MACRO DRIVERS
At the end of June, the economic reopening was broadly underway.
Monetary and fiscal policy coordination has been the most prominent driver of risk-asset performance and we expect this highly supportive backstop to continue.
We believe developed market policy rates and government bond yields will remain historically low until labor markets recover and normal levels of consumer price inflation return.
Hypothetical discount rates, which can be used to determine risk-asset relative valuations, will likely remain low and foster somewhat elevated levels in credit and equity relative to historical averages.
While we anticipate bumps along the road to reopening, we expect economies to make progress toward returning to business albeit at a slow rate. Prior peak levels in GDP may not be reached until 2022.
A spike in COVID-19 infections, or a true second wave of infections during the fall, would be highly disruptive. However, we believe proper regulations and effective medical treatment will keep any outbreaks under control.
While far from full throttle, the global economic engine is up and running. We expect further progress in the quarters ahead but acknowledge that risk assets are largely priced for the better days that we see ahead.
CREDIT MARKETS
US investment grade credit spreads may continue to tighten in the quarters ahead but we do not anticipate a return to pre-COVID lows within the next 12 months.
Leverage has increased substantially given record-setting new issuance. Rightly or wrongly, investors expect companies will reduce debt once the economy improves and cash flows pick up.
Europe and UK spreads did not compress as sharply as those of the US since the risk-on phase began in late March.
We believe high yield spreads are likely to compress by around 40 basis points. Consensus expectations imply a default rate of 10%-13% in 2020, but we believe that estimate may be too high.
There will likely be demand for high yield products, potentially including bank loans, in an environment where government bond yields remain low and volatility eventually subsides.
US securitized spreads lagged the corporate rally because Federal Reserve (Fed) support has been relatively less beneficial for the sector. Therefore, securitized spreads currently look attractive relative to corporates.
In our view, securitized excess return potential looks decent and the sector can offer carry with potentially low volatility.
Emerging market (EM) corporates entered the COVID crisis with strong fundamentals which should help mitigate defaults and allow for a quicker recovery. The spread between EM and US corporates has remained somewhat elevated, leaving further room for compression.
GOVERNMENT DEBT & POLICY
The magnitude and speed of US fiscal policies exceeded our expectations.
Coordination with the Fed was a welcome development and signaled that policy makers were willing to do what was necessary to mitigate economic damage from COVID-19.
While it may be slower to develop, we believe additional fiscal policy support is on the way. The Fed will also continue purchasing a wide range of securities and expand its balance sheet further, albeit at a slower rate than earlier in the crisis.
We believe negative policy rates in the US are highly unlikely because they disrupt the financial sector and have not proven to be effective in Europe or Japan.
Long-term developed market yields are all facing the same set of primary drivers—limited inflation, ultra-low monetary policy rates, demand for relative safe-haven assets and periodic risk aversion.
We expect the short end of developed market yield curves to remain anchored along with near-zero policy rates. We may see very modest upward movement at the long end of the curve.
Unless economic conditions decline substantially from here, we expect capital to shift toward riskier assets, such as credit and equities. Investors will likely seek excess returns over global Treasurys.
While not without risk, emerging market government bonds, which offer relatively higher yields, represent another attractive opportunity for investors.
CURRENCIES
The US dollar benefited from risk aversion in the short, but sharp, downturn phase of the credit cycle.
We see the dollar as a pro-cyclical currency that tends to weaken as the global economy accelerates. The transition to credit repair, which is taking place now, is consistent with a modestly weaker dollar.
Fluctuations in short-term interest rate differentials can impact currencies, but we do not expect much volatility in short rates. Therefore, that driver looks potentially less impactful moving forward.
Nominal US Treasury yields still have an advantage relative to developed market peers, but that positive spread has been compressing since late 2018 and more rapidly since the onset of the COVID pandemic.
Global growth differentials likely favor the dollar and should prevent the currency from weakening materially. We believe the US is well positioned for a return to solid rates of economic growth relatively faster than other countries.
Valuation is not the most reliable timing tool. However our fair-value models suggest the dollar is roughly 10% overvalued relative to the euro. Latin American currencies screen the cheapest, followed by emerging Europe and lastly Asia.
GLOBAL EQUITIES
After outstanding second-quarter performance, we expect modest total returns across global equity markets in the quarters ahead.
As the economy reopens, we believe company management teams will begin to offer some guidance on future earnings after most offered little insight on first-quarter conference calls.
Accommodative fiscal and monetary policy support have contributed to above-average valuations. These levels may remain elevated as investors anticipate a return to more normalized economic activity.
Second-quarter earnings should mark the trough globally and we are anticipating some sequential improvement quarter after quarter heading into 2021.
With outstanding second-quarter performance behind us, we expect modest total returns across global equity markets in the quarters ahead.
Some patience may be required as levels of implied volatility are still above average. However, investors with a time horizon of one year or longer should consider allocating to equities.
Low interest rates and inflation, along with a return to moderate levels of economic growth, are likely to spark a continuation in the performance patterns we had seen pre-crisis.
Indices skewed toward secular growth remain most likely to lead the charge.
POTENTIAL RISKS
The most glaring risk the global economy currently faces is a second wave of COVID-19 cases.
The most glaring risk the global economy faces is a second wave of COVID-19 cases that leads to a surge in hospitalizations and fatalities.
A resurgence would lead to a consumption drawdown once again as consumers recoil and voluntarily shelter in place regardless of their government’s recommended course of action.
As schools begin to open, we will be monitoring case growth very closely for signs of spread, which we presently believe is under control in most regions of the world.
Risk assets are priced for steady economic progress and reopenings. Therefore, any disturbance to these expectations could lead to increased volatility and lower valuations.
In addition to COVID risk, investors are also shifting their attention to the 2020 US presidential election, where odds of a Democratic sweep have been on the rise.
Many associate a Democratic sweep with the passing of legislation that would surely lead to higher corporate tax rates. Rising corporate taxes would pressure profit margins and, as a result, many risk assets would take a hit.
A key silver lining is the fiscal and monetary policy response that has already been put in place. We expect accommodation to continue for some time as the global economy works through the COVID crisis.
ASSET CLASS OUTLOOK
Disclosure
This commentary is provided for informational purposes only and should not be construed as investment advice. Any opinions or forecasts contained herein reflect the subjective judgments and assumptions of the authors only and do not necessarily reflect the views of Loomis, Sayles & Company, L.P. Investment recommendations may be inconsistent with these opinions. There is no assurance that developments will transpire as forecasted and actual results will be different. Data and analysis do not represent the actual or expected future performance of any investment product. Information, including that obtained from outside sources, is believed to be correct, but Loomis Sayles cannot guarantee its accuracy. This information is subject to change at any time without notice.
Past performance is no guarantee of future results.
Indices are unmanaged and do not incur fees. It is not possible to invest directly in an index.
Investing involves risk including possible loss of principal.
Market conditions are extremely fluid and change frequently.
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