From a full-year, 2021 perspective, not much has changed. The underlying fundamental supports for markets are still here. Monetary policy will remain ultra-accommodative, including in the US. Indeed, I expect Fed Chairman Jerome Powell to highlight that tapering of the Federal Reserve’s QE1 (Quantitative Easing) program is not on the cards. Elsewhere, support is only likely to increase, though the People’s Bank of China could reduce support as the Chinese growth engine roars again. With the Democrats’ mini-sweep, fiscal support is set to expand further under the Biden administration. While I do not believe Biden will manage to pass the $1.9 trillion in additional federal aid that he has suggested, an additional $1 trillion is likely. A second fiscal package is set to be unveiled later this year. Earnings are expected to rebound throughout 2021, even though the first quarter might still be difficult, for Europe in particular. Finally, and most importantly, the vaccine rollout is ongoing. It has been a slow start, but distribution should accelerate and expectations are for broad swaths of the population to be inoculated by the summer.
Still, a number of obstacles we anticipated, including logistical hurdles with the vaccines, are unfolding. While these are not surprising, they are delaying the prospects of getting “back to normal” and leading to a pause in the reopening trade. In addition, Biden’s fiscal plan is likely to shrink and take time before it is approved. As such, it appears that much of the good news is already priced in and markets are pausing before the reflation trade takes hold again.
In this context, I remain constructive on risk assets, even if markets see some range-trading in the very short term. I still expect equities to advance and believe the rotation towards cyclicals will gain steam again in the coming weeks. Still, investors may want to keep an eye on sentiment and positioning in a very consensus view climate. I am more cautious on sovereign debt, although I believe that yields will only rise gradually. Indeed, I expect the Fed to act to cap yields if needed. I maintain a preference for credit for the carry and still see opportunities in high yield (HY) and in emerging market debt, where there is more remaining potential for spread compression.
Despite a possible period of consolidation, I continue to believe that equity markets will resume their rally in the coming weeks. Indeed, the underlying fundamental supports of fiscal support, ultra-accommodative monetary policy, vaccines and rebounding earnings all remain.
For now, a pause in the cyclical rotation is possible, as markets process slower vaccine rollouts and a slow approval to Biden’s fiscal aid plan before it regains strength.
Investors may want to focus on the medium term and still favor the reopening trade and more cyclical sectors that have plenty of room to play catch-up. I believe that vaccine rollouts will pick up and the renewed US fiscal impetus will reignite this view. I also expect the recent strong performance of Japan to continue and maintain a positive view of emerging Asian equities. Commodities should continue to rebound with strong Chinese growth, with the developed Pacific region likely to benefit.
Nonetheless, with positioning crowded and valuations rich, investors should likely keep an eye on sentiment to avoid falling into complacency. Given still elevated cash levels and the above-mentioned underlying supports, I expect any potential correction to be mild.
After US yields burst through 1% on reflation expectations, they have retreated from the recent peak as risk appetites take a breather, but are likely to gradually move higher again.
The divergence in spreads between the US and Europe is only likely to increase over the coming months as the fiscal impetus will come from the US and the rise in inflation expectations as well. As such, US Treasury yields have more upside potential than German Bunds, especially with a weak European growth backdrop. Still, European sovereign yields are likely to rise in sympathy, to some extent.
In this context, investors may want to reduce duration, even though I expect yields to remain capped by central bank actions. Overall, I maintain a preference for credit over sovereigns. Spreads have tightened sharply already but potential remains in HY, though we remain selective due to 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.
The recent retreat in risk appetite has benefited the dollar, but I expect it to return to weakness as investor sentiment rebounds again. That said, I believe that USD weakness is likely to be more muted going forward as much of the move is likely behind us already. In addition, it is likely to materialize more against emerging market currencies than against the major currencies that have their own challenges. Indeed, with stronger growth, more fiscal support and higher yields, USD should find some support.
Oil prices should benefit from the reopening trade as it gathers steam again and demand picks up as economic activity starts to get back to normal. However, abundant supply is likely to limit appreciation potential at some point. I expect demand for gold to continue given low real yields, medium-term inflation expectations and central bank QE programs, even if it has paused as of late January.
I continue to see a place for alternatives in portfolios, particularly for investors looking for de-correlating and diversifying strategies to complement traditional asset classes. Real assets can also help provide income in a “lower for longer” world.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed are as of January 27, 2021 and may change based on market and other conditions.
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