Targeting value and growth assets post COVID

Citi Private Bank’s Global Investment Committee (GIC) has left our asset allocation unchanged with an overweight to global equities and REITS stance remaining at +8%. Additionally, fixed income and cash remains at -8%.

As discussed in our Mid-Year Outlook, we expect to transition allocations away from positions held solely to benefit from post-pandemic economic rebound, towards opportunities for potential sustained long-term returns. Our actions already taken include downward shifts in US small and midcap equities and certain Emerging Markets in favor of global healthcare shares. 

We see the healthcare sector providing the cheapest valuation for enduring, steady growth. We also see emerging pockets of opportunity in US and Chinese IT shares but see valuation challenges not completely resolved. 

Global markets have recently been challenged by the US Federal Reserve’s acknowledgment that crisis-level easing steps should gradually be phased out. It may take months before the Fed actually slows the pace of bond purchases, now $120 billion per month.  A first interest rate hike could occur 12-18 months from now under ideal economic conditions. After strong and sudden investor inflows into a variety of cyclical assets including commodities, nearly all “inflation trades” saw sharp, albeit discrete declines on the Fed’s announcement (please see our latest CIO bulletin). With central banks in developed markets, other than the Bank of England, likely to change monetary policies more slowly, the Fed’s communications drove the US dollar to bounce higher after approaching a five-year low (Please see our monthly Foreign Exchange observations).

The longest-term US Treasury yields also fell on the Fed’s hints of moving away from peak monetary accommodation. Short-term yields climbed to price in one 25 basis point rate hike by the Fed before year-end 2022. Bond markets have already been sanguine regarding sharp increases in consumer prices. These seem mostly related to the sudden reopening of sectors of the economy and emergency fiscal stimulus steps that have no prospects of being repeated. 

While US inflation readings should be well above pre-COVID trends in the near-term, the year-on-year pace of 5% in May likely marks a peak. Inflation readings in many other economies should follow a similar pattern. US retail sales dropped in May after sharp early-year gains. 

However, services activity, including travel and hospitality, appears to be rebounding sharply. An all-time high in the combined assessment of US manufacturing and services growth was posted last month as services industries re-opened while producers are still filling goods orders on a lagged basis. With this, the Federal Reserve Bank of Atlanta’s tracking estimate of annualized US GDP growth for the second quarter 2021 is currently +10.2%. Such a reading may mark the peak pace of US recovery with decelerating growth beyond. While this would ordinarily be a bullish sign for safer fixed income assets, their valuation presents a difficult challenge with yields below inflation and forward-looking central bank inflation targets.

In the US Treasury market, negative real yields suggest an 8% loss in purchasing power if 10-year US Treasuries are held to maturity. Non-US developed bond market yields are roughly a full point lower than the US, and we remain deeply underweight. We continue to overweight variable rate loans to take advantage of low volatility and solid yields. For the short-term at least, we also overweight US Treasury Inflation Protected Securities to receive inflation compensation in arrears.

In equities markets, we continue to overweight regions and particular assets that have not fully recovered from the COVID shock. However, we see these opportunities generally diminishing and moderated some allocations in April.  Latin American equities have lagged about 27 percentage points behind US equities since end 2019 and about 42 percentage points in USD terms.  Reflecting COVID trends, including still limited availability of vaccines, these remain among the deepest cyclical laggards on a global basis. Nonetheless, the shares have gained 63% since our overweight was added in April 2020 and we see limited prospects for long-term outperformance. Equity REITS have also lagged behind broader US and Global Equities on a total return basis, but have now risen modestly above end-2019 levels. As discussed in our Mid-Year Outlook we see a wide dispersion of valuations persisting in REITS rather than “full mean reversion.” This is the result of secular changes likely in real estate use stemming from technology and the COVID shock. Mortgage REITS, a small, volatile holding, have returned 54% over the past year. We remain overweight the asset class given a 6% forward-looking yield which is highly appealing to income-oriented investors in a low-yield world.

Looking forward, we are optimistic regarding a sustained economic recovery. In the US, post-World War II economic expansions have persisted more than 5X longer than contraction periods. (Full-year contractions in global economic activity have been even more rare than US recessions as regional contractions tend to be far more common that global shocks.) 

Nonetheless, given financial market and policy developments, we seek to raise portfolio quality as large rebounds have occurred in lower quality assets most impacted by last year’s economic calamity. Consistent dividend growth is one appealing core portfolio strategy as we target particular value and growth assets for tactical weightings.