You can’t have it all, can you?

Chief Investment Officer's team
20 June 2021
The “goldilocks” narrative of high growth coupled with relentless stimulus took a breather last week…


  • The “goldilocks” narrative of high growth coupled with relentless stimulus took a breather last week…
  • … When the outcome of the Federal Reserve’s June FOMC was more hawkish than expected
  • Global markets had a negative week, but we see no game changer to the outlook

Ten days ago, when we implemented the first - though modest - risk reduction to our tactical asset allocation for 2021, we obviously didn’t know that the following week would be negative across all markets. But indeed, all asset classes delivered negative returns, from -6% for gold to -0.5% for emerging market bonds, and including -1 to -2% for stocks.

The reason is simple: the Federal Reserve came out Wednesday with an unexpected shift in guidance, with two rate hikes now expected by 2023. The institution did not change its policy, made only marginal adjustments to its economic outlook and remains open-minded, but markets took note of the very first step towards the start of normalization.

This should not come as a surprise, and the overall modest consolidation of last week is not an expensive price to pay if the message that extraordinary stimulus is not ever-lasting has been delivered to market participants. Our timing hasn’t been unlucky but over such a short time horizon it simply doesn’t mean much. We are less outright bullish than in H1 but we remain constructive, overweight stocks and underweight bonds. The probability of turbulence is simply higher in H2, but we would definitely consider any meaningful correction as a potential opportunity to add to risk.

Sources of potential volatility include the virus developments, with the Delta variant spreading, as well as regional and sectoral divergences in growth, as illustrated by China’s inflexible reduction of policy support to the economy. Still, with record growth in the current quarter, and reasons to believe that inflationary pressures are transitory, the big picture remains overall favorable. Stay safe.

Cross-asset Update

Last Wednesday’s hawkish Fed message is putting various flavors of the reflation trade to the test. In the two days following the FOMC meeting cyclicals underperformed defensives in equities, the yield on the 10-year Treasury note lost almost 15 basis points, market-implied inflation dropped to a 3-month low, losses were widespread across the commodity complex and the US dollar strengthened. We hold the view that it is still too early in the cycle and support too strong for growth to weaken substantially, hence we would see this risk-off episode as a pause in a reflationary trend set to continue. Real concerns regarding reflation sustainability will most likely resurface sometime next year, when momentum in the major central bank balance sheets will dwindle to close to barely positive levels, signalling an obvious tightening of financial conditions. If past patterns are anything to go by, peaking US growth should usher in more muted asset returns, with the catalyst this time provided by a not-so-market-friendly Fed guidance. At the same time, we should also remember that the Fed’s new path is not set in stone, with any disappointments in growth or inflation likely to delay the implementation of the announced tightening.

Counterintuitively, yields continued to fall for the week, actually conveying the consistent message that any withdrawal of support is eventually deflationary. Once investors have adjusted to the new reality and the risk-off episode is over, they should move higher again. Indeed, the Fed’s message is forcing us to revise higher our conservative, year-end target of 1.2% for the 10-year Treasury yield. Long-dated yields are the sum of a shorter-term component, dependent on policy rates, and a longer term one, accounted for by inflation. The Fed boosted both, the former by changing its median forecast for policy rates for 2023 and beyond, the latter by updating inflation forecasts. Our new fair value will be between 1.5 and 2%, taking into account new market-implied fed funds levels and revisions to inflation.

We also beg to differ with the view that inflationary pressures will be tame in the long run. Yes, we think that peak US inflation is going to be reached in the current quarter or the next one, but this does not mean that price pressures will just settle down at pre-pandemic levels. If Joe Biden is serious about his agenda of income redistribution and sustainability, that is beyond doubt inflationary. Lower-income consumers spend a higher proportion of their money and the green economy requires commodity-intensive investments. It may be peak inflation for now, but it should also be higher for longer.

Fixed Income Update

The News-Vs.-Noise debate has reared its head again. The Fed surprised most of the market participants by bringing forward the expected hike in policy rates through the change in dot plots, with the first hike expected in early 2023 according to the median forecast. In fact, in the latest FOMC meeting, as many as seven members voted in favour of a rate hike compared to only four members in the previous meeting. However, investors need to ask if this is a real surprise or complacency had rather set in. While the Fed has kept the duration of its Average Inflation Targeting framework vague, we can guess that the latest dot plots indicate less tolerance for inflation surprises than earlier anticipated. Now the focus is going to be on the timelines for the tapering of asset purchases. Chairman Powell categorically mentioned that “A lot of Notice” would be given, making us wonder if tapering would start in 2021. Most likely, it should in 2022, under the assumption of a strong labour market in the second half of 2021.

The flattening of the US Treasury curve was fascinating. While the shorter-end shifted by more than 10 bps higher for the 2 and 3-year maturities, the 30-year moved lower by as much as 18 bps. The 10-year yield ended the week at 1.43%. Most of the explanations pertain to an aggressive unwinding of the earlier shorts and the reflation trades. As we mentioned in the last weekly, this is a temporary phenomenon, and the 10-year yield is very low as compared to its fair values. We expect this to move up and hence don’t suggest long-duration exposure at the current expensive valuations.

Most of fixed income was in the red across the risk spectrum, with the shorter duration the most affected by the Fed’s shift in tone. Higher-risk debt widened by 5-7 bps with the exception of Emerging Markets. Global HY was the worst affected, losing -0.63% last week, while EM Debt posted a gain of +0.10%. As Treasury yields start to rise again, we may see an outflow from EM IG into DM debt. Anyway we expect the “Hunt-for-yield” to continue and EM high-yielding debt to remain well bid.

Flows into global fixed income funds were robust at +$16bn. Short-duration funds saw the most substantial inflows across fixed income. Emerging Market Debt got a net +$1.5 Bn of funds. YTD defaults continued at 45, which is lower by 59% compared to 2020 defaults. The oil and gas, consumer products, and media and entertainment sectors lead defaults so far with seven, six, and five, respectively. These sectors also led at this point in 2020 but have seen defaults decrease by more than 65%, with credit metrics across these sectors showing signs of stabilizing.

Equity Update

Global markets were lower for the week by almost 2%, with an increase in daily volatility. The only exceptions were the GCC markets and the global tech sector. June has seen the Dubai index build positive momentum, carried into last week with the real estate developers the favorites, reflected in the Abu Dhabi bourse. Abu Dhabi banks also saw some accelerated trading. EM performed better than DM, in spite of a strengthening USD. In the U.S. the industrial heavy Dow Index fell 3.5%, the S&P 500 1.9%, while the Nasdaq fell less -0.3%. Investors’ response to the Fed’s hawkish dot-plot and longer-term inflation expectations being lowered, was to unwind some of the reflation trades, which had become crowded recently. Inflation-sensitive shares and cyclical companies tied to reopening took a hit (financials, materials, and energy were the worst off) while growth stocks such as tech made a comeback. Energy stocks selling off was surprising, considering that oil prices remain resiliently above $70/bbl. Equities continue to see saw record inflows and we remain constructive on equity performance into year end, both DM and EM with a tactical overweight Europe and Asia.

In 2021 so far, fears of rapidly rising inflation knocked tech stocks from their top spot as investors worried that higher yields would affect growth stocks present valuations. Energy and financials rallied on conviction that the resurgence of strong economic growth would breathe life into cyclical sectors. Bond yields continue to be the biggest factor influencing value growth rotation and the Treasury yield curve flattening has now led to a reversal of the value trade. The reprieve from the March spike in yields has been instrumental in the shifting leadership trends within the stock market. The markets’ focus on a possible US rate hike 2.5 years away, is illustrative of Central Bank influence. However, the market once it has crossed peak growth should become less binary in terms of leadership, with macro factors having a lower influence in favor of company/industry fundamentals. A hybrid approach—with a focus on both growth and value factors and quality of companies, regardless of sector biases within Growth or Value indexes, we feel will work better. After a period of brutal factor pivots starting post the 2020 March sell off, the opportunity to differentiate with alpha opportunities is here. Technology and de-carbonisation are becoming a larger component of all industries, and enhancing growth opportunities in many sectors and the distinction between Growth and Value is likely to fade. As the growth cycle matures, we expect to see less of a difference between Cyclical and Defensive parts of the market, and have already started to see good value emerging in Health Care, while some profitable growth stocks such as the FAAMG’s, offer better entry points following the recent relative de-rating.

Material companies, which lost 5% last week, are also now at reasonable entry points after the spectacular rally which began last November, in line with rising commodity prices, especially copper. A good time to add positions for those who missed the rally, with many of these companies now able to generate strong free cash flow yields (average of 10% for companies in our recommended list) and high dividend payouts. Their debt positions are also lower and manageable unlike the past few years.

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