Between the upcoming additional fiscal stimulus and the speeding rollout of the COVID-19 vaccines, the various coronavirus variants may have slowed down but certainly not derailed the global economy, which continues its recovery. Financial markets therefore started to transition towards that “normalisation phase” in February. In that context, on the fixed income side, interest rates – both real and nominal – should continue to rise. Meanwhile, on the equity side, the budding transition has been the trigger for some volatility and a sectorial rotation towards value and cyclical sectors.
Towards a normalisation phase
The past few months have seen a series of fortunate events take place. Last November, BioNTech and Pfizer announced good news about the efficacy of their COVID-19 vaccine, bringing the first sighs of relief to financial markets.
In December, the Trump administration engineered a USD900 billion stimulus plan. In January, the Georgia run-off election resulted in a unified Democrat Congress, which implied further stimulus. In February, the Biden administration’s COVID-19 relief package tilted towards the higher end of the proposed USD1.9 trillion. Early March, the vaccination supply target for the US adult population was pulled forward by 2 months to the end of May.
Economic data still exhibit a gap between the services and manufacturing indices but, as economies re-open and people resume their pre-COVID activities, that gap will be filled.
Also, private households have accumulated savings through staying home and that will also support a COVID-19-sensitive spending rebound. With that in mind, the reflation trade could well move into the next phase as the economy re-opens.
Along with the revival of the services areas of the global economy, financial markets should see another upward move in longer-term bond yields. In this case, value and cyclical investment themes will outperform growth and defensive names and, by the same token, the re-opening basket will outperform the stay-at-home names.
With higher yields and a steepening curve, policy uncertainty is also rising. When and how will central banks start the slow and gradual process of monetary policy normalisation, i.e. tightening?
For now at least, the environment remains compatible with equity upside – under the condition that earnings growth accelerates.
From mechanical rebound to sustainable growth-driven regime
In the first half of this year, the rebound will be mechanical. The world was brought to a halt by the coronavirus in a very short timeframe. Confinement measures kept people safe but pulled the rug from under the feet of sectors such as energy and consumption, and of regions such as Latin America. Now that vaccines are available and mass distribution is happening, in spite of some challenges, growth will increase if for no other reason than the fact that confinement measures are being lifted.
Past that mechanical rebound, though, the key will be for central banks to accompany economies into a healthier “growth-driven” regime via their tools, including keeping control of interest rate increases. Along the way, the argument “There Is No Alternative” that used to highlight the lack of options beyond equities – because rates were so low – will disappear as more viable asset classes, such as developed government bonds, re-surface.
Risks to this increasingly positive scenario
Of course, risks remain. Those associated with the epidemic have not completely disappeared. The virus vs vaccine rollout duel will continue until we reach herd immunity, which is made difficult by the appearance of new variants. A rebound of the epidemic in Q4 2021 is definitely possible.
Another risk that we identify is an uncontrolled rise in bond yields, with higher real rates and inflation expectations, that could potentially be triggered by a demand shock and growth overheating.
Geopolitical tensions (again) also make the list. Revived tensions between China and the US cannot be excluded, although the Biden administration is managing diplomatic relations in a more consensual manner.
Last, but not least, the coronavirus has widened the gap between “losers” and “winners” of the health crisis and quite a few key countries have elections coming up in the next 24 months.
Our current multi-asset strategy
Going from a recession to a recovery year, we are positive equity vs. bonds and, most importantly, in our equity allocation, our strategy being geared towards reflation trades that reflect the last positive evolution in the economy. That includes being overweight European equities with a preference for small and mid-caps, overweight emerging equities with an increasing interest in Latin America (a laggard in the aftermath of the peak of the crisis), overweight US small and mid-caps, and overweight global banks (a sector that usually benefits from the increase in rates).
On the fixed income side, we remain underweight government bonds but with a preference for German and Italian government debt over US debt. We remain long commodities, which should still benefit from the catch-up in demand.
We tactically reduced our exposure to the technology sector and are now neutral. We have also newly become neutral gold and the JPY, which usually underperform in faster-growing phases and act as safe havens in the slow ones.