What our House View means for asset allocation and portfolio construction.
6 minute read
- Raising our allocation to equities as uncertainty subsides and the outlook for earnings growth is positive
- Long-dated yields have limited scope to rise
- USD weakness theme is here to stay
In contrast to how the year began, its final innings has brought about a major reduction in economic and political uncertainty. The removal of two risk events, namely the potential for a seriously contested US presidential election and the possibility of COVID-19 vaccines with efficacy, provided substantial support for risk assets and has lead us to upgrade our allocation to equities.
The discovery of a number of vaccines that are effective and safe brings into view the eventual end of the pandemic’s most serious impact on economic life. So even though the path towards that outcome may be interrupted by renewed restrictions on mobility and economic activity, the market’s tendency to “look through” near-term disruption when the longer — term outcome is more certain should prevail, in our view. We are therefore approaching any setbacks in risk assets as potential buying opportunities and accordingly leave sufficient risk budget to be able to act, should such opportunities arise.
The exit from the ongoing crisis, and with it the potential for profit growth, had always been expected to be swifter and more powerful than after previous recessions. However, upgrades to economic growth based on better than expected vaccine efficacy and distribution should lend further support to the earnings recovery. So should the cost cutting undertaken during the early stages of the crisis, since every unit of revenues earned is — at least initially — being met with a lower cost base. In equity jargon, such sensitivity of earnings to sales is labelled operational leverage. Operational leverage tends to be underestimated during recoveries, creating the potential for continued upside surprises in the quarters ahead.
Studying the anatomy of post-recession interplays between multiples and earnings reveals that earnings tend to take over from P/Es in driving equity returns shortly after the end of a recession (Figure 1). Whilst this mechanically takes down the multiple, rising earnings are typically associated with rising prices (Figure 2), limiting the drop in P/Es. Should there be reason to upgrade earnings multiples, P/Es typically respond positively to such developments. We have already started to see this handover from multiples to earnings beginning sooner than it typically does. In fact, earnings started to rise and P/Es to stabilize during, as opposed to after, the recession. However, the nature of today’s recession is also different in that it was caused by restrictions on businesses operating, and can hence be exited without as big a hangover of indebtedness, bankruptcies, and credit tightening. Finally, the depth of earnings decline during the crisis should lead the way to a much greater and swifter return to earnings growth than historically observed. As Figure 3 shows, today’s forward earnings, indexed to 100 at an ISM manufacturing trough during recessions, have rebounded more strongly than after past inflection points.
Figure 1. Handover from valuation to earnings expansion
Figure 2. Earnings and prices are well correlated
Figure 3. Forward earnings typically rise sharply coming out of a recession
The current environment of easing uncertainty and very strong expected earnings growth is complemented by a symbiotic relationship between exceptionally easy monetary and fiscal policy. What’s more, policy makers have indicated that easy policies will stay in place long into the future. For monetary policy to keep company refinancing costs low well into the recovery and for fiscal policy to move from support to outright stimulus (in a situation where a strong bounce back from COVID-induced lockdowns is anyhow expected) is a powerful alignment of drivers for risky assets. Explicitly, such policy support lends sustenance to top-line growth as well as margins; implicitly, it also supports sentiment as investors won’t need to factor in an eventual return to tighter policies for an extended period of time.
Taking stock at the end of the year, sovereign bonds exercised their defensive role well. By the end of November, the 10-year US benchmark bond index had recorded a 13 per cent gain year-to-date; a generic US all maturities Treasury index had returned 8 per cent. But even the deepest and most liquid market in the world, the US Treasury market, has experienced severe dislocations this year, only resolved when the Fed stepped in to restore market functioning. Short-end yields are anchored by the renewed commitment of central banks to keep rates at zero (or negative) for at least three years (as explicitly stated in the latest RBA statement or suggested by the Fed dot projections). But, what’s the likelihood for long yields to compress further? We think the chances are fairly low, excluding a double-dip recession and/or a renewed wave of risk-off sentiment triggered by COVID-19 dynamics in early 2021. A cyclical recovery and strong policy accommodation in order to counter subdued inflationary pressures suggest we will see moderately higher yields and moderately steeper curves (Figure 4) and therefore are modestly underweight.
Figure 4. Yields curves should continue to steepen somewhat
US yield curve slopes
Importantly though, we don’t see 2021 as the start of a structural bear market for fixed income just yet. Two opposite forces are at work: on the one hand there are the Federal Reserve’s efforts to stimulate demand and stir inflationary pressures. On the other hand, there are nominal yields, which are capped by asset purchase programmes that aim to guarantee accommodative financial conditions. Taken together, as inflation normalizes — not least due to more supportive base effects in the first half of the year — we might see a continuation of the behaviour in rates we have experienced since the summer, where break-even inflation rises whilst real yields remain fairly low (Figure 5).
Figure 5. Rising break-evens meet subdued real yields
US 10-year nominal and real yields
Our expectation of a limited rise in core yields means that a large share of Eurozone bonds should continue to trade at negative yield. At the end of November, this holds true for approximately 40 per cent of Eurozone sovereign bonds. In an environment of historically low yields, the hunt for yield and carry strategies is likely to remain in vogue in 2021. A technical argument reinforces our expectation, namely the fact that net bond issuances after ECB purchases are negative for Euro sovereign bonds in 2021. Needless to say, the expected return from these strategies is becoming thinner and they will also embed more risk. We expect positive returns from exposure to peripheral countries and from modest spread compression in the corporate bond space, where default rates should rise, albeit only modestly. Credit spreads are inching closer to pre-pandemic levels but could tighten a little further in the highyield universe, driven by direct central banks’ backstop, and a supportive supply/demand backdrop. That said, we favour only a modest overweight given the risk/reward trade-off for the asset class.
In our view, the dollar depreciation seen in 2020 — the dollar is over 10 per cent weaker against a basket of trade partners since the March highs — should be only the beginning of a prolonged lower dollar period. Several factors support this view: i) an improved risk picture, ii) solid global growth momentum in 2021, iii) very loose US monetary policy as inflation undershoots target levels, iv) ballooning deficit imbalances and valuations that point to the dollar being expensive against both developed and emerging market currencies. In the developed market space, the euro is also expected to benefit from structurally improved fundamentals and lower political risk premia (as a result of the Recovery Fund approval).
In the near term, already elevated long positioning could be a headwind (Figure 6), and COVID-19 developments will matter as well, while real rate differentials still favour euro appreciation. The yen remains undervalued after decades of deflation and here too, skewed real yield differentials are still in favour of some further appreciation. As such, we prefer to be long euro and yen against dollars. The proportion of G10 FX moves explained by the USD stands currently at 75 per cent, while in the emerging market space it is only at 63 per cent, with a much lower average in 2020. The lower dominance of USD across the FX emerging space opens the door to more idiosyncratic opportunities, with decreased trade and tariff tensions also helping Asian currencies to appreciate, and commodities helping exporters’ terms of trade.