The economic recovery has further to go but its momentum could lose traction in Q4. The virus remains uncontained. Better preparation could prevent large-scale shutdowns but restrictions would persist until a vaccine is available some time next year. Lost jobs and businesses would also cap the recovery.
Macro & Market Views
The economic recovery has further to go but its momentum could lose traction in Q4. The virus remains uncontained. Better preparation could prevent large-scale shutdowns but restrictions would persist until a vaccine is available some time next year. Lost jobs and businesses would also cap the recovery. Stimulus would continue to provide a powerful backstop but the marginal benefit from monetary injections is stalling. Instead, fiscal stimulus would be in the driving seat.
The cycle is overall supportive for risk assets, but softer growth could result in milder headline market returns, all the more so the Q4 environment might be trickier. There would be less economic surprises. Q3 corporate earnings should be solid but the share of companies beating estimates would be softer than in Q2. Also, uncertainty regarding fiscal stimulus has now become a driver of volatility. As a result, momentum forces that provided strong summer market tailwinds, would not repeat into year-end. Also, political uncertainties are reviving, with nearing U.S. elections, Brexit, and heating U.S.-China tensions.
We see more opportunities in smaller segments, including commodities, EM countries, sectors, and factors. Secular themes, key drivers of the post-COVID-19 cycle, are also appealing core portfolio holdings. They include clean energy, new generation networks, digitized consumer, and industries.
We would stay at market weight on global equities with a cautious bias. The cycle remains supportive in the U.S., but higher domestic risks and a weakening news flow keep us neutral. We downgraded Europe to Neutral, dragged by its imbalanced North-South recovery. We upgraded EM equities, which benefit from healthier domestic and external backdrops, albeit with major structural challenges. China and Asia (O/W) would still lead in this group. We are neutral in Japan, where Abenomics looks for new gears. We think U.S. growth and tech stocks are attractive in the long run, despite turbulences in Q4. U.S. exporters could benefit from a weaker dollar. The utilities sector is attractive for hedging and selectively adding value stocks makes sense for diversification. In Europe, we favor low-beta and quality, as well as tech and healthcare sectors. In Japan, exporters could still benefit from their global cycle tilt.
In fixed income markets, govies are unlikely to provide meaningful upside: we are Neutral overall, with only modest U.S. curve steepening. EMU high-grade credit is an attractive alternative to cash. We stay O/W on U.S. high-yield, which nears its peak default rate, but we are Neutral in Europe for the opposite reason. The potential in U.S. inflation breakevens is not fully exhausted yet, a strategic O/W also makes sense. We downgraded EMU breakeven to Neutral given the fading pulse in inflation drivers. Italian and Greek spreads still offer tightening potential.
U.S. dollar is facing higher volatility in Q4, but its medium-term downtrend would resume. We are neutral on Brent due to weakening supply and demand dynamics but tactically target $45/b. Copper is rich but would benefit from solid fundamental drivers and the Chinese recovery. We are O/W Gold, fundamentals are not as strong but technicals are healthier, still an attractive hedge.
Alternative strategies are likely to cushion portfolios if the resurgence of the COVID-19 in developed markets and policy risks (i.e. Brexit, U.S. elections) cause a substantial rise in risk aversion in Q4. We continue to favor L/S Credit and EM Global Macro strategies from a mid- to long-term perspective. For the next quarter we also stick with Merger Arbitrage at O/W for portfolio diversification and protection purposes, while keeping Market Neutral L/S at U/W due to its vulnerability to factor rotations.
We upgrade Discretionary Macro strategies on the back of their tactical bias and cautious positioning on risk assets in developed markets. This upgrade is funded by a downgrade of Special Situation strategies due to their higher sensitivity to market gyrations and a moderate value bias at present.
Overall, we prefer Event-Driven strategies (N) vs. L/S Equity (U/W) and Global Macro (O/W) vs. CTA (N). Our defensive stance on L/S Equity suggests selectivity within this highly heterogeneous strategy. Variable biased L/S Equity strategies remain nonetheless attractive, in our view.