Our base case is that central banks have clearly communicated their intentions to taper slowly, but a policy mistake remains a risk given the amount of liquidity in the system and its importance to markets. Bumps could occur if the Fed or ECB are perceived to be too hawkish or if their plans don’t change quickly enough in the face of a new variant or other COVID surprise.
COVID remains the bogeyman. Its impact on consumer preferences (more saving/less spending) could last longer than expected. And with more than five billion people unvaccinated worldwide, the potential for new, more dangerous variants requires investors to stay nimble and monitor portfolio risks carefully.
In addition, China’s opaque system is difficult to analyze and government priorities aren’t easy to infer. Although not our base case, China’s renewed focus on socializing wealth via regulations could continue or even increase. China’s housing market and debt levels are also concerns, as highlighted by Evergrande’s recent turmoil.
On the upside, two major market drivers, the Delta variant and China’s regulatory approach, could both ease in the coming months. EMs could benefit if China’s policymakers temper their tightening of the property market, boost infrastructure spending, and loosen climate controls — moves that could be spurred by politics ahead of the National Congress in November 2022.
Markets may also be positively surprised by the patience of central banks and find themselves awash in liquidity for several more quarters to come. Interest rates may stay low for an extended period, despite the economic recovery, and risk assets could appreciate further.
Finally, our inflation concerns may be ameliorated by a pickup in productivity, something that many economic models predict and that could get a boost from government spending on traditional and technological infrastructure after many years of underinvestment.
Stick with European equities — Europe’s economy is likely to emerge from the Delta surge first and with higher vaccination rates than other regions, including the US. Politics also seem to be at a tipping point with Chancellor Merkel’s term ending and other German parties intent on loosening fiscal constraints. We believe asset allocators can find yield, quality, and cyclicality in Europe at more attractive valuations than in the US, and particularly in industrials and banks.
Get more selective in credit — Most spreads are rich, but we don’t see a catalyst for them widening much. We see the best risk/reward potential in sectors like bank loans, collateralized loan obligations (CLOs), and residential-housing-oriented structured credit. We think select EM sovereign and EM corporate debt opportunities also offer better upside potential from a spread perspective than US corporates and high yield.
Pursue inflation protection with commodities — Inflation may reach higher levels or be more persistent than many asset allocators expect. While value-oriented equities may provide some protection, commodities (excluding precious metals) have historically been the most inflation-sensitive asset class.
Maintain fixed income for diversification — While our views tilt toward an economic recovery, we think it is still prudent to consider an allocation to high-quality bonds in case of a sharp equity sell-off. A global fixed income universe gives investors more opportunity to add value. We think municipal bonds can play a strategic role for taxable investors, especially given the trend toward greater federal spending. Precious metals and option strategies may provide additional ways to supplement bond exposure.