What to Do After the Recovery?
Summary
- The first eight months of 2021 have been clear: Global equities, with the exception of China, have been the asset class of choice. Corporate bonds outperformed government bonds while commodities also did well, in line with our broader views.
- What do we think about growth in the second half of 2021? Given the dip in bond yields, what are actionable for the rest of the year?
Worry About Growth or Inflation?
The worry about growth, instead of inflation, should be the real concern now: Since July, the reaction of the bond markets to decade-high US headline inflation rates of 5%+ has been puzzling. Rather than seeing rising bond yields, as one would normally expect, long-term bond yields have fallen from their end-March highs. US 10-year Treasury yields have declined to 1.3% (as of late-August), down 0.4% from over 1.7% in March. Similarly, German 10-year bund yields have lost 0.3% from their recent peak.
What are the cautious signals from the bond markets telling us? The bond market is suggesting that future growth, not inflation, is now the principal preoccupation of the financial markets.
This may seem odd given the strong economic recovery evident on both sides of the Atlantic.
How Fast Will Growth Fade?
There is a likelihood of fading effects from pandemic-related stimulus. The recovery thus far has been fuelled by an abnormally large monetary (zero interest rates, bond buying programmes) as well as fiscal (unemployment support, “helicopter money”, infrastructure investment spending) stimulus. This economic boost was a response to the pandemic-induced lockdowns, and thus largely one-off in nature.
As we progressively return to something resembling more normal economic activity, subject to any fallouts from new COVID-19 variants, the impact from this extraordinary economic stimulus will fade post-lockdowns. The bond markets are telling us that there is a substantial risk of subpar economic growth ahead, post-stimulus.
Will Monetary Policy Tighten Too Fast?
There is obviously also the risk of premature tightening of monetary policy. The markets are also warning the risk of a policy mistake by the US Federal Reserve, that the Fed will react to these higher inflation rates by tightening monetary policy too early, at a time when growth is already slowing down. In past cycles, the primary trigger of economic recession has been central banks raising interest rates in response to rising inflation pressures. Recall that the sensitivity of the global economy to interest rates is far higher today than in the past, given the very high debt levels. Any modest tightening of Fed policy could heavily impact the US and global economy.
In that regard, the recent Jackson Hole Symposium had a Goldilocks outcome with Fed Chair Powell stating that labour slack is understated, full employment needs to justify rate hikes, and not explicitly linking any tapering to rate hikes as well. We expect the tapering announcement to be dependant on employment growth over the next few months with implementation in December this year.
Actionable Themes to Year-End
In light of the risk of possible sub-par economic growth as we enter the post-stimulus era, as well as tightening of monetary policy on the horizon, we have identified some themes to help navigate through the rest of 2021.
On-going investment boom: Surging government and corporate investment is a new trend that we believe will be persistent, after a decade of under-investment in the wake of the Great Financial Crisis. Structural shifts in demand and consumption post-lockdowns, and the ongoing record-low cost of debt financing are following winds for corporate investment. Companies are investing for growth, in order to cut costs and generate long-lasting productivity gains, while governments are investing both to support employment, and to upgrade key transport, housing and communications infrastructure.
Focus on real assets for income and diversification
In a world in which cash, Sovereign bond markets and Corporate credit markets offer historically low (or even negative) income yields to investors, we advocate greater exposure to real assets with positive after-inflation yields. We see attractive income and diversification benefits from exposure to infrastructure, real estate and commodities. Pension and insurance funds are having ever greater difficulty in meeting their future expected return targets, given their historically heavy weightings to bonds and credit. We expect these institutional investors to step up their exposure to these real asset classes in the future, looking to match their long-term liabilities with these long-term assets which purport to offer far higher future returns than fixed income.
Refocusing on healthcare and med tech
Healthcare benefits today from a resurgence in investment plus emergent revolutionary technologies. The challenge? To enhance healthy living years while controlling spiralling costs. Healthcare companies are better targeting treatments via more accurate diagnostic techniques, detecting health issues early via a focus on wellness and prevention, and advancing the use of telemedicine for prompter, more effective healthcare delivery. Acceleration in new drug approvals (especially for age-related and psychiatric conditions, e.g. Alzheimer’s/dementia and clinical depression) is boosting the drug pipelines of pharmaceutical and biotech companies, thus driving future profit growth.
Conclusion/Strategy
To end-August, 2021 has been a banner year for developed market equities, real estate and infrastructure with 20%+ returns in each case. We maintain our positive stance on equities and real assets, namely commercial real estate, global infrastructure and commodities.
We expect an announcement on the Fed tapering in 4Q, with implementation in December this year. The sharp recent slowing in US economic momentum complicates the Fed’s decision, and much will be dependent on employment growth over the next few months. The US 10y treasury yield is likely to rise, and we target 2% in 12 months, while retaining our negative stance on government bonds.
Read July Issue of Investment Navigator : Mid-year Outlook 2021: Is The Reflation Story Over?
Overview of our CIO Asset Allocation for September 2021
Note: + Positve / = Neutral / - Negative
GDP & CPI Forecasts
Growth
- The main driver of DM growth was consumption as economies reopened, resulting in a strong rebound in the services sector. Manufacturing lagged a little, due to previous strength and supply chain constraints.
- The fiscal multiplier effect should usher in a high growth environment for a longer period that could lead to positive surprises.
Inflation
- Base effects and supply chain constraints have been the key drivers of headline inflation in the short term. We expect a peak at the beginning of next year in most countries.
- The labour market, especially wages, is the key driver of inflation in the medium term. In the US, there are signs of stress, and wages will rise in the coming months, but less so in other countries.
Equity
- Given the high number of companies above their own 200-day moving averages (80%+ in US and Europe), the breadth of this upwards momentum remains solid, supporting our positive equities stance.
- China conundrum: Chinese equities have sold off on regulatory tightening and a weaker credit impulse since February. On a 12+ month time horizon, we think investors should accumulate on this weakness.
- Upgrade Asia consumer staples to positive: The re-opening momentum accelerates the consumption trend as well as the industry consolidation that benefits industry leaders. Also, packaged food and beverage manufacturers are seizing better opportunities and receptiveness to promote healthier products.
Fixed Income
- We expect the Fed to announce the tapering in 4Q and execute it in December. We expect the Fed to hike rates in Q1 2023. Most policymakers think that the economy has made “substantial further progress” towards price stability and maximum employment. That plan could be delayed if the impacts of the Delta variant were persistent.
- We stay negative on US long-term government bonds. Our 12-month 10-year US bond yield target remains at 2%.
- Turn neutral from positive on US IG corporate bonds: spreads have limited potential to compress further. The asset class could face negative returns if Treasury yields tick up as the IG index duration is close to its all-time highs.
- Stay positive on EM bonds (both USD and local currency): EM assets have lagged. We see recent spread widening in EM hard currency as an opportunity. Also, the risk of Fed tapering is priced in after the recent correction in EM currencies.
Forex & Commodities
- A turnaround in AUD: AUD weakened significantly in recent months due to fresh Covid lockdowns and China slow down that had depressed metal prices. We think the market has priced in too much bad news with AUD’s short positioning the largest among G10 currencies.
- AUDUSD saw a rebound from the recent lows of 0.71. The RBA pushed ahead with a cautious winding back of its bond purchasing program in September, underlining its confidence in the economic recovery outlook. The weaker-than-expected China data also raises market expectation of policy easing. Our 12-month target is 0.76.
- GOLD: The precious metal should benefit from the central banks’ efforts to keep real rates as low as possible given the high level of public debts. We expect gold to trade in the range of $1800-2000.
- OIL: We are neutral in the short term, while remaining bullish in the medium term as we expect above trend global growth. Downside risks are limited due to the OPEC+ supply management. Our 1-year target for Brent is $70-80.
- BASE METALS: We expect base metals to resume their uptrend as soon as the macro outlook improves in China. The medium-term outlook remains bright as demand is expected to increase while supply will remain tight.
Strategic & Tactical Asset Allocation
OUR TACTICAL ASSET ALLOCATION IS BASED ON OUR CIO’S ASSET ALLOCATION VIEWS.
