Weekly investment views across key regions

The moment of truth for jobs in Europe, the Mexico pension overhaul plan, and more weekly insights from around the globe.

 

Asia

Turning less bearish on Hong Kong

The MSCI HK index has corrected by around 11% year-to-date, significantly lagging the MSCI China index and the regional MSCI Asia ex-Japan index. While the entire region has been hurt by the COVID-19 pandemic, growing political uncertainties in Hong Kong and escalating US-China tensions have weighed greatly on HK equities.

In contrast, offshore Chinese equities have prospered as China leads the region in post-COVID recovery. Property landlords and Macau gaming companies are the worst-performing sectors year-to-date due to the social distancing measures and travel restrictions, while the defensive telecom sector is the best-performing sector.

We have turned less bearish on Hong Kong equities following its correction year-to-date and its relative underperformance versus other markets. Though political uncertainties and US-China tensions remain concerns to investors, we think such worries have been largely digested by the market and the bear-case scenario of extreme and abrupt outflows of capital and talent has not materialized.

Local consumption and property sales recovered robustly in May and June as COVID-related restrictions were eased, which echoes the release of pent-up consumer demand in other markets as detailed in our latest CIO Monthly Letter. Earnings revisions have begun to stabilize in recent weeks after a long, persistent downtrend since March.

Meanwhile, Hong Kong continues to see strong capital inflows, with its monetary base increasing by over HKD 100bn since the end of 1Q. Rising capital inflows have been one of the main reasons for the strong asset price performance in Hong Kong since the quantitative easing after the Global Financial Crisis.

Capital flows a key driver of HK equities since post-GFC QE

MSCI HK index, HK monetary base (HKD bn)

Bloomberg, HKMA, as of 24 Jul 2020

The valuation of Hong Kong equities remains undemanding, in our view, with the MSCI HK index trading at 14.1x forward P/E, which is slightly below its long-term average. Supported by strong liquidity, gradually improving fundamentals and stabilizing earnings revisions, we expect the MSCI HK index to deliver single-digit returns over the next 6–12 months.

We recognize that the market’s current penchant for high-growth companies may lead the domestic-focused MSCI HK index to further fall behind other markets in the region. Nonetheless, we see attractive value and upside in a number of selected companies within the financials, gaming, and property sectors.

The recent increase in local COVID-19 cases may dampen investor sentiment and slow the economic recovery's momentum in the near term. But investors have become less sensitive to negative news on COVID-19, in our view, as countries have become more experienced with containing the virus outbreak and several vaccines under development have shown promising data. Thus, while volatility could increase in the near term, we do not expect the current COVID-19 outbreak to result in a large correction.

Author

Dennis Lam, CFA, Analyst, UBS AG Hong Kong Branch

 

Emerging Markets

Mexico pension overhaul plan a (relatively) positive surprise

The Mexican government's economic policy decisions this year have been going against the grain of those of its Latin American peers. While most countries have substantially eased fiscal and monetary policy to help households and businesses sustain the shock from the coronavirus, Mexico has stuck to its austere guns around fiscal easing, and the central bank has maintained interest rates at relatively high levels. Partly on the back of these actions, we expect the Mexican economy to experience a deeper and longer recession than other emerging market countries.

TMore recently, the government unveiled yet another policy decision that contrasts with those of regional peers—but this time, it did so in a constructive way. While Chile and Peru, for example, have moved to allow individuals to make sizable emergency redemptions from their defined-contribution pension plans—dealing a heavy blow to the sustainability of their retirement systems—Mexico introduced a plan to beef up pension contributions and better prepare the country to face the seemingly inevitable challenge of an aging population.

Since the early 1980s, a number of Latin American countries including Chile, Peru, Colombia, and Mexico have introduced individual-account, defined-contribution pension systems, sometimes working in parallel with pay-as-you-go pillars for subsets of the population. Although in principle a good initiative, low mandatory contribution rates and short contribution periods have had the outcome of woefully low replacement rates.

Mexico's pension system, for example, has the lowest replacement rate among OECD countries, at 30%. While low earners in Denmark receive higher retirement benefits than the income they earned during the last years of their active employment, Mexican workers earning a monthly income of MXN 12,000 (USD 537) today will receive a monthly pension of MXN 3,600 (USD 161) when they retire.

After more than a year of negotiations with labor organizations, the private sector, and legislators, President Andres Manuel Lopez Obrador announced a bill he will send to Congress to modify the pension system. The main change is to increase employers' contribution from 5.15% to 13.875% over a span of eight years, raising the total contribution to 15%. This initiative not only aims to increase the replacement rate by 40% on average, but it also helps reduce the uncertainty around the more radical ideas that have been proposed by some in AMLO's party, Morena, such as the nationalization of the pension system. Under the current proposal, in addition to strengthening the pension fund system, increased contributions will translate into incremental money flows into the local financial system, which would deepen Mexican capital markets.

The formal legislation has yet to be revealed, and reviewing its details will be important to more accurately assess the proposal's impact. Some aspects of the reform are a source of concern and need to be closely reviewed. Crucially, it decreases the relative attractiveness of formal job creation in a country with an already high propensity for informal labor. A second concern relates to potential changes in the investment framework of pension fund managers, which may seek to direct more investment into public infrastructure projects. The current administration's track record in selecting productive infrastructure projects has so far been questionable, in our view.

All in all, our preliminary take is that this is a positive reform for Mexico over the long term, as it has the potential to increase savings and investment while simultaneously improving the replacement rate of the pension system, all of which is supportive of Mexico's long-term growth prospects. None of this is enough to change our near-term cautious view on Mexican financial assets, but it has certainly been a positive surprise.

Author

Alejo Czerwonko, Chief Investment Officer Emerging Markets Americas, UBS Financial Services Inc. (UBS FS)

 

Europe

The moment of truth for jobs

Shortly after the COVID-19 crisis erupted in Europe, most governments reacted swiftly to the threat of sudden mass unemployment by setting up temporary job retention schemes. These have been instrumental in cushioning the impact of the recession on both companies and employees. But the crisis still seems far from over, and many sectors might need a few years to recover fully. How many furloughed workers eventually lose their jobs will be determined by government decisions, the future course of the pandemic, and the shape of the economic rebound.

In the Eurozone, the official unemployment rate has so far only ticked up slightly, to 7.4% in June from 7.1% in March. This contrasts with the US, where it has jumped to 11.1% from 3.5%. The reason is that in the Eurozone more than 30 million employees have been shielded by these schemes. This represents an astonishing 19% of total Eurozone's employment in 2019 (roughly 33% in Italy, 27% in France, 23% in the Netherlands, 16% in Germany and 15% in Spain), according to the OECD. Similarly, in the UK, 8.7 million people, or 26% of jobs, were on furlough in May.

Most of those spared by these various schemes can be expected to return to their previous employment as activity resumes, but the recovery will be much slower in transportation, food services, leisure and tourism. As a result, the OECD has warned that one-fifth of temporary layoffs could end up being permanent. Meanwhile, hiring looks likely to stay subdued, as a result of which the Eurozone jobless rate may rise briefly above 10% by the end of this year.

Nonetheless, this outlook is far from certain. While the current emergency schemes are scheduled to expire in the next few months, most national governments have recently indicated they will extend them, particularly for hard-hit sectors such as tourism. If that happens, employers and workers would maintain their employment relationship, enabling immediate rehiring when feasible and avoiding a significant loss of skills and human capital.

Prolonging these arrangements would also sustain households' incomes. This alternative subsidy to workers, many of whom would otherwise not be eligible for unemployment benefits, has allowed aggregate disposable income to fall by far less than hours worked and GDP. As consumption was curtailed during the lockdown, saving rates soared in the developed world. Not all of this saving will be retained, which should see pent-up demand providing a kick-start to retail sales. This should, in time, be followed by a recovery in industrial production and international trade.

Obviously, these job retention systems come at a huge cost to public finances. Budget deficits in France, Italy, Spain and the UK are likely to surpass 10% of GDP this year. Even so, we expect the asset purchase programs put in place by the European Central Bank and the Bank of England to keep borrowing costs low and demand high. Furthermore, the European Union's EUR 100bn SURE loan facility for expenditures to preserve employment will soon be available. The Italian and Spanish governments have already indicated that they are considering using it.

In summary, there is a good chance that furlough schemes are extended in most European countries, perhaps well into 2021. The official unemployment rate could rise less than widely expected and aggregate real disposable income should prove more resilient than indicated by GDP.

It is the fear of both the virus and of job losses that will determine how much household income is spent or saved over the longer term. Consumer and corporate confidence holds the key to how this immense fiscal effort translates into consumption, rehiring and, ultimately, into the strength of the incipient economic recovery.

Author

Roberto Scholtes Ruiz, Chief Investment Officer Spain, UBS Europe SE, sucursal en España

 

United Kingdom

Why has the UK equity market lagged other regions?

The MSCI UK has significantly underperformed other equity market regions this year. While the US and emerging markets have delivered positive total returns, the UK is the laggard at –18%. The MSCI Eurozone, meanwhile, has fared a little better, returning –10%.

The UK's high weightings to the energy and financial sectors have dragged the market lower, as the collapse in the oil price, coupled with the dramatic drop in bond yields, has had directly negative impacts on those sectors, which are both down around 40% this year. The widespread dividend suspensions have also hurt those sectors and the UK market in general, which has traditionally been viewed as a high-yielding market and for this reason often favoured by income investors.

Meanwhile, the MSCI UK's measly 1% exposure to the tech sector by market capitalisation has meant it has been unable to participate in the cyclical and secular technology and digitalisation trends that the US market, among others, has benefited so much from.

Where is the good news, I hear you say?

In terms of what has already done well, healthcare, consumer staples, and materials in the UK have all returned positive performance this year, due to their lesser economic sensitivity, their direct exposure to areas of growth as a result of COVID-19 (such as cleaning products and potential vaccines), and in the case of materials their exceptionally strong balance sheets and exposure to the Chinese economy, which has already been rebounding in recent months.

Looking forward, however, we see significant potential for a rebound in the UK market based on two main areas. The first is a recovery in the oil price. We forecast Brent to recover to USD 55/bbl by mid-2021. The second is valuation. The MSCI UK trades at a 12-month forward P/E multiple of 15x. While this is slightly above its long-run average of 14x, this is arguably justified given the lower bond yields. Bond yields are used to discount the future cash flow of earnings, in order to achieve a present value for the equity. This means the lower the bond yield, the higher the value of the equity. Given the historically low government bond yields currently, it explains why many markets are trading slightly above their long-run average valuations.

It does not, however, explain why the MSCI UK is trading at a 25% discount to the MSCI All-Country World index. The UK's lack of high-growth technology companies is certainly one factor, as is its relatively high 20% exposure to financials, which trade on a 12-month-forward P/E of just 12x. But that still doesn't explain all of the UK's discount valuation gap.

Normally, the marginal buyer of the UK market is the international investor, who holds about 40% of the market. These investors have been significantly underweight the UK for several years. First it was the multiyear commodity collapse which started in 2012 that put them off, and more recently Brexit. At the end of this year, we approach the next stage of the Brexit process when we leave the transition period with or without a deal on the future relationship. With that major uncertainty out of the way, one can't help but wonder if international investors will then finally be lured back to the UK, attracted by the discount valuations. Of course, it will also be determined by dynamics in the global economic backdrop come the year-end.

CIO prefers the UK to MSCI Eurozone based on its cheaper valuation, more realistic earnings expectations, and potential for upside from an oil price recovery.

Meanwhile, we are part-way through the second-quarter earnings season. The UK has very patchy quarterly data, so if we look at the half-year data we can see that earnings are broadly in line with expectations. While financials, utilities, and consumer services have missed earnings estimates, materials, telecoms, and consumer goods have exceeded them. Our estimate is that for the full year, the FTSE 100 will probably see earnings decline in the region of 40% and likely a 30% rebound in 2021.

But it's probably not earnings driving equity markets this year—the big debate lies where the valuation should sit and whether it should be higher than historically due to the lower risk-free rate. This is the conundrum that currently divides the equity strategist community, including those in the UK.

Author

Caroline Simmons, CFA, Strategist, UBS AG London Branch

 

United States

Check your weights

To say that 2020 has been a difficult year is certainly an understatement. The global pandemic has unleashed unprecedented, lightning-fast, and often heart-breaking challenges and changes across multiple dimensions of our society. And this year is far from over with an upcoming presidential election that could have additional, important policy implications.

For equity investors, navigating these turbulent waters has not been easy. It may be hard to believe, but the S&P 500 is actually up about 2% this year. But looking at the aggregate numbers doesn't paint the whole picture. Growth stocks have trounced value stocks. The Russell 1000 Growth index is up 18% while the Russell 1000 Value index is down 13%. This performance gap between growth and value rivals growth's outperformance during the peak of the dot-com bubble in early 2000.

The fab five

Growth stocks also happen to be dominated by the five largest stocks in the market: Facebook, Apple, Amazon, Microsoft, and Alphabet (the parent company of Google) which have risen a remarkable 37% this year. The rest of the market is actually down nearly 5%. In fact only 36% of the S&P 500 constituents have outperformed the market. Not only have investors need to have been in growth stocks, they had to pick the largest growth stocks.

As a result of this very strong performance, these five companies now comprise more than 22% of the S&P 500. This is by far the highest market concentration in our data, which goes back to 1985. The prior high for this metric was again in dot-com era, when it reached 18%.

Strong fundamentals for growth

But earnings results over the last few weeks have reminded investors that the performance dispersion between growth and value may be justified. Growth companies are more digital, more virtual and are benefiting from the stay at home trends that have been so prevalent this year. This was underscored by earnings results from the five largest companies which posted blow-out earnings numbers. And analysts are revising up earnings expectations for the balance of the year. In contrast, value stocks are dominated by banks and energy companies and tend to be more cyclical and therefore more exposed to today's very difficult economic conditions.

Don’t forget interest rates

Interest rates have also played a role. Rock bottom interest rates and continued comments from Federal Reserve Chair Jerome Powell that the central bank is "not even thinking about thinking about" raising rates makes stocks look more attractive versus bonds and have helped push up equity market valuations. Secular growth companies have been key beneficiaries of this trend. In contrast, extraordinarily low rates weigh on profitability for banks and may suggest a muted outlook for economic growth, a tough environment for the value companies that are more tied to overall economic trends.

So what's an investor to do? Despite the fact that growth companies are undoubtedly expensive versus value companies, there may not be a rotation into value until investors have more confidence that the economy can get back to full strength, which should drive at least some pickup in interest rates. As a result, the prospect for medical therapies for COVID-19 will likely be a crucial catalyst.

With well over 100 vaccines in development, there are reasons to be optimistic on this front. Three promising, leading candidates have just started phase three clinical trials which will determine the effectiveness of the shots. We could know the results by October or November. If there is a successful vaccine, markets may very quickly price in a full economic recovery which could drive the long-awaited rotation into value stocks.

Neutral on growth vs. value

Right now, we have a neutral recommendation between growth and value. While growth stocks are expensive, they are nowhere near the bubble levels in the late 1990s. Still, after such impressive outperformance, growth stocks have likely become a larger percentage of portfolios. Investors should check their exposure to growth and ensure it is not excessive. Rebalancing back to neutral would be prudent, in our view.

Investors should apply a similar thought process for the five largest stocks in the S&P 500 and reduce weights that may have drifted from targets. It may also be time to be more selective within this group of companies. Please see our report titled Tech bubble? No, but growth appears expensive; be selective with FAAMNG, dated 27 July 2020 for more detailed views on individual companies.

Even though 2020 has been challenging for investors, it appears that the balance of the year will be no easier. After extraordinary gains from a small segment of the market, now would appear to be a good time for investors to make sure portfolios are properly positioned for the months ahead.

Authors

Solita Marcelli, Head of CIO Americas, UBS Financial Services Inc. (UBS FS)
David Lefkowitz, CFA, Head of Equities Americas, UBS Financial Services Inc. (UBS FS)


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