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- Vaccination progress and policy support make us confident in taking a pro-risk stance, but inflation concerns curb our enthusiasm.
- Within equities, we prefer Europe, where we expect improvement in the domestic economy, and emerging markets, which should benefit the most from a reflating global economy.
- Inflation pressures are likely to persist and commodities may benefit.
- Interest rates could keep rising, especially in Europe, where we see the sharpest acceleration in vaccination progress and the economy reopening.
- Downside risks include a spike in interest rates, COVID-related lockdowns, or a policy mistake. Upside risks include a lift in inflation-capping productivity or a broader and more sustainable reopening than expected.
There is a growing sense that the world is “getting back to normal” and what a relief it is! We see more people venturing out, getting haircuts, going to hotels and restaurants, and returning to the office. Unfortunately, many countries are still dealing with more contagious and virulent mutations of COVID-19 and lower vaccination rates. But in aggregate, the global economy is recovering with the aid of accommodative fiscal and monetary policy, supporting the strong performance of risk assets and the continued rotation from growth to value.
Inflation is the bogeyman now. US inflation leapt 5% in May from a year earlier, well above the Federal Reserve (Fed) forecast for 2021. “Transitory versus persistent” was the central debate at the June FOMC meeting and recognition of the upside risks to inflation accelerated the Fed’s tightening path from zero rate hikes in 2023 to two hikes in 2023. Even though the market has priced in earlier hikes, the Fed’s base case is that temporary factors and base effects are still distorting inflation prints. We see an elevated risk that supply/demand imbalances in labor and commodity prices become more persistent. In housing, for example, structural drivers are contributing to higher prices and could feed into rents 12 – 18 months from now (Figure 1).
Against this backdrop, we continue to seek a pro-risk stance, but it is tempered by a worse growth/inflation trade-off. Within equities, we are bullish on Europe, which we believe is on the cusp of an economic acceleration, and moderately bullish on emerging markets (EM), given their leverage to an improving global cycle and strong commodity prices, as well as continued US-dollar weakness. We remain moderately bearish on government bonds, especially in Europe where negative rates are particularly vulnerable to an improving cycle. Credit spreads are generally rich, but we find some value in bank loans as well as emerging market sovereign and local debt.
Rising inflation supports our value-oriented tilts toward non-US equity markets, smaller caps, and cyclical sectors such as financials, consumer discretionary, materials, and industrials. Within commodities, we favor energy and industrial metals, which have historically been more sensitive to rising inflation than equities and can potentially help hedge against a rise in interest rates.
Equities: More room to run
Among equity regions, we favor Europe, where we expect the sharpest increase in vaccinations (after a sluggish start) and economic growth, and where we find valuations attractive. Leading economic indicators suggest the consumer sector may soon be booming, joining an already strong manufacturing sector.
While we are moderately bullish on EM equities broadly, we see pockets of value and, as always, believe differentiation is key. In Asia, we are hopeful that the Chinese credit impulse will hold up and think net commodity exporters throughout the EM complex could benefit from higher commodity prices and better terms of trade.
We are neutral on US and Japanese equities. While we are quite optimistic about the US economy, equity indices tend to be dominated by growth-heavy, interest-rate sensitive, and expensive stocks. We are also mindful of a potential increase in corporate taxes, which could hamper earnings. We prefer value-oriented equities in the US, as well as smaller caps, which are typically more sensitive to changes in economic growth and less sensitive to rising rates. Similar to Europe and EM, Japan stands to benefit from a stronger global cycle. However, we are less optimistic about any domestic catalyst pushing equities upward and prefer Europe and EM.
Across factors and styles, we generally prefer value-oriented companies that can do well in a higher growth and interest-rate environment. While value has outperformed growth since September 2020, it still has a wide gap to close after lagging dramatically over the past decade (Figure 2).
Commodities: Cyclical and structural factors underpinning performance
We continue to see higher commodity prices as one source of inflation, given broad supply/demand imbalances across energy, metals, and agriculture. As discussed last quarter, there are also structural changes that appear to be making commodity prices more inelastic. First, capital expenditures have been on a downtrend for the past decade, after a period of overspending and under-delivering on long-term projects (Figure 3). Second, amid the transition to a lower-carbon world, areas like metals and agriculture are facing higher costs and potentially lower supply due to climate-related goals.
Finding value in fixed income
The Fed’s more hawkish stance is likely to keep US long-term interest rates range-bound over our 6 – 12 month time horizon. We expect the Fed and the European Central Bank (ECB) to remain accommodative and to very cautiously begin a tapering process sometime around year-end 2021 or early 2022. Still, we think inflation will increase more than central banks forecast. This could pressure global rates higher and Europe’s negative rate structure seems particularly vulnerable in the face of accelerating nominal growth.
We think credit valuations are rich, with most spreads well inside of median levels since inception of the indices (Figure 4). That said, default rates continue to decline and demand technicals remain strong, driven by demand from Europe and Asia, as well as from US pension funds seeking long-duration assets to lock in their improved funded status.
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 the outlook is more uncertain. Low mortgage rates, declining unemployment, and millennials’ growing demand for housing continue to be potential tailwinds for sectors such as workforce housing and credit-risk transfer. EM debt spreads have lagged the tightening in other sectors. We think the outlook for EM will begin to brighten as these countries receive vaccines and benefit from global growth and stimulus. While EM central banks are actually hiking rates to tamp down inflation, we expect currency gains to contribute to local debt performance.
We think the inflation debate will be the market’s focus in the coming months. However, as noted, we expect the Fed and ECB to announce tapering plans in the fall. We think central banks will be extremely careful in how they communicate, but bumps could occur as markets may be sensitive to any perceived change in policy support. The tapering theme and the prospect of less fiscal support in the second half of this year may cap total returns in risk assets and are the main reason we are only moderately bullish on developed market equities.
Another risk is the potential for COVID variants to spread further and disrupt the recovery. We are also monitoring the global cycle impact of tightening financial conditions in China.
On the upside, global markets may be underestimating the Fed’s commitment to its new average inflation targeting policy. A scenario could unfold in which interest rates remain anchored at low levels for longer than anticipated and risk assets ramp considerably higher.
Finally, governments are spending on traditional and technological infrastructure after many years of underinvestment. Targeted investments could boost productivity and cap inflation because higher revenues can absorb increased wages without the need for higher prices.
Stick with value — We remain in the recovery phase of the cycle, and the risk of inflation and higher rates points to potential outperformance in value-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.
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, CLOs, and residential-housing-oriented structured credit. We think EM sovereign and local debt also offer better upside potential from a spread and currency perspective.
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.