Chief Investment Strategist and Chief Economist
March 18, 2021Posted InInvestment Strategy
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We have liquidated our overweight in gold and reinvested the proceeds in certain equities and bonds.
The Citi Private Bank Global Investment Committee (GIC) eliminated our tactical overweight in gold, reinvesting the proceeds in US Treasury Inflation Indexed bonds and UK equities. This resulted in slight increases in both global equity and bond weightings. (Global Equities and REITs rose from +9.0% to +10%, while Fixed Income rose from -9.5% to -9.0%. We remain underweight cash by 1.0%).
The GIC added gold as a tactical overweight in August 2019 on what was then a plunge in global bond yields. We added further to the position during the crisis months of early 2020 before scaling back. Gold has risen 16% over the period.
The case for gold as a long-term strategic holding is improving among real assets generally, as central banks target a higher inflation rate. However, like long-duration bonds, gold is a tactical performance risk when market interest rates rise. Since 1985, gold has risen more than 20% during six periods, and fell more than 20% in four cases. The sizeable gains for gold through 2020 reflected a peak pace of US monetary easing. This leaves both gold and bond valuations vulnerable this year.
We remain deeply underweight Global Fixed Income because of record low sovereign bond yields, particularly in Europe and Japan. We would expect 10-year US Treasury yields to average 2.5% in the coming few years, versus 1.65% at present. We are also fundamentally optimistic on credit assets. Nevertheless, the 13% decline in long-duration US Treasuries in 2021-to-date has reduced valuation risk. The large and rising US yield premium for long-term US Treasuries compared to other developed markets will attract global demand, likely slowing the rise in US yields. A plunge in foreign exchange hedging costs for US dollar assets is a critical support.
We expect near-term inflation to spike, with US consumer price inflation (CPI) likely to rise above 3% annualized for the remainder of 2021. US TIPS holders will directly receive this inflation compensation, but lose a smaller amount of accrued principal. The Fed’s higher inflation target – to make up for the past decade’s shortfall in hitting that target – should benefit TIPS holders over the long term.
Given large distortions to the world economy and record fiscal stimulus at a time of effective vaccinations, headline inflation in the coming year will likely exceed the long-term rate. The rise in gasoline futures prices alone suggests a greater- than-3% twelve-month CPI increase even with no change in the pace of other price gains.
To limit our overall bond valuation exposure to fixed income during a time of rising inflation, we trimmed the allocation for US government guaranteed debt, such as agency Mortgage Backed Securities.
Both TIPS and UK equities are already overweights within our asset allocation. We added 1.0% to both weightings today. UK equities sport a 4.0% average dividend yield, which appears increasingly well supported and likely to grow. UK equities trade at a valuation of just 14.2 times current year EPS estimates, a nearly 40% discount to US equities, with a strong EPS rebound likely through 2022.
UK equities were hamstrung by a heavy cyclical composition of industries most exposed to COVID disruptions. The strong performance of the UK vaccination rollout contrasts with a highly uneven one in the European Union. Now largely resolved, Brexit trade uncertainties have held back foreign investor allocations to the UK over the past five years. Strong trade exposures and a rebounding domestic economy should support various UK equities across sectors. While UK equities have performed in line with emerging markets (EM), the country has a far lower negative correlation to movements in the US dollar than EM. With the rise in US relative yields and a record US fiscal stimulus likely to push US real GDP growth toward 6% this year, we consider a rebound in the US dollar a potential performance risk to assets we believe are otherwise poised for recovery.
Looking ahead, we are keenly watching US large-cap and Chinese equity markets. These are both neutral weightings in our asset allocation apart from healthcare and REITs. With US large-cap value outperforming growth by nearly 15 percentage points over the past six months, we will reallocate towards longer-term enduring growth opportunities at some point after the recovery from the COVID shock in cyclical industries is more fully priced – see our Outlook 2021 for discussion.