Chief Investment Strategist and Chief Economist
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While the Global Investment Committee remains constructive about the outlook for risk assets in 2021, we have slightly lowered our large equity overweight.
With mass distribution of effective COVID vaccines likely this year, we expect a lasting global economic expansion. In the early stages of the post-pandemic period, we expect a sharp, temporary bounce-back as COVID has distorted the world economy. We expect a rapid recovery in services activity by late 2021 even as macro policy stimulus – crafted for the acute crisis phase – remains in place. Following that phase, some fading of the strength of goods-producing sectors – such as home electronics – is likely given the substantial rise driven by the pandemic. While presently boosting North Asia’s exports, this may restrain them when looking a year or more ahead. With a very strong growth performance in China, we neutralized the country overweight and resumed an overweight in Asian EM debt. We remain overweight equities in the broader Asia region.
Present interest rate levels and early-cycle growth conditions still favor equities far more than bonds. Even at present valuations – which are high in the US tech sector – global equities are attractively priced and likely to outperform most fixed income in coming years. Barring a massive bout of exuberance in equities and a sharp rise in yields, we are likely to overweight equities for a lengthy period.
The allocation changes we made on 27 January represent the very first small steps away from assets we overweighted solely for their recovery potential rather than long-term growth prospects. Since adding an overweight to US SMID in April, this asset class has gained nearly 80%. The more important context is that US SMID gained nearly 30% since prior to the start of the COVID shock. By comparison, our overweights to Latin America and Southeast Asia have gained 46% and 28% respectively. These equities are still 19% and 7% lower than at the end of 2019.
With this in mind, we see a substantial opportunity in global healthcare, with its relative valuation near historic record lows compared to other sectors. The sector underperformed global equities by nearly 8% last year, despite having the most stable growth fundamentals. The sector’s weighting within global equities markets has increased for decades as it has the most consistent profit and revenue growth, exceeding that of broad indices. While it is still early in the new expansion, the rapid recovery in US cyclicals to date suggests an opportunity to upgrade this high quality sector as a thematic holding.
Broad market comment: As usual, equity and credit markets moved significantly in anticipation of recovery last year. We disagree with views that this has been overdone, given the likelihood of double-digit EPS gains in 2022 after a snapback of at least 20% in 2021. However, increased speculative activity of late suggests a short-term consolidation. We also see the possibility of increased US stimulus spending boosting economic growth relatively more than asset prices.
If stimulus is expanded, the Fed is unlikely to increase further the pace at which it monetizes US official debt through bond purchases. (China is also likely to be reluctant to add credit stimulus given its recovery). US yields have risen slightly compared to other developed markets in recent months, while the US dollar fell. Speculative positioning in the dollar has now become overwhelmingly bearish.
In time, the Fed’s higher inflation target and vows to remain highly accommodative deep into the coming recovery should still weaken the dollar further. However, a countertrend rebound in the US dollar could interrupt some of the gains in markets we favor.
As noted, there has been a rise in speculative positioning in US equities. A rise in call option buying and a sharp decline in short positions is indicative of bearish investors “capitulating.” Such movements could precede a setback in markets. This is a fairly frequent occurrence and should not be confused with a new trajectory for the economy. In contrast, if a COVID mutation takes hold that proves resistant to the vaccines developed in the past year, it would represent a much larger, fundamental risk. In this case, greater policy easing and interest rate declines would likely boost defensive assets while hurting cyclicals.
Our base-case view anticipates continued upward long-term interest rate pressures, gains in commodity prices and equities, as the world economy recovers from the COVID shock. Central banks continue to seek a higher trend inflation rate, partly through setting negative inflation adjusted interest rates. If the Fed does not move to deliberately control long-term US borrowing costs, US long-term yields could rise into a 1.5%-2% range by year-end 2021. This yield would still be lower than the US inflation rate.
While we seek to add high quality safer assets to portfolios for hedging and diversification purposes, we have maintained an overweight only in US Treasury Inflation Protected Securities among long duration bonds. In the future, we may reallocate to government bonds from our gold overweight. With our tactical return targets set for 12-18 months ahead, we view present bond valuations as too unattractive to make the move now.