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Our outlook on critical drivers of investment performance

The global economy is indeed recovering from the COVID-19 shock. We expect the recovery momentum to normalize in Q3 2020 to a pace slower than in May-June. Full recovery of GDP lost in H1 2020 will take several quarters. Many sectors (travel, hoteling, real estate) will have to change business models permanently, which will take time. Progress on COVID-19 is critical. With cases rising, return-to-work strategies could be delayed or even reversed, denting the recovery process. Were that to happen, Global GDP growth and corporate earnings estimates would see another leg down. Expiring fiscal support measures is another critical component. The global economy is not on a strong enough footing yet to withstand a rapid withdrawal of support, so complacency could create a negative feedback loop.

Inflation came off sharply in Q2 2020 but as growth and commodity prices recover, the worst of the inflation decline is behind us. Our cyclical indicator predicts a gradual rise in H2 2020. A more mature recovery where consolidation gives some pricing power to survivors will add to inflation tailwinds. Restrictive government trade policies too can enable more pricing power to such firms by reducing competition. Evidence of market structures influencing inflation can be found in US Services and US Medical CPI (lower substitution effects), which grew at 2.5% and 3.1% annualized over the last 15 years (May 2005 to May 2020). In contrast, overall CPI rose at 1.6% annualized.

  • Anti-fragile assets like global safe-haven treasuries and gold are expensive.
  • Equity valuations are optically expensive after the impressive recovery in prices since March, combined with deep earnings cuts. However, depressed safe haven asset yields is a key supporting factor. Visibility on normalization of earnings (recovery after the decline) is crucial for markets to sustain current valuations.
  • Corporate spreads have narrowed in the last two months. While IG is approaching fair value, there is room for HY spreads to compress. Central bank intervention via corporate purchases is helping the flow of credit; fundamentals (corporate ability to payback debts) will guide the path that spreads take.
  • The US$ is expensive based on purchasing power parity. Combined with reduced interest rate differential for US$ fixed income assets, it will make it a steeper climb higher for the greenback unless COVID-19 related uncertainty and rising geopolitical tensions generate a risk-off bid for it. A weaker dollar will be a big positive for risk assets in emerging economies.

Global monetary policy has never been easier, both in terms of policy rates and in terms of central banks’ will to use their balance sheets. Yet, fears of a deep recession have considerably tightened the spread, equity and volatility components of our financial condition indices. As the announced monetary and fiscal measures work their way through, we expect a positive impact on spread (tighter), equity (higher), and volatility (lower) which may start easing financial conditions. While that is our base case, uncertainty will likely remain high as long as visibility on containing the virus in the US is low.

The market isn’t oversold anymore, nor does it appear overbought. Declining volatility implies systematic, riskparity and momentum strategies have added risk but there is scope for them to add further. Retail sentiment has been far from euphoric. Overall, we assess these indicators to be neutral.

At this stage, the key risks we envision are:

  • Failure to contain the spread of COVID-19 leading to a strengthening of restrictions.
  • Monetary/fiscal policy supports are withdrawn too soon.
  • The US election cycle increases political noise (dysfunctional Congress and US-China relationship under strain as China becomes a focal point). Democratic control of all 3 branches of the Govt. will almost certainly cause corporate taxes to rise. Historically, a clean sweep has yielded weaker results than a divided power set-up. 
  • From a longer-term perspective, Government intervention in allocation of resources will come with strings attached. Laws could be tightened around buybacks, distributions, leverage etc.
  • Social stress caused by COVID-19 could manifest itself in unanticipated ways including bouts of unrest, which could dampen the recovery. Also, prolonged unemployment payouts could disincentivize workers from returning to work, impacting potential labor supply

As of 30st June 2020. These are the current views and opinions of Principal Global Asset Allocation and is not intended to be, nor should it be relied upon in any way as a forecast or guarantee of future events regarding particular investments or the markets in general

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This document has been prepared by Principal Global Investors for informational purposes only. The contents of the document should not be construed as an advice on legal, financial or regulatory issues. No person should rely on the contents of this document without first obtaining independent advice from qualified professionals. The National Bank of Ras Al Khaimah (P.S.C), its employees and consultants expressly disclaim all liability and responsibility to any person who reads this document in respect of anything done or omitted to be done by such person in reliance, whether wholly or partially, upon the contents of this document and shall not be responsible for the results of any actions taken on the basis of information provided in this document or for any error in or omission in this document.