Buying a recovery

Fiscal spending is another diverging factor. In the US, both houses of Congress have approved Joe Biden’s USD 1.9 trillion stimulus bill, which will send direct payments of up to USD 1,400 to most Americans. Recent reports suggest his economic team are now putting together a USD 3 trillion infrastructure spending plan to combat climate change, reduce inequality and fortify the economy. In contrast, the EU has yet to put its EUR 750 billion ‘recovery fund’ to work.

Currency values are a function of many factors, and one of them is confidence in the outlook for the underlying economy. This relationship explains why the US dollar has been strengthening against the euro, and we expect this trend to continue. We also think long-term government bond yields will rise further, but at a more moderate pace. Short-term bond yields are less likely to rise because central banks are committed to not hiking policy rates for quite a while.

This year’s investment environment has been a challenging one for asset allocation, with different regional economies and financial markets moving at different speeds. We’ve concentrated on finding asset classes that are undervalued and have the potential to catch up with the broader market, and then monitoring them carefully when they have done so.

At the start of March we closed our overweight allocation to emerging market (EM) equities against eurozone government bonds. Since we initiated the position, EM equity valuations have risen towards multi-year highs but more recently market momentum has faded. EM equities are one of the most volatile asset classes in our investment universe, and we decided the tactical case for continuing to hold this position was no longer convincing.

We’re exposed to inflation in many positions, most notably US Treasury Inflation-Protected Securities (TIPS), and we’re monitoring the situation closely. Although rising bonds yields can put pressure on some areas of the market, the overall outlook for risky assets remains positive, supported by progress on vaccinations, especially in the US and UK, pent-up demand and policy support.

We’re maintaining our overweight allocation to equities, which are well positioned to benefit from the economic and earnings recovery, in particular US equities. In addition, we have overweight allocations to asset classes that have the potential to catch up with the rest of the market, including UK small-cap stocks and Asian high-yield bonds.

Financial markets often become preoccupied with a particular theme and at the moment it’s inflation. Government bonds yields have risen (meaning prices have fallen) to reflect concerns that an economic boom could reignite inflationary pressures. Although the scars from the Covid-19 pandemic remain significant, the combination of ample financial stimulus and pent-up demand being unleashed has led many analysts to increase their growth forecasts for 2021.

The gap between countries that have rolled out their vaccination programmes successfully and those that have lagged is widening. Economic activity in continental Europe is slowing due to rising infection rates and lockdown extensions. In contrast, the US and UK should experience an early recovery in services and consumer spending as restrictions are lifted.

Headline inflation (the overall measure) is likely to pick up over the next few months as lockdown restrictions relax and people return to shops, restaurants and offices. Yet core inflation (which excludes more volatile items such as energy and food) should soon settle back down. Our forecasts take into account the key factors that drive inflation, including wages and unemployment, inflation expectations, pipeline price pressures as captured by producer prices, exchange rates, oil prices, the role of China in the global economy and seasonality.

It’s now been more than 12 months since the coronavirus pandemic changed the world in ways we could never have imagined. Although successful vaccinations mean that we’ll be able to see our friends and families again soon, the timing depends on where we live. America’s vaccine rollout has been among the best in the world and the UK continues to have one of the highest vaccination rates. In contrast, the EU moved more slowly in securing contracts and approving vaccines.

This divergence is something for us to consider when making investment decisions. We believe that the overall outlook for risky assets is positive and the global economy should continue to heal as lockdown measures relax and stimulus measures kick in. Inflation is likely to pick up as spending on services and restaurants surges. But it’s probably going to prove a fleeting phenomenon, and not something that will pose a serious, longer-term challenge to markets.

The global economy is recovering but a gap is starting to open up between the regions that are managing their vaccination programmes more effectively

A two-speed recovery

COUNTERPOINT APRIL 2021