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Less Reward, More Risk
Risk assets have rallied strongly over the last seven weeks as policy actions have been forceful, COVID-19 cases have peaked in important areas and investors have been willing to look past the short-term economic carnage. Chief Investment Strategist Jim McDonald shares how this impacts our outlook for the economy and financial markets.
Risk assets have rallied strongly over the last seven weeks, as policy actions have been forceful, COVID-19 cases have peaked in important areas, and investors have been willing to look past the short-term economic carnage. Let's take a look at how this affects our outlook for the economy and financial markets. Economic forecasts remain unusually uncertain, as is the outlook for corporate earnings. Using consensus forward earnings, equity market valuations worldwide have rebounded significantly and are at or above five-year highs.
Looking at valuations based on our 2021 earnings forecast, which assumes some level of economic normalization, the US equity market is selling at 18 times a relatively uncertain earnings number. The market assumption may be correct, but we believe the rally has reduced the margin for error and have consequently, reduced the recommended tactical risk in our global policy model this month.
The outlook for corporate earnings and risk appetite will be significantly influenced by the pace of COVID-19 over the next six to 12 months. Most major economies are starting to ease social distancing restrictions, but are doing so without significant advances in treatment or vaccine. And some are doing so without showing the level of progress that health officials believe is necessary to prevent a second wave.
Compounding the uncertainty, are early reports that children previously thought to be relatively safe from the virus, may be at risk of related health complications. For the economy to return toward full activity, citizens will need to be confident that their health is safe, which will likely require either a vaccine or a dying out of the virus after this season. We continue to think broad vaccine availability is likely more than a year out. The vaccine not only needs to be developed, but also robustly tested for safety and manufactured at a scale likely never seen before.
The combination of the significant rally and risk assets and continued uncertainty in the economic outlook led us to reduce the recommended proportion of risk assets, a combination of global real estate, high yield and US equities, and are tagged to a global policy model by 7%. We have redirected the proceeds to risk control assets, such as investment grade bonds, inflation protected bonds, and cash.
This change leaves us in a neutral risk position, as we balance the potential for both positive and negative surprises over the next 12 months. Our risk cases include the potential of insufficient policy support in the wake of a resurgence of COVID-19 cases, or the potential of fiscally-led inflation, which would undermine current valuations.