Still, inflation expectations plateaued over the month and Treasury yields retreated, stalling the reflation trade. This was also partially sparked by the spike in Indian Covid cases and a rise in cases in developed markets as well. However, with cases starting to roll over, reopening prospects should improve again, and the reflation trade should gather steam again over the coming months. As such, the cyclical rotation should resume, with energy, materials, and financials advancing. I also think that Europe and Pacific ex-Japan should benefit from reopening expectations, recovering global trade and higher commodity prices.
As we wait for the next catalyst – whether higher oil prices, yields or better Covid news – equities should remain favorable. Indeed, the medium-term supports for equities remain unchanged, with vaccination, fiscal spending, accommodative central banks, and rebounding earnings still present. Conversely, sentiment and positioning are already very bullish, and investors should keep an eye out and not fall into complacency. For now, enough concerns linger, but over-optimism is a risk.
On the fixed income side, while I believe that a lot is priced in in terms of fiscal stimulus and inflation expectations already, and yields have probably seen the bulk of the move, they could move higher in the short term, before retreating again further out. As such, shorter durations appear favorable and I remain cautious on sovereign yields. Credit is preferable, though already tight spreads and longer duration suggest less potential upside from here. High yield should do better, as it is less rate-sensitive, but selectivity will be important. While EM often struggle during rising US yields, they are in better positions than during previous such bouts and have handled the recent move better than expected. EM hard currency corporate debt also has more room for spread tightening and therefore potential to absorb higher treasury yields.
With spiking cases in India and higher cases in Europe and the US, the reflation trade stalled in recent weeks. However, I think it should resume as cases roll over and the vaccination effort continues to accelerate.
While we wait for the next catalyst to spark a renewed rotation towards cyclicals, equity markets appear constructive, and looking for opportunities to “buy the dip” may be advantageous. Indeed, longer-term supports remain in place, especially with the Fed reemphasizing it is not close to reducing its support and President Biden looking to spend trillions more.
I expect cyclical sectors to outperform again, favoring financials, energy, and materials. European and Japanese stocks should also benefit from the move to value-tilted construction of their indices. Commodities should continue to rebound with strong Chinese growth and reopening expectations, and I expect the developed Pacific region to benefit in particular.
Keeping an eye on sentiment and positioning portfolios appropriately will be important at this stage of the recovery, as a lot of good news is already priced in. Indeed, while the Q1 earnings season has been very strong so far, stocks have not reacted as much, suggesting expectations for earnings. With spiking cases in India and higher cases in Europe and the US, the reflation trade stalled in recent weeks. However, I believe it is set to resume as cases roll over and the vaccination effort continues to accelerate.
Yields retreated from their recent peaks over the month of April, but they are likely to move higher again in the short term, as Covid cases roll over, vaccination accelerates in Europe, and the reopening trade gathers steam again.
However, while they can move somewhat higher in the coming months, the bulk of the move is likely behind us as much of the inflation and spending expectations are now priced in. Moreover, Biden’s infrastructure plans, while large in scale, are set over 10 years, suggesting less impact on growth and inflation expectations for 2022.
Still, shorter durations appear more favorable. I remain prudent on sovereign debt, both US and European. The longer duration of IG indices and the very tight spreads suggest less room to absorb higher rates than in HY, though we remain selective given lingering default risk.
I continue to see opportunities in hard currency emerging market corporate debt, where the carry is attractive and there is further room for spread compression. This should also allow some absorption of higher Treasury yields, as seen in the better-than-expected performance of the segment in recent months.
After staging a rebound at the start of the year, the dollar retreated with US yields and has settled into something of a trading range with major currencies. As the reopening trade picks up again, “risk on” and commodity-related currencies should benefit, but I think that stronger growth, higher yields, and ongoing fiscal impetus should limit dollar weakness.
With reopening prospects set to improve again, oil prices should move higher again as OPEC+ maintains supply cuts. However, the balance is fragile and overall abundant supply is likely to limit appreciation potential at some point.
Demand for gold should improve with the reopening of EM economies – leading to better physical demand – low real yields, and medium-term inflation expectations, even if it has paused for now.
Alternatives continue to provide diversification and re-correlation in portfolios, a welcome complement to traditional asset classes. Real assets may also help provide income in a “lower for longer” world.
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