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- Encouraging vaccine progress, policy support, and gradually reopening economies make us confident in taking a pro-risk stance over a 12-month time frame.
- We think a vaccine-driven reopening will be the catalyst for a continued rotation from growth- to value-oriented exposures. Within equities, we prefer Europe, Japan, emerging markets, and smaller caps, and think cyclical sectors are attractive relative to growth sectors.
- We expect inflation pressures to show up sooner rather than later, improving the outlook for commodities and related sectors.
- Rates could rise further, a challenging backdrop for duration-sensitive markets such as government bonds, some credit sectors, and growth-oriented equities.
- Downside risks include a spike in rates, a disappointing vaccine take-up rate, and waning stimulus. Upside risks include another major dose of policy stimulus or a faster or broader reopening than expected.
The darkest days of the pandemic seem to be behind us. Vaccines are being distributed and administered around the globe, which augurs a material pickup in economic growth this year. In addition, developed market policymakers, perhaps recalling inadequate responses during past crises, have kept fiscal and monetary support in high gear. Risk assets have responded favorably and the rotation from growth to value has gained momentum.
As we map the road ahead, we think it’s worth contemplating the possibility of a strong but relatively short recovery. The next phase of the rebound, when services reopen, employment grows, and overall activity improves, should be good for risk assets. However, we seem to be moving quickly from early-stage to late-stage asset behavior judging by the rise in inflation-sensitive assets like cyclicals and commodities. We think rising demand, higher commodity prices, low inventories, and wage pressures, among other factors, could push up inflation and inflation expectations sooner than the market expects. In addition, we expect more bouts of the market challenging the Fed by driving real yields higher.
Ultimately though, we think the Fed will stick to its commitment to look past higher inflation prints and keep policy rates at zero, and that, as a result, the runway for cyclical assets to outperform extends through our 12-month horizon (Figure 1).
The environment we describe could be conducive to outperformance by a range of value-oriented equity exposures, including non-US developed markets (versus US equities), emerging markets (EM), small-cap equities, and cyclical sectors such as financials, consumer discretionary, materials, and industrials. In contrast, fixed income performance will likely be challenged. We are moderately bearish on credit, where spreads are at the expensive end of their historical range, as well as government bonds. Given the risk of higher inflation, we are moderately bullish on energy, industrial metals, and commodity-oriented sectors. We think long US-dollar exposure could potentially hedge the risk that the Fed pushes up its timetable for rate hikes, in which case we’d expect real yields to rise and the dollar to strengthen.
Equities: Tilting away from the US
We remain moderately bullish on Japanese and European equities, where we see attractive valuations and a number of positive fundamentals. Japan’s leading indicators are improving, and we think the economy and equity market should outperform if global growth improves. Japan was slow to start vaccinations but cases remain relatively low. Vaccination progress has also lagged significantly in Europe (other than the UK), but manufacturing is doing well there and the leads on services are pointing up sharply.
We are moderately bullish on EM equities and, as always, differentiation is key. We prefer net commodity exporters outside of Asia, which could benefit from increased commodity prices and better terms of trade (Figure 2). Various Latin American countries and companies are net commodity exporters and offer what we think are attractive valuations, whereas Middle Eastern countries that are big exporters of oil are less attractive from a valuation standpoint. We are less optimistic about Asian EM equities as we fear that their COVID-19 advantage of 2020, namely diligent social distancing and mask wearing, will diminish as vaccine supply and effectiveness favor regions more geared to recovery.
We are neutral on US equities despite solid vaccine progress and our confidence in a strong economic recovery. If interest rates rise further as a result of growth or inflation, the expensive growth and technology stocks that dominate the US market could lag value-oriented and less rate-sensitive areas. Within the US, we prefer smaller-cap stocks, which are typically more sensitive to changes in economic growth and less sensitive to rising rates.
Commodities: Shifting dynamics in the most inflation-sensitive asset class
We see higher commodity prices as one source of inflation, given broad supply/demand imbalances across energy, metals, and agriculture. This includes the cyclical tailwind of growing demand as economies begin to reopen amid unusually low inventories.
But there are also structural changes that appear to be altering the fundamental rule that says higher commodity prices lead to more production, eventually driving prices back down. First, energy producers are increasingly responding to shareholder pressure to restrain capital spending and return capital to shareholders. Second, decarbonization is shifting capital spending away from companies’ traditional hydrocarbon base and toward renewables, while also raising the cost of capital and leading to higher production costs and, in turn, carbon pricing. These decarbonization effects are not limited to energy companies. Metals and agriculture are also facing higher costs and potentially lower supply due to climate-related goals. These dynamics suggest lower price elasticity of supply across the commodities complex. Precious metals are a slightly different animal, but higher real yields are likely to be a headwind for performance.
Finally, we would note that investors may benefit from a positive roll yield, a result of the futures market being in backwardation due to particularly acute shorter-term supply deficits. Taking all of these factors into account, we have moved from moderately bearish to moderately bullish on commodities.
Higher rates still a risk for credit
We believe a broader cyclical recovery in 2021 will mean higher yields in longer maturities, while central banks will keep short rates pinned. Even though interest rates in the US rose about 100 basis points between last August and the beginning of March, risk markets didn’t respond negatively until February. We think that’s because the rise in nominal yields was first associated with a rise in long-term inflation expectations, which risk markets embraced as a healthy byproduct of improving growth. Plus, levered companies can benefit from higher inflation, as it boosts revenues and reduces real debt.
More recently, markets have pushed short-term inflation expectations higher, in effect challenging the Fed to waver from its commitment to keep policy rates at zero until late 2023. We expect this dynamic to induce more rate volatility even though we believe the central bank will maintain its resolve. We also think debt concerns will weigh on the long end of the yield curve. Together, these factors could push 10-year yields to the 2% – 3% range in the next 6 – 12 months.
We have lowered our view on credit from moderately bullish to moderately bearish, given the prospect of higher government bond yields and narrow spreads (Figure 3). We are only moderately bearish because improving fundamentals are supportive and demand technicals remain strong, especially from Europe and Asia where US corporate yields are still attractive, with hedging costs having declined. Within credit, we prefer short-duration sectors, such as bank loans and certain areas of the securitized market. We continue to view securitized assets as a way to express a positive view on residential housing, but remain cautious on commercial property, such as malls and offices, where we see enduring stress and which tend to be long-duration assets. Low mortgage rates, declining unemployment, and millennials’ growing demand for housing are potential tailwinds for sectors such as workforce housing and credit-risk transfer. For its part, EM debt has been walloped by higher US Treasury yields and a stronger US dollar, and appears to be among the cheaper spread sectors in credit. However, we think there may be a stronger case for taking EM risk in the equity markets, so as to avoid the duration risk.
Amazingly, given the depth of the global recession just last year, we are concerned that inflation may rise quickly enough to upset markets. But we are comforted by the fact that higher inflation typically causes material market dislocations only when it is starting from a high base, which is not currently the case. Nonetheless, we could hit a few bumps along the way as some investors, caught off guard, chase after inflation-hedging assets.
Another potential market irritant is higher real yields. While they have generally pushed equity prices lower since the global financial crisis (GFC), that relationship has been less clear in more cyclical areas of the market. And pre-GFC, higher real yields were associated with stronger equity markets. We suspect that as growth and technology stocks have gained share, some of the stock market’s effective duration has lengthened, so we think there is reason to consider focusing on shorter-duration areas like cyclicals, small caps, and non-US equities.
Of course, pandemic-related uncertainties remain. In particular, some governments have loosened restrictions faster than public health experts advise. In addition, vaccine take-up could slip as less vulnerable populations become eligible. Finally, there is always the risk of a new variant that proves resistant to current vaccines.
On the other hand, a pending wave of vaccine supply and warmer weather in the northern hemisphere could spell a faster return to normal than markets anticipate. We envision a massive increase in spending on services if such a scenario unfolds.
We also see a chance of more fiscal support, including in Germany, following the elections this coming September, and in the US, where the Biden administration will likely pursue a meaningful infrastructure package this year. Both could lift risk assets, depending on the state of growth and inflation. We have already seen the European Union (EU) agree to a fiscal push over and above steps being taken by the underlying EU countries.
The rotation is real — With developed economies on the cusp of a broad reopening and long-term yields threatening to move higher, we think value-oriented exposures will continue their recent resurgence versus growth-oriented exposures. We prefer non-US equities and other value-oriented exposures, including smaller-cap equities and cyclical sectors such as financials, materials, and industrials. We think there are attractive opportunities in select energy companies that have strong plans for navigating the transition to a lower-carbon economy. Finally, we believe that in some cyclical industries, such as hotels, gaming, and retail, there are opportunities among companies that have depressed valuations and, in adapting to the pandemic, have seen improvement in medium-term fundamentals.
Seeing less value in credit — Spreads have narrowed to rich levels and we don’t see a catalyst for them widening much. From a total-return perspective, we see better risk/reward potential in other asset classes, including shorter-duration sectors like bank loans, CLOs, and residential-housing-oriented structured credit.
Pursuing inflation protection with commodities — Higher inflation may come sooner 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.
Maintaining 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. We think taxable investors should consider municipal bonds given attractive valuations. Long US-dollar exposure could serve as a hedge in a risk-off scenario, particularly since “short US dollar” is the consensus view. Short-duration, precious metals, and option strategies may provide additional ways to supplement bond exposure.