Investment Traffic Lights | Quarterly Edition

2.1 Fixed income

Given that our view of the economic and inflation outlook is in line with central-bank expectations, we do not expect either the U.S. Federal Reserve (the Fed) or the European Central Bank (ECB) to raise interest rates in the coming twelve months, but we do expect the Fed to gradually scale back its bond purchases starting around the turn of the year. For the ECB, however, tapering might have to wait until next summer. But for assessing yields in one year's time, one has to look at what investors will be expecting then for the coming twelve months. We therefore still expect a slight drop in bond prices and increase in yields for all maturities.

For 10-year government bonds we expect yields to rise by around half a percentage point on both sides of the Atlantic. We think the short end will anticipate the approaching possible interest-rate moves by central banks (especially in the U.S.) while the long end reacts to the progress of the economic recovery and the phasing out of bond purchases. We expect a rising yield curve overall, apart from the segment between 10- and 30-year U.S. Treasuries. Developed-market sovereign bonds are likely to generate largely negative total returns, while investment-grade corporate bonds should only just make it into positive territory. Things look better for high-yield bonds, where the economic recovery and low default rates are also having a much stronger (positive) impact. We also prefer the high-yield segment for U.S. municipal bonds ("munis"), which remains an important segment for institutional investors anyway.

Away from developed markets, we particularly like Asian bonds, although we found Chinese securities overpriced even before the regulatory offensive. This offensive is likely to cause higher volatility in the Chinese bond market for some time to come and has made yields more attractive in Asian markets generally in the meantime. Asia is currently also being held back by the spread of the delta variant, but it continues to benefit from solid government finances and close ties to the global recovery. In currencies, we see the euro at $1.20 in twelve months. 

2.2 Equities

In our view global equity markets will continue to be driven by fiscal and monetary support. Not since World War II has the level of stimulus been so high, especially in the U.S. It’s therefore difficult to imagine that there is much more return potential from the current record-high index levels, and that is a concern. But we nevertheless expect total returns to average around five percent over the next twelve months. We leave our previous valuation assumptions unchanged, i.e. we assume a price-to-earnings (P/E) ratio of 22 times for U.S. equities and significant discounts for all other developed markets.

Our forecasts are based on the following assumptions: 1. real yields on longer-dated bonds remain negative for the foreseeable future, further supporting the "TINA" (there is no alternative) argument. 2. Tapering (the reduction in central-bank bond purchases) is well digested by the market over the medium term. 3. Inflation declines in 2022 and the global economy continues to grow above its normal potential growth rate in 2022. What do these assumptions mean for our forecasts? 

In the last three years, value stocks have lost considerable ground to growth stocks. We assume that the P/E discount for the former against the latter has increased from 20% to 50%. This process has been driven by collapsing interest rates (which are bad for financials) and the continued depreciation of sectors with poor ESG ratings (e.g., energy and commodities). Meanwhile digitization, strong earnings growth in global technology stocks, and low discount rates have driven up the multiples for growth stocks in particular.

We do not expect value stocks to reduce that discount fully in the next twelve months, nor do we favor either investment style over this period. However, given the forecasts of solid economic growth, progress with vaccinations and the likely easing of supply-chain issues, we see a good chance for a "second cyclical wave" of economic recovery in the second half of 2021. Regionally, this would benefit Europe and Japan. But in other regards both regions currently lack a clear catalyst that would narrow their increased discount to the U.S. In terms of sectors, we maintain our barbell strategy of overweighting IT and selected cyclical sub-sectors, while underweighting the defensive side of the market.

In emerging markets we have become somewhat more cautious in the short term, above all because of China. The regulatory initiatives could drag on into the fall of 2022 and individual sectors or companies could again be surprisingly targeted by the authorities. The markets could remain volatile as a result. In the long term, however, the regulations and reforms that are being applied could benefit the economy and thus the market as a whole – provided not too much favoritism is shown towards quasi-governmental companies (SOEs) over private companies. We have increased our target discount for emerging markets from 33% to 40% and remain cautious despite the current low market levels.

The Chinese experience provides a taste of how governments in general can erode profits and curtail business models. We see a risk for U.S. tech companies as well. In any case we do not expect (after-tax) earnings growth for the U.S. in 2022, due to the likely tax reform.

2.3 Alternatives

In the alternative space we expect sideways movement for both gold and oil. Gold is likely to be capped – on a 12-month horizon – by weakening inflation concerns and slightly rising interest rates. We prefer industrial metals such as copper and aluminum which face their supply constraints while demand is rising. Oil might rise slightly if OPEC+ countries have enough discipline to keep their supply in line with global demand growth, not ahead of it.

Infrastructure assets should continue to benefit from low interest rates coupled with higher inflation as they can usually pass cost increases on. Real estate also continues to benefit from this environment. Prices have already risen sharply in some markets. In the U.S., annual house-price inflation is at its highest since data began to be collected in the late 1980s. But the market is not overvalued in relation to real interest rates. The ongoing economic recovery continues to support our sector favorites – industrial, logistics and residential properties – but their outperformance now argues for a more balanced positioning. In any case, we are taking a selective approach on office and retail properties.

2.4 ESG developments

The observation that 'ESG' themes, especially the E for environment, have done well so far this year reflects in part the bad news we have all heard – but at least this bad news might be followed by positive change. Environmental disasters have dominated the headlines, especially in the summer, with droughts and wildfires or floods, sometimes not far from one another, and both in the United States and in Europe. Climate change and how to deal with CO₂ emissions have therefore become ubiquitous topics. Though declarations of intent still seem to be more prevalent than concrete action, the momentum on this issue is undeniable. Equally undeniable is the fact that a great deal of groundwork is still needed on how investment dollars can be channeled in the best possible way. One of the most important issues is assessment of the environmental profiles of individual companies. Here, investors are eagerly watching the ECB which intends to provide more details on its Green Agenda in the coming quarters. This will include how it defines the selection criteria for green bonds.

Apart from green bonds, CO₂ emission rights in particular are likely to preoccupy the capital markets in coming years. The fact that prices for carbon emission allowances more than doubled within a year already impressed investors in the spring of 2020. And this issue is likely to become still more important, with governments and regulators intending to subject more sectors to the emissions rights system, especially in Europe. The likely fall of carbon-emission caps (which should therefore become more stringent) and the introduction of a carbon border-adjustment mechanism will probably also drive up the price of certificates. Last but not least, the inflationary effect of certificates should also concern investors.

3 / Past performance of major financial assets

Total return of major financial assets year-to-date and past month

4 / Tactical and strategic signals

The following exhibit depicts our short-term and long-term positioning.

4.4 Legend