Things are likely to get bumpier on capital markets in the coming weeks and months as the tapering, i.e. the reduction of quantitative easing (QE) by the Federal Reserve, is imminent. The monthly bond-buying volume of USD 120 billion will be gradually scaled back and the Fed is expected to end the QE program by summer 2022. In markets flooded with liquidity, this withdrawal is likely to cause repeated turbulence in the short-term. In addition, financial markets are now already expecting two rate hikes of 25 basis points each in the coming year. This is significantly more aggressive than signaled by the latest “dot plot”, which summarizes the rate expectations of members on the Federal Open Market Committee. Similarly, the rise at the long end of the G7 yield curves is likely to increase headwinds for risky assets. In Germany and Switzerland, ten-year government bond rates are still trading just below zero, and in the US, ten-year government bond yields are only 10 basis points away from our current fair value of 1.75%.
So far, investor sentiment has not dimmed. However, investors are very selective and are avoiding, for example, companies that are hardly profitable despite the excellent economic environment.
Although the macroeconomic environment is robust and stock markets are trading at new highs, consumer sentiment in the United States has deteriorated recently. The causes can be quickly identified. Uncertainty, triggered by disruptions in supply chains, is depressing the spending mood. In addition, the steady rise in inflation and the persistently high core inflation rate are causing consumers to doubt whether the price increase is really only temporary. In our view, this uncertainty is likely to drag on well into the next year.
The months from November to January are historically consi-dered to be particularly promising for stock markets. Of course, there have been exceptions, such as during the 2008 financial crisis. But usually, this phase is characterized by above-average capital inflows into the markets and greater visibility for companies' business performance. This provides tailwinds and tends to reduce the potential for setbacks. This year, we have already seen a record-breaking capital inflow of over USD 1 trillion into US equity funds in the first ten months. We expect the supportive trend to continue in the coming weeks.
Although financial markets are likely to become more uncomfortable, investors should remain invested and take risks very selectively and deliberately. In the current global low interest rate environment, where some yield curves – such as in Germany and Switzerland – remain in negative territory, investors need to take risks in a controlled manner in order to generate a positive return in the medium to long-term. With the rise in inflation rates in major developed countries, this challenge has even grown since the outbreak of the Covid-19 pandemic.
Across assets, real assets remain the focus of attention in the months ahead and should be favored over nominal asset classes. In terms of the main asset classes, we are sticking to our ranking and prefer commodities over equities, liquidity and bonds. New exposures should be built primarily in commodities and equities. The major central banks have inflated their balance sheets enormously over the past 18 months, thereby not only controlling volatility in most asset classes, but keeping it artificially low. We expect a normalization in the coming quarters and advise to use setbacks in periods of short-term rising volatility as buying opportunities. For now, the market remains in a classic buy-the-dip mode, even if liquidity is waning compared to last year.
The earnings season for the third quarter is well underway and earnings revisions remain supportive for the market. Earnings revisions, while declining, are still in positive territory. This is a normal process after a strong V-shaped earnings recovery. In the US, earnings are over 25% higher than before the corona pandemic. Within sectors and industries, however, differences are large, so selection will be key for the rest of the year. We recommend continuing to focus on quality stocks as well as companies that benefit from long-term trends such as digitalization.
Investment opportunities are scarce in the bond universe. The hybrid space as well as emerging market bonds in local currencies remain our favorites. The problems of China's second largest real estate group Evergrande have led to an unprecedented sell-off in individual segments of the Asian high yield market. This area has therefore selectively become attractive again. At the moment, the return potential even outweighs the risk, and we prefer fixed-income investments to equities within China.
Publisher: LGT Bank (Switzerland) Ltd., Glärnischstrasse 36, CH-8027 Zurich
Author: Thomas Wille, Head Research & Strategy, Email: firstname.lastname@example.org
Editor: Alessandro Fezzi, E-Mail: email@example.com
Source: LGT Bank (Switzerland) Ltd.
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