What our House View means for asset allocation and portfolio construction.
- Re-opening of the global economy has the potential to create a virtuous cycle for growth, supporting companies’ earnings, wages, employment and investment
- Inflation is not entirely transitory, meaning QE and low rates will be less necessary in coming quarters
- Tapering and tightening make policy less loose, but not restrictive – especially with fiscal policy accommodative
- Climate goals and higher taxes are also possibly inflationary, and may prove challenging for certain sectors
The key House View themes of strong growth, pro-cyclical fiscal support, and expansionary monetary policy persist.
They are joined by a new subject that interacts with them, and impacts all asset classes: inflation, which, together with more challenging valuations (high P/Es, tight spreads, elevated commodity prices) creates a trickier investment environment. Growth should slowly decelerate from here, and even after central banks have recalibrated their targets, QE is on the way out and rate hikes are beginning to come into focus – in several major emerging markets, they have already started in earnest.
Policy is still promoting a stronger expansion, even if the “delta” is not as large, and the surprises relative to expectations of new programmes is smaller. We still expect the US to implement a large infrastructure package in H2, the benefits of which outweigh any tax hikes and reregulation; additional tax cuts and redistribution may also provide an offset to declining older stimulus.
Advanced economies maintain expansionary fiscal policy; EMs are less able to do so
Similarly, the EU is now funding itself via NextgenEU bonds which will be deployed via the Recovery Fund over coming years, and Japan has expanded its fiscal thrust with supplementary budgets as it prepares for its delayed Olympics. Austerity: RIP and good riddance! Well, not quite: China’s credit impulse has rolled over as property and infrastructure ending slows, and many emerging markets have less policy space to continue fiscal profligacy; EM finance ministers must find a way to tighten budgets and consolidate deficits even as damage from COVID persists.
As the global economy moves from healing its wounds to a more robust expansion, and with scope for further gains from equity markets, credit products should perform decently too.
Almost 18 months since the onset of the COVID crisis, the recovery is well underway in both economies and asset prices, meaning additional gains will be less vigorous: earnings usually lead equities at a more mature phase of the business cycle, with high multiples staying flat or even decreasing gently, absent a bubble. We maintain our highest conviction asset allocation views in equities, where even though stock markets are at or near record levels, further gains are in order especially in energy (where consensus needs to catch up) and financials that benefit from earnings growth and still rising expectations (Figure 1).
Figure 1. Forward earnings are rising robustly across equity markets
MSCI 12 months forward earnings per share (rebased to 100 in January 2002)
There are other thematic, medium and long-term beneficiaries of this unusual “business cycle”; our climate change regulation thesis is complex, and includes recipients of decarbonisation largesse companies that improve energy efficiency, or legacy players reaping bumper profits of past investments in commodities as future investment is curtailed. The strategic competition between China and the United States has morphed from a myopic focus on trade deficits into an arms race of investment in current and future technology while punishing anyone on “our team” who is too much help to “their team”; we want to make sure our investments can benefit from such tailwinds, but not get caught offside and be penalised.
We see limited scope for corporate credit spreads to tighten much further
Credit spreads have not been tighter than they are now since the Global Financial Crisis – and before that were grossly overvalued – so excess return from investment grade and high yield credit will come from this limited carry and rolling down somewhat steep credit curves. This may not suffice to offset losses from the interest rate duration, especially for the longer-dated maturities, although they should still outperform government bonds. Eventually, should a slowdown raise the risk of a recession, or a global shock materialise, spread widening can unravel many quarters’ worth of excess returns as well.
Even though we don’t see such a negative event on the investment horizon, we continue to recommend underweights in investment grade, and are keeping a neutral stance towards high yield and hard currency EM (which benefit more from global growth and upgrades).
We do see inflation as a dominant theme for markets; coupled with the base effects on energy prices, upward pressures are building up as a mix of supply constraints intersect with accelerated demand caused by rapid post-COVID reopening.
Such a combination does not have any historical precedent. Although this does not describe a “supply shock” since the capacity for output is not reduced, it will take some time for the supply to overcome current limitations and match the demand; this means that inflation should be transitory, although in our minds transitory means at least for the rest of this year. In the United States, where the output gap will soon turn positive, the risks are skewed to the upside, because demand pressures might further feed the underlying inflationary impulse.
In such a context, potentially higher inflation and monetary policy uncertainty attached to a more outcome-based Fed guidance should be the key drivers of higher bond term premia (Figure 2 & Figure 3). As a market implication, we underweight nominal government bonds, and in particular US long-dated bonds, where the retracement lower in US yields since March has created a short opportunity.
Figure 2. Lower inflation uncertainty has been a key driver
US term premia (10y) and inflation uncertainty
Figure 3. Lower monetary policy uncertainty has contributed too
US term premia (10y) and monetary policy uncertainty
US treasury yields are expected to move higher as the FOMC is gearing up to start reducing its super-loose monetary policy, and those periods usually see higher yields across the curve. The move could be led by a move higher in FOMC median long-run rate projections (terminal Fed Funds rate) but also by a rise in term premia in anticipation of QE tapering.
From the trough of 2020, break-even inflation rates for many markets are materially higher (Figure 4), while real yields are barely above their recent lows. We think that low real yields in the near term are supported by Fed, ECB and BoE policy. A material negative carry (caused by the current high inflation prints) is an additional technical factor not supportive of a short position in TIPS.
Figure 4. Inflation expectations have risen from the depths of the crisis
5y5y swap fwd
Nevertheless, later this year, when we expect the Fed will have reached a consensus on tapering QE purchases, it will mean that substantial progress in the real economy has been achieved, and some reopening price jumps will be behind us. Moreover, our main scenario foresees for this and next year US growth in line with pre-COVID trend.
We do not see real yields going back immediately to pre-COVID levels, but gentle upward pressure on the average level of long-term real yields looks more likely than declines from current levels. As we discussed in the last House View, this is not usually a bad environment as long as inflation expectations are not falling, even if no longer as marvellous as the policy-supportive reflation of late 2020 and Q1 2021.
Within currencies, the USD dollar outlook is more uncertain. The broad-based growth environment, a higher US twin deficit looking forward and the elevated valuation of the dollar are the main factors that would point to further dollar weakness in the long term (Figure 5).
Figure 5. The real, trade-weighted dollar remains at relatively strong levels
JP Morgan CPI REER - percentage deviation from 20y average
So far this year, the US dollar has appreciated by roughly 3 per cent vs the major world developed countries’ currencies (DXY index), and it has appreciated during March and June when the markets have cast doubts on the ultra-loose Fed policy stance. Although continued QE and zero rate policy from the Federal Reserve will limit the extent of dollar appreciation in 2021, the near-term direction might be conditioned by the macro data volatility and markets’ doubts on the strength of their commitment to Average Inflation Targeting. Finally, the performance of USD tends to be less broad-based and more mixed across currencies in the case of rising real yields, hence pushing for more differentiation across high and low-yield currencies.
Commodity prices and higher rates may support currencies such as the Canadian dollar and Norwegian krone
In this environment we prefer to buy commodity currencies, such as CAD and NOK. We believe that the global recovery environment and the higher commodity prices tend to favour the outperformance of commody currencies, which exhibit a positive correlation with both global growth and oil.
Moreover, both the Bank of Canada and the Norgesbank have recently revised up their economic projections, and have been the first two developed market central banks to tune their communication for future normalisation of monetary policy. In Canada, the rate lift-off is now expected to happen sometime in the second half of 2022 (brought forward from 2023); in Norway the lift-off date has been brought forward from December to September of this year.
In emerging markets, currencies got a reprieve in Q2 as G10 yields retreated, but are sensitive to rising US nominal and real yields. As a result, EM central banks are raising rates already (e.g. Brazil, Czech Republic, Hungary, Mexico, Russia, Turkey) and many more will have to normalise policy in H2, adding to the challenges for EM local debt and equity (Figure 6).