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Fourth quarter outlook

  • Financial Analyst
  • Blog post submitted on 14th September 2020

The backdrop to the outlook for financial markets will be the continued monetary and fiscal support from policymakers. Indeed in spite of investors’ economic and political apprehensions, equities are set to enjoy a favourable tailwind into 2021, aided by the unprecedented amount of paper currency inflation in the global financial system.

Fiscal stimulus is also having a significant economic effect, with Japan spending 21 per cent of GDP on fiscal stimulus, followed by the US at over 13 percent so far this year, and with France recently announcing a €100bn fiscal stimulus package. This should support a global economic, and thus earnings, recovery over the next months, given the usual lag from such stimulus spending. These two forces, together with attendant real rates in increasingly negative territory, will be the most potent macro drivers of equity markets globally to the end of this year.

On the credit side, the outlook is more mixed as the new credit cycle which witnessed credit outperforming equities in April and May has come to pass. Corporates have raised an enormous amount of liquidity as investors fled to higher quality assets, dropping yields to unprecedented levels. Indications are that we moving from the repair phase to the recovery one, as growth is tentatively increasing, leading economic indicators have turned positive, and corporations remain disciplined and focused on keeping a strong balance sheet.

This has lead investors to gradually move out of the safe havens into lower-rated assets narrowing spreads over the past couple of months, a trend that is set to continue. What’s unique about this downturn is the extent to which policymakers are targeting the credit market.

Corporate bond market conditions have become a specific policy target, and there is very little tolerance for tighter credit conditions as this was considered to have exacerbated the financial crisis experienced in 2008.

Despite having the same target, the Fed and the ECB apply different strategies: the ECB buys a significant amount of corporate bonds under the PEPP and the CSPP liquidity programs, whereas the Fed has explicitly targeted “Corporate Bond market conditions to return to pre-COVID levels” but has only needed to buy a small amount of corporate bonds so far. With this backdrop, cyclicals-sensitive, low-rated credit should outperform, High Yield especially, in the next stage of the rally.

The corporate bond supply/demand imbalance should be favourable for prices in in credit markets as corporates don’t need additional funds as they reached their liquidity targets with the record issuance in the first half of the year.

On the other hand, judging from the sustained inflows into credit funds, demand should remain stable. The aforementioned record levels of paper currency in circulation has added to this effect. In terms of fundamentals, we view the next leg of the rally as make-or-break moments for corporates, especially high yield. Downgrades and defaults are expected to peak through to the end of the year, with the expected recovery in 2021 and beyond carrying upwards the corporates which have been critically impacted by the pandemic induced crisis.

This is particularly relevant for corporates exposed to emerging markets, where economic risks remain elevated despite a modest recovery in activity levels, as foreign capital flows remain weak.

Markets are expected to remain highly sensitised to pandemic related news in the short term, with vaccine hopes countered by fears of second waves and ancillary lockdowns in countries, as was announced in Israel over the weekend. Furthermore, the US election is expected to make strong headlines and influence sentiment as the two presidential candidates trade barbs and fight for position.

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