What our House View means for asset allocation and portfolio construction.
- Aggressively pro-cyclical fiscal and monetary policy create a new investment paradigm
- Long-dated yields will stay under pressure as growth and inflation accelerate
- Equities are likely to weather the yield pick-up, even if the risk of temporary setbacks has risen
- Emerging market assets are vulnerable as real rates continue to rise
Our above-consensus view on economic growth has been given a further boost by the US’s newly united federal government, its passage of a $1.9 trillion support package to stimulate the economy, and further plans for a huge infrastructure package.
Government support in the UK, the EU, Japan and China is also sizeable, and the rejection of the post-GFC austerity mistake means that this newly found fiscal generosity will persist into the expansion phase.
At the same time, central banks have made it clear that they won’t be the ones interrupting the cyclical recovery, given their commitment to achieve — or even temporarily overshoot — inflation targets, and a more explicit aim to engineer employment gains that permeate through all parts of society. This pro-cyclical shift of both fiscal and monetary policy has implications for the interplay between asset classes.
We had previously been cautious on duration, given expectations of a successful reflation of economies through reopening and policies, with an eventual slow normalization in real rates. Our Q1 2021 House View noted that “the risk case is that the recovery gathers pace far quicker than we expect, which could see inflation moving higher sooner”; this elevated inflation scenario remains just a risk, but expectations of its likelihood are increasing, justifiably.
With manufacturing PMIs in the high 50s and prospects that services will join the party soon, as they already have begun to in the US, we maintain our bearishness on longerdated bonds. Shorter maturity yields will remain low as, outside of EM, most central banks will refrain from hiking for a while and avoid the mistakes they made in 2010-11’s premature hawkishness (in the case of the ECB, RBA and Riksbank) and to live up to amended objectives (in the case of the Fed). Either translates, if successful, into steeper curves, as the short end of the government bond curve remains lower for longer, while the long end starts to reflect a faster and higher pick-up in policy rates to be commenced at a later point in time. This dynamic is only beginning to be reflected and not yet fully appreciated.
In the early stage of the recovery, inflation expectations were very low, and the yield curve was suppressed by quantitative easing. This meant that as reflation expectations rose, breakeven inflation (the difference between nominal and inflation-linked securities’ yields) went higher, sending real yields lower: a very positive development for risk assets. Now that inflation expectations are closer to targets and stickier, with 5yx5y inflation swaps above pre-crisis levels in the US, UK, and euro zone (Figure 1), further rises in yields are starting to result in higher real rates too: a mix of rate hike expectations and rebuilding of term premia. This is a marked change in the financial environment.
Figure 1. Inflation expectations have risen to above pre-crisis levels
Once the risk-off period during the 2020 crisis was quashed, the main reflation and recovery trends were lower real interest rates, higher breakevens, a weaker dollar, and rising earnings expectations driving equity prices higher and spreads tighter.
The outlook for 2021 is more complex. During times when yields rise or fall sharply, which is often during shifts in monetary policy or expectations of central bank action, the normal “risk-on, risk-off” positive correlation of bond yields and risky assets like equities flips (Figure 2). This phase is usually temporary, but we are currently in such a period and expect this to remain the case until the timing of tapering and rate hikes is clarified – then, the monetary policy reset theme will again be more supportive for equity prices.
Figure 2. Bond-equity correlations flipped on fears of tapering and rate hikes
US Equity and 10y Treasury yield correlation
These short-term negative correlations between yields and equities are a headwind, but do not materially shift our asset class outlook on duration (negative) and equities (positive) from the Q1 2021 House View, as over longer time periods higher yields go hand-in-hand with equity bull markets.
The most positive environment for equities, characterised by rising breakeven yields but falling real yields, is arguably behind us. Equity returns should slow from here but remain positive as real rate pressures on valuations are balanced by a bright outlook for earnings. Hence, we maintain our overweight stance on the asset class.
This view is reinforced by history: Figure 3 shows that median US equity returns remained positive over the 6-12 months after previous real rates troughs, while Figure 4 shows that average positive weekly equity market returns have slowed in a regime of rising breakeven and real rates compared to one of falling real rates and rising breakeven rates.
Figure 3. Equity returns after real rate troughs
MSCI US Index around previous real rate troughs (normalised at zero for respective troughs, monthly data)
Figure 4. Positive but lower median equity returns as real rates join rising breakeven rates
Weekly performance of SPX (in per cent) in different BE & real rate regimes (since 2012)
Steeper curves in combination with a positive cyclical outlook leads us to maintain our cyclical equity exposure in Energy and Industrials.
Regionally, we are downgrading EM equities from overweight to underweight: EM equities offer (too) little compensation in terms of earnings growth and FX yield for the risk embedded in the asset class at a time when monetary policy starts to tighten (actual in EM and prospective in DM) and concerns over asset prices and regulation in EM are elevated. Strong past inflows into EM and the region being a consensus overweight suggests that there is little margin for disappointment. Market perception on EM, as captured by pairwise momentum indicators, is starting to turn, which in itself has provided a useful signal for pair’s investment environment.
Corporate credit spreads are extremely tight, particularly in Investment Grade, where the index’s OAS trades below 100bps in both the US and Europe (Figure 5). This offers barely any scope for capital gains even should we reach the pre-2008 credit bubble records; moreover, issuers have taken advantage of the low yield environment and termed out maturities (Figure 6), saddling investors with more risk and lower total returns, guaranteed. We shift to underweight after a year of stellar performance that went from extremely distressed levels of cheapness to modest overvaluation.
Figure 5. Credit spreads at pre-pandemic lows offer asymmetric returns
Figure 6. Corporates’ average duration has grown, increasing risk for the asset class
We maintain a neutral stance on High Yield, where spreads in the low-300s are supported by central bank corporate bond purchases and expected low default rates. The past year has seen around five per cent of junk bonds default, with some delayed restructurings and bankruptcies that will come this year already “in the price” and are slightly more attractive in the current environment.
We are further closing our overweight on EM credit, noting that duration is playing an unusually large part in total returns, and that the emerging rate hiking cycle in EMs — which began in earnest in March with Brazil, Russia and Turkey all raising rates more than expected — probably has some way to run before the carry picture becomes compelling.
Within FX, we are closing our short USD bias. We foresee the strength of the US economy in comparison to rest of world to at least pause the pressure that low US real rates and a general risk-on environment had previously exerted on the dollar.