Central banks will win the tug of war in markets

Central banks will win the tug of war in markets

Financial markets are being pulled in different directions by two big forces: the injection of liquidity from central banks and concerns over a “second wave” of Covid-19 infections.

Daily news headlines can lead us to believe that, of the two, coronavirus is the dominant force for markets. The coming months are likely to show that it is not. Investors should back central bankers to win this tug of war, and set up their portfolios accordingly.

Policymakers around the world responded to the pandemic with unprecedented scale and speed. While they continue to support riskier assets, such as stocks and corporate bonds, through vast asset-purchasing programmes and rock-bottom interest rates, the most important thing investors can do is to stay invested.

In particular, we think the UK and German equity markets are likely to outperform, even though we expect Europe’s overall earnings recovery to lag other regions.

The composition of the UK stock market, which trades at a sizeable discount to other major markets, leaves it well placed to benefit from the global recovery from Covid-19. Some 40 per cent of the benchmark FTSE 100 group, by market capitalisation, is made up of value companies — meaning they trade at a low valuation compared with their earnings or assets. These should outperform as the recovery progresses.

The UK is also set to benefit from a recovery in Brent crude prices, which we expect to rise to $55 a barrel by the middle of next year. Energy stocks, typically a defensive investment, account for 11 per cent of the MSCI UK index, compared with 4 per cent for the MSCI World index.


40%


Of the benchmark FTSE 100 group, by market capitalisation, is made up of value companies

While negotiations over a post-Brexit trade deal with the EU remain strained, the risk of no-deal seems exaggerated. Such an outcome would be mutually detrimental and both sides are going to work to steering clear of it.

Germany also has several advantages going into the recovery phase of the pandemic. The nation entered the crisis with strong public finances, reflected by a ratio of debt to economic output of around 60 per cent, compared with a eurozone average of close to 85 per cent. As a result, the country has been well placed to support its economy with large stimulus.

Berlin’s response has been to unleash a fiscal expansion equivalent to around 8 per cent of gross domestic product, and it has the potential to inject more if needed. The composition of the German market also helps, as it is heavy on industrial stocks that could rise in lockstep with a global economic recovery.

By contrast, the US equity rally since March has been narrowly focused on a handful of mega-cap tech stocks. The sharp rotation out of tech within the last week pushed the whole market lower, but it also highlights the need to diversify. We recommend investing in long-term trends that have been accelerated by the current crisis. For example, supply chains are likely to be less global and more local in future, which will benefit the automation and robotics sector. Europe is home to many of the market leaders in global factory and process automation.

Digitalisation of the healthcare industry also looks set to grow in the wake of the pandemic. Europe already accounts for 22 per cent of the companies in an MSCI index tracking such “medtech” companies.

Green initiatives at the core of Europe’s Covid recovery plans also provide an opportunity for the region’s companies. In July, EU leaders agreed on a €750bn recovery fund, the core element of which focuses on climate protection and digitalisation. Over the long term, this should encourage the development of areas such as renewables, energy efficiency, electric vehicles and infrastructure related to mobility and transport.

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Further virus outbreaks could result in a more stop-start approach to reopening economies, but these will only slow, not derail, the recovery.

We now know more about the virus than at the start of the year. Estimates of both the mortality and virus transmission rates have fallen since the start of the pandemic, and a significant proportion of some populations have already contracted the virus.

This will allow policymakers to adopt less economically destructive measures in containing new outbreaks, including mask wearing, contact tracing and social distancing. In addition, there is evidence of progress on vaccines and therapeutics. While fears of a second wave will add volatility around the strength and speed of the recovery, we expect increased economic momentum over the coming year.

All this suggests room for global stocks to move higher. But investors will need to choose particularly carefully.

The writer is chief investment officer at UBS Global Wealth Management