (USBIG)
- racks the performance of US Dollar-denominated bonds issued in the US investment-grade bond market. Introduced in 1985, the index includes US Treasury, government sponsored, collateralized, and corporate debt providing a reliable representation of the US investment-grade bond market. Sub-indices are available in any combination of asset class, maturity, and rating.
- The Citi World Broad Investment Grade Bond index
- is weighted by market capitalization and includes fixed rate Treasury, government sponsored, mortgage, asset backed, and investment grade (BBB–/Baa3) issues with a maturity of one year or longer and a minimum amount outstanding of $1 billion for Treasuries, $5 billion for mortgages, and $200 million for credit, asset-backed and government-sponsored issues.
- Corporate High Yield
- is measured against the Citigroup US High Yield Market Index, which includes all issues rated between CCC and BB+. The minimum issue size is $50 million.All issues are individually trader priced monthly.
- Corporate Investment Grade
- is measured against the Citi World Broad Investment Grade Index (WBIG) – Corporate, a subsector of the WBIG. This index includes fixed rate global investment grade corporate debt within the finance, industrial and utility sectors, denominated in the domestic currency. The index is rebalanced monthly.
- Developed Market Large Cap Equities
- are measured against the MSCI World Large Cap Index. This is a free-float adjusted, market-capitalization weighted index designed to measure the equity market performance of the large cap stocks in 23 developed markets. Large cap is defined as stocks representing roughly 70% of each market’s capitalization.
- Developed Market Small- and Mid-Cap Equities
- are measured against the MSCI World Small Cap Index, a capitalization-weighted index that measures small cap stock performance in 23 developed equity markets.
- Developed Sovereign
- is measured against the Citi World Government Bond Index (WGBI), which consists of the major global investment grade government bond markets and is composed of sovereign debt, denominated in the domestic currency. To join the WGBI, the market must satisfy size, credit and barriers-to-entry requirements. In order to ensure that the WGBI remains an investment grade benchmark, a minimum credit quality of BBB–/Baa3 by either S&P or Moody's is imposed. The index is rebalanced monthly.
- Dow Jones Industrial Average (DJIA)
- is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange (NYSE) and the NASDAQ.
- Emerging Markets Equities
- are measured against the MSCI Emerging Markets Index, which is free-float adjusted and weighted by market capitalization. The index is designed to measure equity market performance of 22 emerging markets.
- Emerging Sovereign
- is measured against the Citi Emerging Market Sovereign Bond Index (ESBI). This index includes Brady bonds and US dollar-denominated emerging market sovereign debt issued in the global, Yankee and Eurodollar markets, excluding loans. It is composed of debt in Africa, Asia, Europe and Latin America. We classify an emerging market as a sovereign with a maximum foreign debt rating of BBB+/Baa1 by S&P or Moody's. Defaulted issues are excluded.
- The Euro Broad Investment-Grade Bond Index (EuroBIG)
- is a multi-asset benchmark for investment-grade, Euro-denominated fixed income bonds. Introduced in 1999, the EuroBIG includes government, government-sponsored, collateralized, and corporate debt.
- Europe Ex UK Equities
- are measured against the MSCI Europe ex UK Large Cap Index, which is free-float adjusted and weighted by market capitalization. The index is designed to measure the performance of large cap stocks in each of Europe’s developed markets, excluding the United Kingdom.
- The EURO STOXX 50 Index
- covers 50 blue-chip stocks from 12 Eurozone countries: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain.
- Fed Funds Rate
- is the rate at which depository institutions (banks) lend reserve balances to other banks on an overnight basis. Reserves are excess balances held at the Federal Reserve to maintain reserve requirements. The fed funds rate is one of the most important interest rates in the U.S. economy since it affects monetary and financial conditions, which in turn have a bearing on critical aspects of the broad economy including employment, growth, and inflation. The Federal Open Market Committee (FOMC) that meets eight times a year, sets the fed funds rate, and uses open market operations to influence the supply of money to meet the target rate.
- Global Bonds
- are measured against the Citigroup Broad Investment Grade Bond. The index is weighted by market capitalization and includes fixed rate Treasury, government sponsored, mortgage, asset backed, and investment grade (BBB–/Baa3) issues with a maturity of one year or longer and a minimum amount outstanding of $1 billion for Treasuries, $5 billion for mortgages, and $200 million for credit, asset-backed and government-sponsored issues.
- Global Equities
- are measured against the MSCI All Country World Index, which represents 48 developed and emerging equity markets. Index components are weighted by market capitalization.
- Gross Domestic Product
- is the total value of goods produced and services provided in a country during one year.
- The High-Yield Market Index
- is a US Dollar-denominated index which measures the performance of high-yield debt issued by corporations domiciled in the US or Canada. Recognized as a broad measure of the North American high-yield market, the index includes cash-pay, deferred-interest securities, and debt issued under Rule 144A in unregistered form. Sub-indices are available in any combination of industry sector, maturity, and rating.
- Leading Economic Indicators
- are measurable economic factors that change before the economy starts to follow a particular pattern or trend. Leading indicators are used to predict changes in the economy, but they are not always accurate.
- MSCI All Country World Index
- captures all sources of equity returns in 23 developed and 23 emerging markets.
- MSCI Emerging Markets Index
- reflects performance of large and mid-cap stocks in roughly 20 emerging markets.
- MSCI Japan Large Cap Index
- is a free-float-adjusted market-capitalization-weighted index designed to measure large-cap stock performance in Japan.
- The NASDAQ
- is a composite index is a market-capitalization weighted index of more than 3,000 common equities listed on the Nasdaq stock exchange.
- The Nikkei 225
- is Japan’s leading index. It is a price-weighted index comprised of Japan’s top 225 blue-chip companies on the Tokyo stock exchange.
- Price-to-Earnings Ratio (P/E ratio)
- is the ratio for valuing a company that measures its current share price relative to its per-share earnings. The price-earnings ratio is also sometimes known as the price multiple or the earnings multiple. The P/E ratio can be calculated as: Market Value per Share / Earnings per Share.
- S&P 500 Index
- is a capitalization-weighted index, which includes a representative sample of 500 leading companies in leading industries of the US economy. Although the S&P 500 focuses on the large cap segment of the market, with over 80% coverage of US equities, it is also an ideal proxy for the total market.
- The Unemployment Rate
- is a measure of the prevalence of unemployment and it is calculated as a percentage by dividing the number of unemployed individuals by all individuals currently in the labor force. During periods of recession, an economy usually experiences a relatively high unemployment rate.