We recently published our House View Q2 2021. Michael Grady (MG), Head of Investment Strategy and Chief Economist and Fabio Faltoni (FF), Multi-asset & Macro Investment Director discuss our latest economic outlook and its implications for global investment markets.
FF: Last quarter’s House View publication stated: “We believe that economic recovery will still be a key theme throughout 2021 and well beyond.” Do you still agree with this remark?
MG: We have not changed our overall view on the potent combination of economic drivers for 2021, which lead us to an above-consensus outlook. Those factors remain: 1) economies reopening; 2) vaccine roll-out largely removing COVID uncertainty; 3) release of pent-up demand for those activities forgone in 2020; 4) increased savings buffer to draw down; and 5) supportive monetary and fiscal policy.
FF: So what your economic recovery outlook looks like?
MG: As we look further into 2021 and 2022, we expect a somewhat faster pace of recovery than previously, with global activity reaching the pre-COVID trend by the end of 2021. At the global level, we expect growth to be around seven per cent in 2021 and 4.5 per cent in 2022. We judge the growth risks to be tilted to the upside given our relatively conservative assumptions regarding fiscal multipliers and the release of excess household savings.
FF: Despite global GDP being revised upwards, are monetary and fiscal policies expected to remain accommodative?
MG: Indeed. Central banks are expected to delay any tightening in policy until inflation has moved above two per cent for a period. And looking beyond the pandemic, many governments are planning to increase spending on public infrastructure, as well as in other areas, to stimulate future growth.
FF: Many people are of the opinion that too much fiscal/monetary will drive up inflation. What’s your take?
MG: As long as spare capacity remains in most economies, underlying inflationary pressures are expected to be muted. That said, a variety of factors, such as energy prices, will impact the year-on year comparison for both headline and core measures of inflation over the course of 2021, pushing measured inflation temporarily above target in most major economies. Just how temporary that proves to be will depend on the pace of recovery.
We expect spare capacity to be eliminated much more quickly than 2008
We expect spare capacity to be eliminated much more quickly than was the case in the recovery from the global financial crisis of 2008. Indeed, in the US we expect the output gap to turn positive by the end of 2021, with the euro zone to follow around a year later. That could put upward pressure on underlying inflation in 2022 and beyond, something that we think would be welcomed by central banks, so long as it was not excessive.
FF: Based on the above, is there a risk that investors are “pricing for perfection?”
MG: We are conscious that the expectation for a rapid recovery in global growth in 2021 is almost unanimous among market participants. Similarly, expectations that a favourable growth backdrop will support risk assets, are widely held.
As a result, some parts of the market may still be effectively “priced for perfection”, when that outcome is rarely what actually happens. While history never exactly repeats itself, recent periods of market exuberance have often been followed by an extreme, but short-lived spike in volatility stemming from market corrections. The trigger for such corrections has however been highly unpredictable and difficult to forecast. The team therefore remains very vigilant on upcoming economic data and vaccine news.
FF: Turning to asset allocation, what are your views on the equity market?
MG: The most positive environment for equities, characterised by rising break-even 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.
We maintain our overweight stance on the equity market asset class
Hence, we maintain our overweight stance on the asset class. Looking across the major regions, we prefer to be slightly underweight emerging markets given they offer too little a valuation cushion given the increased risks of rising US bond yields, weaker local currencies and tighter domestic monetary policy. We prefer to be more overweight the US and UK markets, where domestic growth differentials, strong policy support and strengthening global trade should be supportive.
FF: Is the value vs growth equity rotation expected to continue?
MG: Three months ago, we had expected “high growth” stocks to underperform and “value” and “cyclical” stocks to continue their recent outperformance, as we expected bond yields to continue rising. That has largely transpired, and we expect that trend to continue.
FF: So you are more constructive on equities, but less so on credit. Is this a fair statement?
MG: Corporate credit spreads are extremely tight, particularly in investment grade, where theindex’s OAS trades below 100bps in both the US and Europe. 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, saddling investors with more risk and lower total returns, guaranteed. We have shifted to underweight after a year of stellar performance that went from extremely distressed levels of cheapness to modest overvaluation.
Our view on high yield credit is more neutral
Our view on high yield credit is more neutral, where spreads in the low-300bps are supported by central bank corporate bond purchases and the expectation of low default rates. Even then however, the bar for further spread compression has become higher than a year ago.
FF: What about duration?
MG: Government bond yields have risen in recent months, reflecting the brighter economic outlook and increased fiscal support, particularly in the US. We think that longer-term bond yields can rise further, albeit with central banks set to keep policy rates at the effective lower bound for some time, there remains a limit as to how far yields can rise. As such, we prefer to be modestly underweight duration.
FF: One of the most significant changes to the House View is in relation to the US dollar. What has changed?
MG: 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.
View the latest version of the House View here.
