“It was the best of times, it was the worst of times,” begins A Tale of Two Cities. The esteemed Victorian novelist Charles Dickens might well have marvelled at the dramatic events of 2021’s volatile beginning. In one stroke, we saw an alarming new stage in the pandemic and an unthinkable attempted coup on Capitol Hill in the United States.
From a different vantage point, however, the beginning of 2021 can be seen as positive. Vaccine rollouts are bringing us closer to the end of the pandemic, uncertainty around Brexit is over and a Democrat majority in the US Senate will enable enhanced fiscal support.
Furthermore, while the COVID-19 situation has worsened, governments have learned how to mitigate the economic impacts since the first wave last March, and we do not believe the second tsunami of infections will derail the recovery. Crucially, vaccination is helping businesses see the light at the end of the tunnel and hold tight until things normalise.
The spectrum of sentiment ranges from deep concern to animal spirits. From one standpoint, investors view the pandemic as a natural disaster that will pass while governments pick up the bill. The bear perspective is that the vast debt this event has created will be the true legacy of the pandemic, as the next generation suffers years of stagnation.
Perhaps never before has there been such a need for dynamic asset allocation in the face of elevated uncertainty. Not only are investors grappling with macroeconomic unknowns, waves of disruption and a truly global emergency, it is also becoming clear that future monetary policy is approaching a point where it will be far less of a sure-fire bet—and fiscal stimulus will have its limits.
To navigate this complex backdrop, we look at how investors can navigate this tale of two perspectives and continue to unearth consistent returns. Above all, investors must be nimble to pick up yields and pockets of alpha against the push and pull of inflationary forces.
Capitalise on the inflation surge
An improving vaccine outlook has sent forward-looking markets rallying to new highs, and we expect pent-up demand to continue fuelling macroeconomic momentum. Surging markets have also sparked a frenzy of retail trading, which has soared during the pandemic, and the so-called gamification attacks on hedge-fund positions—just one more sign of how COVID-19’s long reach is altering every sphere of life.
Within the context of continuous accommodative central banks and supportive governments, we should also see inflation pick up from its low base. This acceleration will not be permanent, however. The long-term “Japanification” trend of low growth and low inflation—which does not rule out short reflationary cycles—will inevitably resume its gravitational pull on the economy towards the end of the year.
Once the recovery is well underway, perhaps towards the end of the summer, we expect governments and central banks to shift their tones gradually, highlighting economic improvements rather than downside risks. As they contemplate the withdrawal of supportive measures, markets will need to fundamentally reassess the outlook. The removal of the proverbial punchbowl can hurt assets across the board and lead investors to re-evaluate the premiums they are prepared to pay for risks.
With this in mind, the current rally presents a tactical window of opportunity to capitalise on higher growth and inflation. Since November, when we identified the potential for a return of growth, we have been gradually repositioning portfolios to capture more cyclical equity exposure and less rate sensitivity. As economic data has steadily confirmed the upward trend, we have made a series of incremental changes—from increasing the equity allocation and reducing our bias for quality growth stocks to obtaining broad-based value exposure through global ETFs (exchange-traded funds).
Capture cyclical upswings
Our confidence in imminent economic growth has increased, and we are now contemplating additional moves within the equity allocation—replacing sector-neutral value and quality growth stocks temporarily with sector-specific cyclical exposure. While we will retain certain all-weather quality growth stocks, we want to benefit from the cyclical companies poised to assume market leadership.
Downtrodden commodity-related sectors, such as materials, and financials offer significant catch-up potential, and the temporary growth outlook offers a tactical opportunity to benefit from these sectors that we otherwise classify as “structural losers” of Japanification. A reflation scenario should increase demand for raw materials, while financials, which have lagged structurally over the past several years, should rapidly benefit from steeper yield curves and higher long-term rates. Despite an initial rebound, these sectors are still cheap compared to others.
Core eurozone equity markets, such as Germany and France, are also attractive, given the super-low-rate context in Europe, and could benefit from a global reflation scenario, as could the Japanese market. Meanwhile, Chinese equities continue to be boosted by macro momentum and a raft of domestic support measures.
Look to emerging markets for credit opportunities
On the fixed-income side, we have also made changes to reflect the solidifying reflation scenario. As the US curve appears prone to further steepening due to positive growth prospects and additional fiscal stimulus, we are exercising caution on nominal government bonds, especially US Treasurys.
A combination of rising yields and stretched valuations across the entire credit spectrum has also led us to decrease our investment-grade credit exposure, as both carry and potential for spread compression are very limited. In fact, credit spreads are at risk of widening along with rising rates. While macro and liquidity conditions are favourable, we prefer to seek opportunities elsewhere, as the potential for positive performance appears limited in a temporary reflation scenario.
Emerging-market (EM) hard-currency debt remains our favourite segment of the fixed-income universe, as the combination of improving global growth dynamic, ample US-dollar liquidity, very low rates and recent weakening of the dollar clears the outlook for some issuers and allows us to benefit from still attractive spreads.
We also continue to see value in high yield—additional spread compression remains possible for cyclical issuers, and short-dated bonds offer positive carry.
“It was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us” (excerpt from A Tale of Two Cities). Dickens would have seen both perspectives as we journey deeper into 2021.
What is sure is that there is no absolute certainty of the outcome. Equity markets may continue to party through the pandemic, or the music may stop, depending on stimulus efforts or long-tail events. Against this backdrop, allocators must be prepared to harness all the instruments in their arsenals—and keep minimum levels of protection in their portfolios.
Thus, the sage investor must also look to the long term, which is so often easier said than done, while seizing on opportunities across the spectrum to make accretive, resilient gains in what is sure to be a volatile period ahead.