Invesco - The investment climate and what it means for markets

The unlocking of economies is causing a rebound in activity with the prerequisite pick-up in profits expectations, albeit from a very low base. After the initial surge in activity as business and consumer pent-up demand comes through, the longer-term recovery will be slow and difficult as economic disruption and disinflation will remain, absent a universally available Covid vaccine. Structurally high unemployment is likely set to persist for many years as economies adjust to the new ‘normal’.

Investors will potentially have to get used to renewed lockdowns as and when the disruptive head of Covid reappears, although governments now appear more willing to close towns and cities rather than the whole economies, in order to limit the economic damage. The policy response to the economic disruption has been strong either in actual or promised monetary support mechanisms ranging from liquidity and credit provisioning and interest rates capped close to zero. Central bank quantitative easing (QE) is funding aggressive fiscal expansion, including quasi ‘modern monetary theory’ (MMT), and direct ‘helicopter money’ via grants. This has supplied a real lifeline to many businesses.

What does this market backdrop, or ‘investment climate’ mean for markets?

Equities have already enjoyed a strong rally since the worst of the Covid induced sell-off in the early part of 2020, but despite this most markets don’t look highly overvalued. At present investors are looking at low discount rates and monetary support as an investment justification. Capital is being allocated to parts of the equity market that look set to survive in the longer-term just as new-economy disrupter stocks take market share from traditional bricks and mortar businesses. The lack of return potential from alternative asset classes such as government bonds and cash is directing investors towards equities.

One note of caution going forwards is that despite the strong recent rebound, equities maybe vulnerable to further volatility as longer-term profits expectations look too elevated as present and rely on a continued improvement in earnings expectations that are starting to appear.

Credit spreads appear to discount different default outlooks and hence there appears more value in investment grade than high yield, which could be vulnerable to corporate profit uncertainly. Helpfully though, some government bail-out schemes have targeted credit across the risk spectrum. The appetite for high yield names may be limited due to ratings downgrades, but there also appears high investor demand as some yields look attractive. Indeed, high investor demand for credit has allowed many corporates to issue bonds to support their balance sheets relatively cheaply.

Emerging market debt yields, despite the credit risk, remain attractive as local central banks appear willing to ease policy, including deploying QE, to counter recession even if that means currency weakness and hence the chance of higher imported inflation.

The major central banks are targeting government yield levels close to zero, with sustained curve steepening likely met with bond buying, suggesting the return outlook for this asset class is limited unless there is a further sustained economic slowdown. The compression trade is still playing out in the US relative to Europe, but all other major bonds markets are seeing yields close to zero and so return potential from here is limited. Central bank targeting of both the curve and yield levels, as part of monetary policy, will also keep bond volatility unusually subdued in this recovery when compared to past recoveries.

Important information

All data in this document as at 31 July 2020 unless otherwise stated. Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice. www.invesco.co.uk