Why the head of Equity Research at Bank Julius Baer remains bullish on the markets

The economic macro picture has improved significantly compared with Q2. What is your view on the coming months?
Indeed, the picture overall has improved but there is a twist; while leading indicators confirm a swift execution of the first part of the recovery, we believe that the second part, leading towards a full normalisation, could be more uneven and heterogeneous, as containment and policy measures diverge. The lack of governmental ability or willingness to provide continued fiscal support will result in a growth divergence between advanced economies and China on the one hand, and emerging market economies, in particular outside of Asia, on the other. Not least due to the timing of the impact of the coronavirus, China is currently leading in terms of growth, followed by Europe and the United States. Growth patterns are likely to be two steps forward, one step backward, as local flare-ups of Covid-19 occur.

In order to reach pre-crisis levels in terms of growth, fiscal support is crucial. Which countries have reacted most decisively?
Many countries reacted swiftly to the impact of the exogenous shock on their economies and provided large stimulus measures. Unsurprisingly, those countries that can actually afford it, dug deeper into their pockets – and they stand to profit from that going forward. Japan, Singapore, Germany and Sweden have all provided fiscal stimuli of about 20 per cent of their yearly gross domestic product (GDP). Less convincing action has come from the United States with packages mounting up to about 14 per cent of its GDP.

There are some economists warning that such large spending programmes may create inflation over time. What are your thoughts on the matter?
Well, inflation expectations have not jumped so far – and we do not expect that to change. On the contrary, inflation in the eurozone actually turned negative again just recently. Continued low inflation readings are a signal that the pandemic has dragged consumer spending down deeply and continues to affect prices even though the economic backdrop is improving. The demand shock from the pandemic will keep inflation contained for the time being.

Inflation expectations in the US are back up at their February 2020 levels, but US government bond yields remain near their all-time lows. What is your take on this?
There are plenty of reasons to explain why US government bonds yield so little in the current environment including ongoing financial repression and the safe haven nature of these instruments, to name just two. However, looking at ‘fair value’, we would still expect yields to increase over the coming months. This is just one of the reasons why we continue to advise fixed income investors to consider moderate credit risk when seeking exposure to the asset class.

Equity markets have performed well over the past months. Many investors are reluctant to increase exposure now, citing valuation levels and various risk factors. What do you tell them?
Well, to cut a long story short, it is TINA (‘there is no alternative’), in my view. True, there are plenty of risks around, causing investors to scratch their heads. They include further trade tensions, fears of a second Covid-19 wave, monetary and fiscal policy errors, the US elections, a hard Brexit or Quitaly, to name just a few. These risks are all real but we do not consider any of them a ‘game changer’ for investors. Mind you, based on the equity risk premium, stocks remain cheap, especially versus bonds.

When it comes to stock valuations, we admit that based on our earnings expectations for 2021, the S&P 500 is currently trading comfortably above historical averages, but the earnings recovery is on track, and we continue to expect further earnings upside revisions.

Further broad-based lockdowns remain unlikely, as targeted quarantine measures are more effective, hospital treatment has improved and mortality rates continue to come down as the virus is mutating. Against that backdrop, the economic recovery should continue, and the valuation gap between the digital lockdown winners and the rest of the market is likely to continue to narrow over the coming months. In our opinion, this is a mean reversion trade and not a change in the structural trends that continue to favour digital winners in the IT sector.

Which sectors/segments do you consider attractive now and why?
We see no evidence for a change in leadership in equity markets but expect the sector rotation into beaten-down cyclical stocks to continue as the economy continues to recover.
While we see comparably more upside for US stocks overall, we would also highlight the European small-cap segment, which has a high exposure towards cyclical sectors. Its recent outperformance has been moderate at best, compared with historical post-recession periods and relative valuation metrics, which are still well below historical averages.

Anything slightly more novel, maybe?
Yes, of course. For diversified investors, the newly launched Hang Seng Tech Index, another proof of the coming of age of Chinese financial markets, provides an interesting investment opportunity.
The ‘Hong Kong Nasdaq’ is an effective representation of the Chinese ‘new economy’ sector as tech companies form the bulk of it. Some investors may be concerned about the high valuation of the index, which is a common feature of most ‘new economy’ stocks. However, we argue that macro dynamics (ie growth scarcity and massive liquidity) over the past decade have continuously re-rated these growth stocks.

Lastly, what do you expect will happen in the financial markets on the day of the official approval of a vaccine for Covid-19?
Well, I have no crystal ball of course but once an effective vaccine becomes widely available, the premium, which has been priced into some of the major growth stocks in the internet and technology sector since March, is likely to evaporate. Partly, this has already happened but the process is not yet complete.

As a result, cyclical stocks still have some catch-up potential. In any case, the consequences of the corona crisis will resonate for longer, affecting individuals, companies and countries for years to come.