Danske Bank Quarterly House View Summer 2020

Equities worth the high risk

We have seldom experienced greater uncertainty on the prospects for the economy and corporate earnings than at the moment. Nevertheless, we see a reasonable return potential in equities over the coming year and are cautiously optimistic about our investment strategy.

Return potential and risk in the shadow of the corona crisis

While there is great uncertainty on how the economy will perform going forward, in our view an overly negative and cautious stance on investments is not the right strategy at the moment.

First came the coronavirus and the lockdown of large parts of the economy, quickly followed by huge economic as- sistance packages from the politicians and central banks – and whereas the virus triggered panic and pronounced price falls in the financial markets, the assistance packages helped spur a partial recovery.

We have now entered a phase where global economies are starting to reopen, and that has further boosted equities and other risk assets. How- ever, this by no means signifies that things are back to pre-corona times. Economic activity is still greatly reduced and overall expectations for corporate earnings this year have taken a consid- erable beating – and after the rebound of recent months, where investors have already priced both the large assistance packages and the expected reopening of economies into equity prices, we could say that the easy bit is now over.

Going forward, substantial progress is most likely required in relation to the economy and the coronavirus if we are to see significant price increases, while at the same time there remains great uncertainty on where the economy will be in just a couple of months, never mind six months or a year. Economists are starting to run out of letters to designate the various potential future scenarios.

— Going forward, substantial progress is most likely required in relation to the economy and the coronavirus if we are to see significant price increases.
Henrik Drusebjerg
Chief strategist

Equities expected to rise in the slightly longer term

In a nutshell, this uncertainty is what we as investors now have to navigate and try to make the most of – however, we do not see this as a time to be overly negative and cautious in terms of one’s investment strategy.

There is no doubt that we will gradually see a pick-up in economic activity as economies around the world reopen, and while investors to some extent have already priced in a share of that progress, we nonetheless expect to see reasonable increases in equity prices in the slightly longer term as the economic recovery gradually takes hold.

Return on equities during the corona crisis

Since global equities peaked on 19 February this year.

5 years’ accumulated return

US equities have clearly performed best over the past five years and European equities worst.

Source: Macrobond, data for MSCI index, total return, local currency. Calculated as of 27.05.2020.

Moreover, we should also remember that the corona crisis, in contrast to the financial crisis, has not been triggered by a deeper structural crisis founded on major economic imbalances that require a painful period of economic ad- justment. While the coronavirus has hit the economy hard, it is likely to be more temporary in nature, plus politicians and central banks have acted more swiftly and enacted more comprehensive measures than during the financial crisis. All this may also encourage the economy to shift up a gear or two more quickly and get many of the recently jobless back to work.

Cautious optimism is the way ahead

All in all, this gives us a well-founded belief that we can avoid an extended economic recession and, while new setbacks will doubtlessly arise, over 12 months we expect a return from global equities in the range of 2-6%. We are therefore maintaining an overweight in equities – in other words, we have a higher share of equities in our portfolios than we expect to have in the longer term, while we have an equivalent underweight in bonds.

However, we are not blind to the very high level of economic uncertainty prevailing at the moment, so our overweight is modest.

First of all, we have to remember that the financial markets are always ahead of economic developments and, as mentioned, this means that the significant equity price rises seen since the bottom was reached on 23 March already reflect expectations of society reopening and increased economic activity in the coming months. There is simply a great deal of uncertainty sur- rounding how quickly and strongly the economic recovery will unfold, just as the risk of a second wave of coronavirus outbreaks lies not far below the surface. Looking at corporate earnings in 2020, these are also associated with substantial uncertainty, so for an investor it is difficult to determine whether or not the falls in equity prices since the market peaked in February reasonably reflect the downturn in corporate earnings.

Collapse in business confidence illustrates the intensity of the corona crisis

The business confidence indicators (PMI) are normally important key figures for gauging sentiment and growth prospects in the global economy. Values above 50 indicate that a majority expect growth, while values below 50 signal a downturn. As the graph illustrates, the corona crisis has hit global business confidence on the production side and – particularly – the service side of the economy very hard.

Source: Macrobond as of 25.05.2020

Trade war and Brexit could flare up
Moreover, considerable political risks exist that complicate the picture and could trigger further market turmoil:

TRADE WAR COULD FLARE UP: In the US, Donald Trump has – not least in an election year – a need to disown responsibility for the corona crisis and the explosive rise in US unemployment. A blame game is under way in which he is painting the Chinese as the guilty party and has hinted he might introduce new trade sanctions to punish China for the pandemic. At the same time, the pandemic provides greater political support with which to pursue his agenda of shielding advanced US technologies from the Chinese and ensuring the US maintains its global dominance in the tech field.

In our opinion, this has been the key underlying force for the trade war between the US and China, increasing the risk of a renewed flare up. However, for now we expect Trump will stick to limited measures and threats, as neither of the countries can afford a major escalation in the trade war at the present time. Nevertheless, this remains a risk we should be aware of.

Factors that could boost equities further

Faster economic recovery than expected:

In this best-case scenario, economies are reopened relatively quickly and efficiently without any major setbacks in terms of the spread of the coronavirus. The delayed private consumption and business investment of recent months further boosts economic activity and corporate earnings, contributing to business and consumer confidence correcting faster than expected. Altogether, this provides fertile ground for a solid rise in equity prices. If we, in addition, see marked progress towards the develop- ment of a vaccine or effective treatment for the corona- virus, the increase in equity prices could experience an extra tailwind.

Slow, but stable, reopening of the economy:

Even a slower economic recovery could benefit equities. If the economic data shows gradual progress without deviating too much from expectations, that could remove some of the massive uncertainty prevailing over economic growth and corporate earnings at the moment – and less uncertainty is always positive for equities.

Companies less vulnerable than expected:

The best-performing equities this year have been those whose business models have only been affected to a limit- ed extent by the coronavirus – or perhaps have even been positively affected. These companies continuing to deliver solid results could support investor sentiment, particularly if coupled with the outbreak resulting in fewer bankruptcies than feared and more companies than expected managing to keep their businesses afloat through the crisis.

Further economic stimuli:

Governments and central banks have enacted huge fiscal and monetary policy easing measures to support their economies during the crisis – but they can do more. In the US, talk of major infrastructure investments has been circulating, while European governments and the EU could further increase fiscal policy stimulation and more specifically, appear to have several large initiatives on the drawing board, focusing on the green transition, for example. Looking at the US central bank, the Fed, in pure percentage terms it has not ramped up its bond purchase programme as quickly and aggressively as during the financial crisis, so here too, more could potentially be done to support the global economy and hence also the financial markets, if necessary.

Investors have cash in reserve:

Data for institutional investors (from Bank of America Merrill Lynch) shows that they currently have a very high share of their funds in cash compared to the average of recent decades – and also a higher share of cash than during the financial crisis. This is hardly surprising given the high degree of uncertainty at the moment, and it also gives investors more flexibility to buy equities – even if equity markets suffer a setback, as this could be seen as a buying opportunity.

Brexit rearing its head again

In Europe, we expect the uncertainty surrounding Brexit to intensify in the time ahead. The UK is set to definitively exit the EU at the end of 2020, when the current transition period expires, but the corona crisis has further complicated negotiations over the future relationship between the EU and the UK. If the required progress in negotiations does not materialise, the parties must agree on a potential extension to the transition period by the end of June – but the UK prime minister, Boris Johnson, has so far been very firm in his rejection of that option. This presents a significant risk of a so-called hard Brexit at the end of the year, in which the UK cuts its ties to the EU without having a trade deal in place – a horror scenario for both companies and the financial markets.Ï

Italian debt problems

The co- rona crisis has also placed renewed focus on the strained debt situation, particularly in Italy, where the huge bill for the corona crisis is pushing the government’s debt levels even higher, while financing costs – in other words, interest rates on the Italian debt – have risen at the same time.

Return potential on bonds minimal

That being said, there are also factors that could push the financial markets in a positive direction – such as a break- through on a treatment or vaccination for the coronavirus, or the economy in a best-case scenario returning to a normal level more quickly than expect- ed.

Factors that could lead to renewed falls in equity prices

Economic recovery slow in coming
In a bad scenario the global economic recovery could drag out due to the coronavirus having had a deeper impact on the economy than expected. The dramatic rise in unemployment, especially in the US, may prove to have a more long-lasting impact on growth and corporate earnings than expected, and the same applies if the economic and political uncertainty causes companies to be overly reductant to make new investments. This negative scenario could be further fuelled by a second wave of coronavirus infections as economies are reopened around the world – or if the development of a vaccine or effective medical treatment for the virus falters. US Fed chief Jerome Powell has stated that the US economy may not regain its full strength until we have a vaccine against the corona- virus – and if that is the case, a full recovery of the global economy could be slow in coming.

Valuations unsettle investors
The combination of rising equity prices since they bottomed out on 23 March and declining expectations for corporate earnings mean that equity valuations are no longer cheap. That could prompt investors to wait and see with investments until valuations are more favourable. However, investors at the same time face the challenge of very low yields making bonds not particularly attractive as an alternative.

Political risks flare up
As we have outlined in our main article, both Brexit and the US-China trade war are simmering political risks at the moment that could suddenly erupt – and we have previously seen how the trade war, in particular, can have a distinctly negative impact on global equities.

Economic stimuli run dry
Should the corona crisis drag on for a long time or even worsen, neither politicians nor central banks have limitless ammunition to stimulate the economy. Government assistance packages to date have led to dramatically increased levels of debt for many countries around the world, and even though central banks can purchase even more bonds, at a certain point it will provide diminishing returns in terms of economic support. The US central bank has already cut interest rates to zero, but has so far seemed reluctant to discuss negative rates, which we have seen in Europe, even though some market participants see this as a possibility. Politicians and central banks may thus face a difficult balancing act by having to signal they are ready to support the economy further if needed, but without promising too much. Moreover, the wrong announcements at the wrong time could increase uncertainty and result in price falls in equity markets.

Furthermore, global equities are still trading significantly below pre-corona levels despite the rebound in recent months. The sum of all these various factors makes us cautiously optimistic overall and we have a modest overweight in equities. We estimate the potential from equities in the slightly longer term will more than offset the short-term risks. In addition, the return potential from government bonds, in particular, is extremely limited – firstly, because yields are close to historical lows and, secondly, we expect that a gradual recovery in the economy and increased investor appetite for risk will eventually lead to slightly higher yields, which means a fall in bond prices.

However, in the short term at least, we expect the massive asset purchase programmes of the central banks to keep yields low. Also, despite the modest expected return from the most secure bond types, they still have a valuable function in investor portfolios, where they can increase the stability of the overall return – something we, of course, have seen the value of during the corona crisis.

US housing market is now more robust

The financial crisis largely stemmed from a deep structural imbalance in the US housing market, where far too many poorly performing mortgage loans had been issued. The current picture looks much healthier by comparison, with a much lower housing debt-to-GDP ratio.

Source: Macrobond as of 25.05.2020

Regional allocation: Where we see greatest return potential


Attractive sector mix
Even though US equities have outperformed global equities during the corona crisis, we continue to expect that they will deliver an excess return in the time ahead. Politicians in the US have been more active and resolute during the corona crisis than many other places around the world, and the US central bank, the Fed, has been quick to launch assistance packages on a scale we have never seen before. These factors contribute to our expectation that the US economy is better positioned than most other countries in terms of growth.

Furthermore, the composition of the US equity market is attractive. The IT and communication services sec- tors, for example, together make up around a third of the market, and these are two of the sectors we see the most potential in – in some cases reinforced by the corona crisis. Among other things, the crisis has increased the appetite of consumers for digital entertainment and corporate appetite for technical solutions that facilitate working from home.

The US is also home to many so-called quality equities, which are characterised by stable earnings growth and limited debt – the type of company that tends to be more robust in uncertain times. A key risk in the US is that the economy reopens too quickly and triggers a second wave of Covid-19.


China a reopening frontrunner
Emerging market equities have a solid long-term potential, headed up by China as the largest and most important economy. Just as China was the first country to go into lockdown because of the coronavirus, the Middle Kingdom was also the first to reopen, so the recovery in economic activity here is presumably a step ahead of most other countries. Moreover, the Chinese authorities still have the potential to stimulate the economy further via both monetary and fiscal policy if necessary, which could help stabilise emerging market equities. Fluctuations in local currencies could be a headwind for emerging market equities. However, the extremely accommodative US monetary policy with very low interest rates makes the higher interest rates in emerging markets relatively more attractive, which would tend to support emerging market currencies. Within the emerging markets sphere, we prefer Asian equities, as this is where we see the greater growth potential and least dependence on oil exports.


Low growth and political risks weigh negatively
We see limited growth potential for the European economy in the shorter term. Economic activity has been harder hit than in the US, and the slowdown has resulted in increased inventories in the large European industrial sector. Hence inventories will likely have to be reduced first before industrial production returns to normal. This would tend to reduce growth potential in the shorter term. On top of this come the pronounced political risks, which we wrote about in greater detail earlier, such as Brexit, Italy and the trade war. Cyclical sectors weigh relatively heavily among European equities and this could mean European equities outperforming other markets if the recovery in the global economy happens faster than expected. Our assessment, however, is that the risk inherent in European equities overshadows this, and we have recently increased our underweight here.


Growth outlook remains subdued
We generally see less growth potential in Japan than in the US and emerging markets. One positive factor is that Japan’s central bank is not only buying up bonds to support the Japanese economy, but also equities. Nevertheless, the subdued growth outlook means that we see more attractive alternatives elsewhere, so we are maintaining our underweight in Japanese equities.

Bonds: Where we see greatest return potential


Attractive middle way in the bond market
Investment grade bonds are corporate bonds of high credit quality, and in our opinion they present an attractive middle way in the bond market at the moment. They offer a higher yield than government bonds – not least after the corona crisis has extended yield spreads – but carry a lower risk than more risky credit bonds, such as high-yield bonds. Given the continuing high level of economic uncertainty going forward, we estimate that investment grade offers the right balance between expected return and risk – which is why we have an overweight here.


Preferred asset class with higher risk
While the asset class has given a negative return so far this year due to the corona crisis, we see an attractive potential in the longer term. The credit spread – in other words, the excess yield relative to the most secure govern- ment bonds – is in our view hovering around an attractive level at the moment, and while some of the oil-exporting countries have been hit by low oil prices, the asset class is well diversified across many countries. Furthermore, the very accommodative monetary policies of the European Central Bank and the US Fed are a supporting factor for the asset class, as they – when financial market jitters calm – make emerging market bonds relatively more attractive for investors seeking a reasonable return in a low interest rate environment. The huge costs associated with the corona crisis may result in falling credit ratings for some emerging market countries, which would be negative for the asset class, but in our view the higher credit spread during the corona crisis compensates for this. That is why emerging market bonds are our preferred asset class among the riskier segments of the bond market.


Could come under renewed pressure
High-yield bonds are corporate bonds of low credit quality, and they suffered heavy price falls when the corona crisis culminated for the financial markets towards the end of February and into March. They have corrected somewhat since then – in our view largely due to central banks supporting bond markets. Should the economic recovery post-corona draw out, or the rate of bankruptcies rise, we could risk further price falls here. Investors should also be aware that the high-yield segment includes a not insignificant number of energy companies, many of whom are suffering due to the low oil price, which is an additional risk factor for the asset class. High-yield bonds can perform very well during periods of rising economic growth, but at this juncture we do not wish to assume an excessive risk in the bond segment of our portfolios, and so we are underweighting high-yield bonds.


Low yields – but impart stability
Given the unusually low yields on government bonds at the moment, the long-term return potential is extremely limit- ed. While central banks and their accommodative monetary policies are helping to keep interest rates low and hence support bond prices in the short term, we expect interest rates and yields to rise modestly as economies begin to gradually reopen – and that equates to declining bond prices, which would erode return. The impact of the coronavirus on economic growth is also negative for inflation expectations, which means that the return potential on index-linked bonds (government bonds where the yield is dependent on inflation) looks rather minimal. Nevertheless, we should not dismiss the value of government bonds as a stabilising element in a portfolio during uncertain times like now, so despite the very low return expectations our underweight in the asset class is modest.

Always remember your risk as an investor: This publication is based on Danske Bank’s macroeconomic and financial market expectations. Deviations from our expectations could potentially affect the return on any investments negatively and result in a loss. Danske Bank has prepared this material for information purposes only, and it does not constitute investment advice. Always speak to an advisor if you are considering making an investment based on this material to establish whether a particular investment suits your investment profile, including your risk appetite, investment horizon and ability to absorb a loss.