"Our outlook for 3Q" is the continuation of the series where UBS Chief Investment Office provides quarterly updates on the investment outlook.
In this edition, we address five questions at the forefront of investors’ minds at the mid-point of 2021: Where can I still find short-term portfolio growth? How can I protect against downside risks? How do I boost my portfolio income?
How should I prepare for higher inflation? What are the most attractive structural opportunities?
Predator or prey?
You’ve probably noticed that some animals, like chickens, sheep, and zebras, have eyes on the sides of their heads, while others, like wolves, tigers, and owls, have eyes facing front. The first group, whose primary aim is not to be eaten, values awareness of what’s around and behind. For the second group, more focused on the catch, the ability to perceive depth is critical to successfully navigating the world and securing their prey.
For investing, seeing what lies ahead is paramount. Our perception of future economic trends helped us increase our risk asset exposure when virus fears were high last year. It also helped us tilt exposure toward reopening and reflation beneficiaries in September, even before vaccines had been broadly rolled out.
Today, if we just look around and behind us, we see economies reopening, inflation rising, and equity volatility sitting at its lowest level since before the pandemic. But if we look forward, we see something different.
First, while we expect economies in the US and Europe to reopen successfully, we think the best opportunities are shifting toward Asia, as vaccinations in the region positively impact local markets. We like Japanese stocks, which languished in the first half, as Japan is now vaccinating more than 1% of its population each day. We also see vaccinations and lower infection rates lifting India’s markets. Meanwhile, we expect Chinese equities to benefit from the strong earnings growth we anticipate next year.
Second, we expect inflation to fall from today’s elevated levels as base effects and pandemic-related supply issues dissipate. This will keep the pressure off central banks to take drastic action, and we expect yields to remain negative in real terms. As such, investors will need to look for opportunities to maintain purchasing power and generate returns. For income, we like US and Asia high yield credit, select dividend-paying stocks, as well as “alternative yield” strategies.
We see limited near-term catalysts for tech mega-caps in the US and Asia. However, we see opportunity in digital leaders in Europe; in small and midsize firms exposed to trends like 5G, fintech, greentech, and healthtech; and in digital subscription businesses. Looking further ahead, the inflation outlook remains uncertain and the Federal Reserve has acknowledged the potential for more persistent inflation. For long-term inflation protection we like stocks that exhibit quality growth at a reasonable price Q-GARP, private market infrastructure opportunities, and commodities.
Finally, experience tells us that volatility will return at some point in the future. Investors can use periods of low volatility to prepare. Strategies include utilizing options and structures to reduce downside exposure, taking profits on certain stocks that have notably appreciated, and diversifying into hedge funds.
short-term portfolio growth?
Global equity markets are now 24% above pre-pandemic levels, leading some investors to wonder if upside may be limited from here. However, we think equity indexes can move higher, driven by a combination of robust earnings growth, still-attractive valuations relative to bonds, and accommodative central banks.
The rally is underpinned by very strong earnings growth, which has continued to beat expectations over the first half of this year. We now expect S&P 500 earnings to be 30% above pre-pandemic levels in 2022. Eurozone earnings should be 18% higher, and Asia ex-Japan earnings 50% higher. At a global level, the current equity risk premium for the MSCI All Countries World Index is around 400bps, comfortably above its long-term average of 274bps.
The 2022 P/E ratio is 18.8x. But while we continue to anticipate gains at a global index level, we don’t expect those gains to be evenly distributed. We see greater potential in regional markets that underperformed in the first half of 2021, particularly China and Japan. We also think there is more upside to come in stocks that are more heavily exposed to economic reopening.
protect against downside risks
As equity markets have rallied to record highs, some investors are beginning to focus more on potential downside risks, including coronavirus mutations, inflation, and geopolitics. They’re considering whether it’s time to lock in profit, or to wait before committing more capital.
Overall, we do not think the downside risks we face today are higher than average. In our base case, we do not expect them to topple the rally, and long-term investors should generally not try to time the market, in our view. Waiting for risks to subside can be an indefinite and costly process, and investing at all-time highs has historically not proven to be riskier than investing during other periods.
At the same time, investors should regularly review if equity market gains mean they are now taking excessive portfolio risk. If so, they should consider ways to reduce some of that risk, while keeping long-term plans on track. This can be done by locking in gains on stocks that have outperformed and now have limited upside, or by seeking greater downside protection via hedge funds, options, and structures. Diversifying into select defensive stocks is another option to consider.
BOOST portfolio income
Despite high levels of growth and inflation, interest rates are likely to remain low in the months and years ahead. Our view, mirroring the Fed’s own projections, is that US rates are likely to remain in the 0–0.25% range until 2023. Rates in the Eurozone and Switzerland are negative, and increases there could take longer still.
For investors who rely on their portfolios to provide income, this environment is especially challenging. Even if smaller economies like Norway, Canada, and New Zealand raise rates sooner, in most major currencies yields not only are insufficient to compensate for inflation, but also are not expected to risein the immediate future. With inflation elevated, real returns are under particular pressure.
This means investors will need to find ways to boost portfolio yield. In various recent publications, we‘ve discussed the need to diversify away from cash and investment grade bonds into higher-yielding assets. But as market leadership shifts away from growth stocks, we think the “hunt for yield” will also become more worthwhile for equity-heavy investors too.
Specifically, we see less potential scope for meaningful gains among mega-cap growth stocks, whereas we expect a recovery in dividend payments in other parts of the market in the second half of the year. This backdrop provides investors with the opportunity to diversify into select dividend stocks, senior loans, or engage in “alternative yield” strategies.
Preparing for higher inflation
Inflation has not been a major problem for investors since the 1980s. After averaging 7.1% in the US in the 1970s, and 5.6% in the 1980s, inflation rates since 1990 have averaged just 3.0% in the US, 2.3% in Switzerland, and 1.3% in the Eurozone (since 1997).
Yet, as the post-pandemic recovery takes hold, prices of various goods and services are rising. In the US, the consumer price index rose by 4.2% year-over-year in April and 5% in May, and the Citi US inflation surprise index is at its highest level since its inception in 1998. The Bloomberg Commodity index went up more than 50% over the last year, and the UN FAO food price index is up 40% in one month.
In our base case, we don’t think persistent inflation above 3% is likely. Many of the structural factors that have helped keep inflation low during the last decade remain in place, including the ongoing shift to services, the influence of technology, aging populations, and inequality. In addition, low, stable inflation remains a primary central bank objective, and policymakers have the necessary tools to keep it in check.
That said, the Federal Reserve’s new average inflation targeting framework, unprecedented fiscal stimulus, and policymakers’ more tolerant attitude toward high debt-to-GDP levels could drive a regime change. In particular, the current spike in inflation could prove sustainable if labor market imbalances lead to higher wages, excess savings are spent, or if companies seek to exercise their pricing power.
Higher inflation is relevant for investors for two reasons. First, higher inflation and inflation volatility could drive higher interest rates, leading to volatility in stocks and bonds. Second, if sustained, higher long-term rates of inflation would erode purchasing power more quickly, making investors reassess whether current financial plans were still viable. Investors need to make sure they are prepared for both eventualities by building inflation protection into portfolios. Without portfolio adjustments, just a 1pp increase in long-term inflation would mean a 21% reduction in sustainable real spending power (assuming the difference between the impact of 2% and 3% inflation on a 60/40 portfolio over 16 years).
The pandemic accelerated a variety of secular trends, including e-commerce, digital payments, and remote working, driving strong performance across the technology sector. But as economies reopen, investors will need to be more selective about long-term growth exposure.
Mega-cap tech has already benefited from significant upward revisions in analysts’ earnings estimates, with 2021 expectations raised by between 7% and 24% over the past three and six months. With product refresh cycles generally unfavorable in 2Q and the second half now offering limited scope for earning beats, we don’t see many catalysts for mega-caps to move markedly higher from here.
But we think there are still other opportunities for investors seeking structural growth. In particular, we highlight some of the overlooked parts of the growth space, including smaller and mid-cap technology companies in high growth industries, and digital subscription business models.
We have also identified several ways for investors to go sustainable across electric vehicles, greentech, and in stocks that are solution providers for the Future of Earth. Separately, we note that private markets can also often offer better access to early-stage, innovative companies operating in these thematic areas.
Position for reopening and recovery
The world economy is reopening, with both inflation and growth picking up supported by the vaccine rollout and stimulus measures. We favor more cyclical markets, and think select areas like financials and energy should benefit, as should select re-opening winners across regions and commodities including oil.
Global equity markets are now well above pre-pandemic levels, leading some investors to wonder if upside may be limited from here. However, we think equity indexes can move higher, driven by a combination of robust earnings growth, still-attractive valuations relative to bonds, and accommodative central banks.
The rally is underpinned by very strong earnings growth, which has continued to beat expectations over the first half of this year. We now expect S&P 500 earnings to be 30% above pre-pandemic levels in 2022. Eurozone earnings should be 18% higher, and Asia ex-Japan earnings 50% higher. At a global level, the current equity risk premium for the MSCI All Countries World Index is around 400bps, comfortably above its long-term average of 274bps. The 2022 P/E ratio is 18.8x.
But while we continue to anticipate gains at a global index level, we don’t expect those gains to be evenly distributed. We see greater potential in regional markets that underperformed in the first half of 2021,. We also think there is more upside to come in stocks that are more heavily exposed to economic reopening.
Investors remain confident: 70% of investors are optimistic about stocks over the next six months.
At a sector level, we see the most opportunity for near-term gains in parts of the market most heavily exposed to economic reopening and recovery. This includes the energy, materials, and financials sectors, which, despite their recent impressive performance, still have scope for further gains as industrial production continues to recover, default risks subside, and yield curves steepen. While energy and financials have underperformed the global MSCI index by 31% and 17% respectively from the March low of last year to November (when the Pfizer vaccine’s efficacy was announced), since November materials and financials have only outperformed the wider index by 6-12%. We also think US small- and mid-caps have further scope to gain from the US cyclical recovery. At a more granular level, we also see catch-up opportunity for select names across Europe, Asia, and the US as the economy reopens.
Energy materials, and financials
Although global energy stocks have rallied by 32% year-to-date, the sector is still only pricing in a Brent crude oil price of USD 55–60/bbl, versus our September forecast of USD 78/bbl and our year-end forecast of USD 75/bbl. Materials, supported by a rebound in industrial production, a 21% rise in commodity prices, and a possible USD 2tr US infrastructure bill, should also continue to rally as the economic recovery gains traction.
Meanwhile, we think that the combination of steeper yield curves, reduced loan-loss provisions, and credit growth, should brighten the profitability outlook for the financials sector. Consensus expects an earnings rebound of 37% this year, and 37% for stocks as a whole. This would leave global financials trading on a P/E of just 13.3x, with a 2.8% dividend yield, once regulatory curbs on shareholder payouts are lifted.
US small- and mid-caps
We also see potential for continued outperformance for US small-caps and mid-caps over large-caps, given their more cyclical nature. In addition, valuations for US small- and mid-caps are near 20-year lows relative to large-caps, and earnings growth for smaller companies should outpace large-caps through at least 2022.
Stocks exposed to reopening
We think there is further potential for a catch-up trade among select stocks exposed to economic reopening across the US, Asia, and Europe. In the US, our list focuses on companies that should benefit from pent-up demand across leisure, energy, and financials. As the US economy reopens, we expect to see a pickup in business investment. In addition to the cyclical recovery, which will spur business spending in the near-term, the post-pandemic rebuild should support investment over a multi-year horizon. Structural trends such as re shoring, digitization, automation, and de-carbonization will likely influence where dollars are spent in the years ahead. We believe that companies across a number of sectors—primarily industrials, technology, real estate, and financials— stand to benefit from greater capital outlays.
Commodities and oil
Commodity prices are positively correlated with inflation, and energy has historically outperformed when US headline CPI is above 2% and rising. The current economic environment is conducive for higher commodity prices, in our view, and we expect broadly diversified commodity indexes to deliver total returns of about 10% over the next six months. We expect declining inventories and spare capacity to drive Brent prices higher and we forecast USD 78/bbl by end-September and USD 75/bbl at the end of the year. With the copper market still in deficit, we forecast prices to rise to USD 11,000/mt by end-September (from USD 9,570/mt today). Agricultural prices have also risen sharply this year, with the FAO Food Price Index climbing to its highest level since 2011. While our base case is for some moderation over the next 12 months, there’s still a risk of moderately higher prices as key Northern Hemisphere crop dates approach.
Key investment takeaways:
We think equity indexes can move higher, driven by a combination of robust earnings growth, still-attractive valuations relative to bonds, and accommodative central banks.
But we don’t expect those gains to be evenly distributed.. We think there is more upside to come in stocks that are more heavily exposed to economic reopening.
The current economic environment is conducive for higher commodity prices, in our view, and we expect broadly diversified commodity indexes to deliver total returns of about 10% over the next six months.