The early part of a year gives investors an opportunity to take stock. Sunil Krishnan reflects on how the current environment is shaping our views for multi-asset portfolios.
Despite some clear economic challenges, we are constructive on the outlook for the economy and risk assets. Strict lockdowns have been imposed in Europe once again, and at least parts of the US have followed suit. However, the distribution of vaccines to bring the global pandemic under control should have a positive impact on economic activity in the medium term.
Two other themes inform our current views. The first is that there are signs of froth in equity markets, particularly in US small caps and some tech companies. Retail investor participation, especially from US households, is high in these names and there is evidence of speculation in short-dated options, again likely from retail investors. Signs of excess bullish sentiment are increasing across a range of markets.
Signs of excess bullish sentiment are increasing across a range of markets
Although we do not yet see them as being material enough to pose a systemic risk to the global equity market, we are watching closely for indications of contamination. Following Tesla’s entry into the S&P 500, it would be a concern if gains in a single stock became a major force in the overall index performance. Similarly, if GameStop-style speculative behaviour began to emerge further afield, in European or Asian markets for instance, we would see it as a further warning sign.
The second theme informing our views is the change of administration in the US. Following the Democrat Senate wins in Georgia, investors have been debating whether the prospect of greater stimulus would be balanced out by more investor-unfriendly measures like tax rises or tightening of regulation.1
Stimulus and regulation
On balance, we see the election result as constructive. While there may be appetite to consider changes in the tax regime, it is unlikely to be high on the US administration’s priority list in the middle of a pandemic, whereas President Biden has already put forward a $1.9 trillion rescue plan and is talking of an ambitious recovery plan to follow.2 This proposal may be watered down in the legislative process, but even a programme of half the size would have been unthinkable before the Georgia Senate election results given the recent passage of a smaller programme. We expect to see increases in near-term fiscal stimulus.
The environment is a stated priority for the new administration
With regards to regulation, the environment is a stated priority for the new administration. President Trump passed a raft of executive orders to roll back environmental regulation over the last four years, and the Biden administration has already begun to restore some of it.3 However, this is a return of the inevitable rather than a major surprise, especially in light of the global trend towards decarbonisation.
The second area of debate concerns the tech sector and whether regulation there could pose an existential threat to the largest companies. There is growing interest in trust-busting measures in China, Europe and the US, but without international coordination regulators will struggle to force major changes in tech companies’ business models.4,5,6 For example, large US tech firms may be tempted to address European Union rules by simply creating a standalone European entity.
Regulators are also looking at whether companies’ past acquisitions were made for anti-competitive purposes. It would be difficult to unwind those decisions, but it signals greater scrutiny of such deals in future. The real question is to understand which companies’ business models are most dependent on being able to acquire assets defensively and which benefit from organic growth and innovation. We may see more differentiation between the two in the medium term. But we do not see the current regulatory pressure as a major challenge for tech earnings as a whole in 2021.7
The final element of pressure on tech relates to content moderation due to public and political criticism over the seeming inability of platforms to address hate content. Regulators aim to put social media platforms in the position of content editors. It is to some extent inevitable, and we expect the distinction between platforms and content publishers to diminish over time, but this is more likely to require platforms to refine rather than upend their business models. They may need to invest in moderation or editorship, but it is not quite the same as having to shut down large parts of their business.8
Threats to big tech do not look quite so severe but could still be a headwind for those companies
If the threats to big tech were more existential, they would lead us to challenge the US market as an investment. At the moment, they do not look quite so severe but could still be a headwind for those companies. That is one of the reasons we prefer to remain diversified in terms of geographies, despite the relative US outperformance over the last year and decade.
Diversified exposure in equities
We otherwise remain constructive on equities, particularly since investor expectations do not yet fully reflect the positive medium-term impact of vaccine rollouts in some sectors (despite signs of froth elsewhere). For instance, in industries suffering most from the pandemic, such as airlines, or areas that are highly dependent on global economic demand like energy, prices remain well below pre-pandemic levels.
Figure 1: Airline and energy stock prices, 2019-2021 (US$)
Despite the uneven price recovery between sectors, we prefer to keep our equity positions broad-based across developed and emerging markets. This is partly because of the potential regulatory headwinds for US tech stocks and general signs of froth, and partly because focusing solely on sectors where stock prices are lagging can become bound up in style and factor risks.
European firms are much more advanced in adapting their business models to a net-zero future
The exception we make is in European oil and gas, as a cyclical play which has not recovered very strongly. Even allocations to energy can be influenced by environmental, social and governance (ESG) considerations. Our ESG team’s analysis shows European firms are much more advanced than their US counterparts in responding to engagement and adapting their business models to a net-zero future.9
In terms of valuations, one of the key drivers for energy companies is oil prices. The pandemic continues to limit the potential for increases for now, but the medium-term outlook for demand is more positive in light of vaccine rollouts. In addition, at a meeting in early January 2021, OPEC surprised the market by deciding against a widely expected rise in production levels, to which Saudi Arabia added a unilaterally expressed willingness to take on more of the burden in terms of output reduction to protect prices.10 Suppressed production and a more favourable demand outlook in the medium term could combine to support oil prices.
Credit is more sensitive to US Treasuries
Credit has been a preferred allocation for us over recent quarters as the economy recovered and central banks pledged support, helping underpin corporate bond markets.
However, alongside high yield and hard-currency emerging-market debt, investment-grade credit has seen significant spread compression since the wide levels reached in March 2020 when the pandemic first hit. As spreads have tightened and total yields converge on equivalent government bonds, these markets have become more sensitive to interest rate moves and the US Treasury market. In this regard, they have become less compelling.
Figure 2: HY, IG and EMD option-adjusted spreads, 2020 (basis points)
In contrast, local-currency emerging-market debt is not as sensitive to US Treasuries and could benefit if emerging-market currencies rally against the US dollar.
Local-currency emerging-market debt could benefit if emerging-market currencies rally against the US dollar
This did not happen strongly in 2020 despite dollar weakness versus developed peers; perhaps reflecting investor caution towards emerging economies given the progress of the pandemic. However, that could change in 2021 if economic activity rebounded in emerging markets at the same time as in the US – especially as a more dovish Federal Reserve will not tighten policy in a hurry, creating less supportive conditions for a strong dollar.11
Figure 3: JP Morgan Emerging Currency Index (US$)
‘Risk-neutral’ Japanese yen
In terms of currencies, we continue to like being long Japanese yen versus the US dollar, although it may be less of a risk-reducer than it once was. Indeed, as more investors short the US dollar, the currency’s correlation with risky assets could become more negative. In other words, episodes of weakness in risky assets could see the dollar rally as investors unwind their levered positions.
Japanese yen could be somewhat sheltered from risk-on/ risk-off movements
In the current context, being long Japanese yen and short US dollars is not a risk-off position but, with the Japanese yen being a traditional safe-haven currency, it could be somewhat sheltered from risk-on/ risk-off movements.
The currency is also supported by domestic investors bringing more investments back into Japan. There is some evidence reshoring began towards the end of last year, especially in equities, and we expect it to gather pace in 2021.