Indeed, growth is likely to have already peaked in the US and in China, stoking fears that a slowdown will lead to a sell-off in markets. However, although we may be past the peak it does not mean that we are late in the cycle, nor that we are set for a sharp deceleration. We expect growth to remain strong for a number of quarters ahead and believe markets will come back to this view over the coming months as data confirms underlying economic strength. Moreover, while cases are surging, hospitalizations have not risen to the same extent, especially among vaccinated individuals, suggesting that the link has been broken. In our view, hospitalization is the factor to keep an eye on.
Yields Expected to Drift Higher
In terms of inflation, it is likely to remain higher than previously anticipated for some time, but the degree of size, length, breadth and impact of the increase is yet unknown. In this context, we believe that yields are too low and will drift higher as confidence in the recovery returns. Still, the rise could be limited as variant and growth concerns should keep the Federal Reserve accommodative.
Overall, we remain cautious on sovereign debt and continue to prefer credit. Credit spreads have broadly remained contained and well behaved despite higher volatility in the equity market, suggesting that calm permeates. We continue to see opportunities in high yield on a selective basis, and in emerging market corporate hard currency debt, where the pick-up in yield remains attractive and spreads have more room to tighten.
Equity markets have oscillated between inflation and growth fears, which should not coexist. We tend to side with the bull case: growth will hold up, the reopening will last and the Fed will err on the side of caution and maintain its accommodative stance, even if tapering is announced sometime in the fall (to begin in 2022). That said, with less visibility for the second half of the year, we expect more volatility ahead, as fears around growth and variants persist, especially as we have already seen the peak in support from fiscal and monetary stimulus, a plateau in vaccinations in the West and the biggest part of the rebound in earnings. Still, while all of these supportive elements remain present, the downside should be limited. Moreover, with a growing ‘wall of worry’ for investors to surmount, complacency is becoming scarce and positioning has become less aggressive as a result.
As such, the reflation trade should gather steam again. This should make Europe, Japan, energy, and financials more attractive than other areas. Also, maintaining some dry powder over the summer to be able to seize opportunities for the latter part of the year may be a smart move, as the coming weeks could remain bumpy.
The rise in Covid cases due to the Delta variant has raised questions about reopening prospects, stalling the reflation trade. However, with hospitalizations rising only slowly, renewed lockdowns or stringent measures appear unlikely, for now at least, across the West.
With that, peak growth fears have climbed as well. But we expect data to prove solid over a number of quarters ahead, and as releases confirm sustained strong growth, risk assets should move higher still. That said, the second half should prove more volatile than the first, in part because visibility on the outlook has faded.
The Fed’s tapering timeline is coming into focus, negotiations on the infrastructure package are ongoing, and earnings may not grow at the same speed as in the first half. Still, these supports remain present even if past their peak, which should support equities going forward. We therefore maintain a preference for cyclicals, which should advance as growth fears recede. Sectors such as financials, energy, and materials look more favorable. European markets should benefit from the growth recovery in the second half of the year. Also, Japanese stocks should benefit from improving sentiment surrounding the Olympics and the fact that bad news is already priced in.
After falling below 1.15%, yields on US 10-year Treasuries have rebounded somewhat, as investors weigh growth and variant fears with the reality of economic strength. Still, we believe that these levels are too low given the current environment, and yields should gradually rise as growth and inflation data remains high. However, we expect the Fed to remain prudent and accommodative, and believe the European Central Bank will find ways to maintain support to its banking sector and the peripheral countries.
We remain more prudent on sovereign debt and prefer taking credit risk rather than duration risk. The longer duration of Investment Grade indices and the very tight spreads suggest less room to absorb higher rates than in high yield. Careful selection remains important. With high yield spreads widening recently, some opportunities have emerged. We continue to see opportunities in hard currency emerging market corporate debt, where the carry is attractive and there is further room for spread compression.
The US dollar is benefitting from inflation fears and a perceived more hawkish Fed, but the upside may be limited as growth outside of the US picks up and risk-on sentiment recovers. Still, strong growth and earnings, and higher carry should eventually limit the downside for the dollar, as well. As such, we expect broad range-trading against major currencies, though some emerging market and commodity-linked currencies should benefit.
With production cuts still in place, oil prices can move higher as confidence in the sustainability of the global economic recovery grows again over the coming months, especially if demand recovers better than currently expected. However, overall supply remains abundant, which is likely to limit appreciation potential at some point. We also expect demand for gold to improve with the reopening of emerging market economies, leading to better physical demand, along with low real yields, and high medium-term inflation expectations.
Alternatives continue to provide diversification and de-correlation opportunities. We believe that real assets can also help provide income in a world where interest rates should remain lower for longer.
All investing involves risk, including the risk of loss. Investment risk exists with equity, fixed income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided. Investors should fully understand the risks associated with any investment prior to investing.
Foreign and emerging market securities may be subject to greater political, economic, environmental, credit, currency and information risks. Foreign securities may be subject to higher volatility than US securities, due to varying degrees of regulation and limited liquidity. These risks are magnified in emerging markets.
Commodity-related investments, including derivatives, may be affected by a number of factors including commodity prices, world events, import controls, and economic conditions and therefore may involve substantial risk of loss.