Even though the short-term recoveries on the stock markets may suggest it – the markets remain volatile, and, in our view, investors’ portfolios should be defensive until further notice.
In view of increasing inflationary pressure, the central banks (especially the ones in the USA and Canada) are expected to further reduce the monetary policy pandemic stimulus and to raise interest rates further in the medium term. With a global debt of over US$ 300 trillion and the huge expenditure plans of many countries for climate, infrastructure, and digitalization, this is a highly risky balancing act for monetary policy. Higher interest rates would not only jeopardize the debt sustainability of many highly indebted states. The insolvency of individual states would entail further (panic) bond sales by institutional investors, with further interest rate hikes and market distortions as a consequence.
Also, current news from China in connection with the attempt to prevent the bankruptcy of the highly indebted real estate service provider Evergrande with impacts on the entire real estate sector (real estate and the related industries represent about one-third of the Chinese gross domestic product) do little to calm things down as well as the geopolitical tensions between China and Taiwan in the South China Sea. In addition, a stagflation scenario threatens: the entire world economic activity is currently cooling down, while inflation remains high due to the strong shortage of labor force and raw materials.
Even corporate earnings seem to have reached the peak. The MSCI All-Country World Index has posted earnings per share of 20% for the next 12 months, compared to 60% in June. Rising bond yields are likely to weigh on the price-to-earnings ratio of equities that are still (over) valued, as future cash flows will have to be discounted with higher interest rates. Some models assume share price declines of up to 20% if long-term bond yields rise by around 100 basis points. The risk is even greater as a late cycle of rising inflation begins, in which returns on stocks and bonds tend to be more positively correlated. The correlation between the two major asset classes is currently the highest in 15 years.
The most endangered areas are growth-oriented equity markets and sectors. On the other hand, the beneficiaries would be defensive quality stocks with high dividend yields, high-quality cyclical stocks and investments in regions where economic momentum is more robust. One example is the Eurozone with its still strong economy, especially since the European Central Bank does not plan to tighten its monetary policy so quickly and liquidity measures would thus continue to support the markets.
However: There is light on the horizon. Once the global economy catches up on the output that was lost due to the pandemic, the US yield curve might flatten significantly in the coming year and pushes global equities. Overall, however, modesty is required for the next few years as far as future yield targets are concerned. Many market participants are forecasting annual returns on US$ equities of no more than 6% for the next few years, which would be less than half of the total annual return of the past decade.