J.P. Morgan Asset Management is pleased to present the latest edition of Quarterly Perspectives. This piece explores key themes from our Guide to the Markets, providing timely economic and investment insights.
THIS QUARTER’S THEMES
Diverging recoveries, diverging policies
- Variations in vaccination progress and economic stimulus have delayed synchronisation of the global economic recovery. The U.S. is expected to lead the recovery in 2021, and Europe should follow. China’s economy has normalised and is expected to expand along its trend growth.
- Global inflation has accelerated as expected, but there is little clarity whether a series of one-off factors, such as supply-side bottlenecks, semiconductor shortages and commodity price volatility, could prolong this trend.
- Desynchronised recovery implies diverging paths for global monetary policy. Some smaller central banks have already become more hawkish. China has started to normalise with slower credit growth, and the U.S. is still being patient, despite a pick-up in inflation. Meanwhile, the priority of most Asian central banks is to get through the latest wave of infections.
Uneven global recovery
The next phase of recovery should be determined by the progress of vaccinations, which in turn will boost consumption and business investment.
- The U.S. and the UK have been the leading major economies in vaccinations. China and Europe have also accelerated the pace of inoculating their populations. However, Asia and other emerging markets are lagging due to vaccine hesitancy and insufficient supply.
- Locations with better progress on vaccinations can re-open their economies on a more consistent basis, attracting consumption and business investments. This is already happening in the U.S., alongside sizeable fiscal stimulus.
- For the laggards, the recovery will likely be delayed until 2022 or beyond. For Asia, the export outlook is still favourable, but the outlook for domestic demand and travel is subdued for much of 2021.
Inflation is driven by a series of one-off events
Global inflation has accelerated as expected. But a few one-off factors in the U.S. are driving prices higher.
- The U.S. labour market distortions could push up wages in the near term. Businesses are struggling to hire despite the still elevated unemployment rate. But the situation may ease in 3Q 2021 as supplemental unemployment benefits come to an end.
- Nonetheless, supply-side bottlenecks, such as rising shipping costs, could continue to assert pressure on prices. A shortage in semiconductors and fuel could also prolong elevated inflation in the coming months.
- We still expect U.S. inflation to revert to the Fed’s 2% long-term target in 2022. However, investors will remain focused on whether more one-off events would delay the return to normality, and whether the Fed will be pressured to raise rates earlier than expected.
Central banks are going their separate ways
The varying pace of recovery could prompt global central banks to adopt different strategies in normalising their monetary policies.
- The Fed is still a kingpin given its influence in global markets. We expect the Fed’s asset purchases to slow in early 2022, and it has indicated the first rate hike may come in 2023, should the inflation momentum persist and the unemployment rate continue to fall.
- The People’s Bank of China has already pared back credit growth in the first several months of 2021, with an emphasis on constraining corporate leverage and the real estate market.
- Asia’s central banks are lagging the rate-hike cycle amid new waves of infections in several Asian economies, despite the recent pick-up in inflation. This could also limit the strength of Asian currencies in 2H 2021.
- The economic recovery should continue to be positive for risk assets. However, the varying pace of the recovery implies investors should take a more active approach when allocating by region.
- The U.S. and China are still leading in terms of economic performance, even though the strongest period of their rebound has probably passed. Europe is starting to benefit from a higher vaccination rate and the implementation of the European Recovery Fund.
- Asia’s domestic demand remains challenged by further waves of infections, but its export sector is recording strong demand.
- Ongoing inflation worries and future policy normalisation could push bond yields higher, which require fixed income investors to be agile. Yet, higher inflation would raise demand for income, pushing investors to other income-generating assets such as high-dividend stocks and alternatives, alongside high yield (HY) debt and emerging market (EM) bonds.
The recovery playbook
- The ongoing recovery and rising yields still favour risk assets such as equities, corporate HY debt and EM fixed income.
- Recovery has peaked for the U.S. and China, and there is more in store for Europe, as well as Asia and other EM economies, as vaccination rates increase and infections recede. This implies relatively modest returns for equities at the index level, but ample opportunities among sectors.
- Higher U.S. Treasury (UST) yields still pose a challenge for fixed income. HY corporate bonds and EM debt remain viable sources of income generation.
Recovery is still positive for risk assets but expect more moderate returns
The different recovery stages call for a more diversified approach on global equities.
- China and the U.S. are likely to have gone through the strongest period of their recoveries, but their growth paths have solidified. This implies rotation within the indices would be critical in return generation rather than at the benchmark level.
- Europe is in a sweet spot as the region is emerging from the latest wave of infections at a time when vaccination rates are accelerating. The European Recovery Fund should also provide some fresh growth momentum.
- Asia and emerging markets may require more patience and differentiation. The export sector remains in solid shape, but domestic demand will take longer to revert back to the long-term trend as vaccination rates remain a critical ingredient.
Cyclical rotation to continue
With rising yields and the ongoing economic recovery, tactical investors will favour cyclical sectors.
- Rising government bond yields have supported cyclicals, including financials, materials and industrials, while technology (tech) has come under pressure. We expect this to continue in 2H 2021.
- Strategic investors may look to build their tech portfolios during this period of underperformance, given the sector’s long-term track record. In the U.S. and China, tech leaders are under regulatory scrutiny, but this presents opportunities for the sector’s smaller players.
- Rising labour and raw material costs are a concern for manufacturers. Downstream players in the supply chain are currently in a more vulnerable position. Materials and energy could be useful as a hedge against inflation and higher prices.
Preparing for higher yields
UST yields are still expected to rise over the long term as recovery solidifies, alongside the possibility of inflation staying higher for longer.
- UST yields are expected to rise in the medium term on the back of higher real yields. Sustained inflation could add to this scenario. Short duration is one way to protect investors from such a scenario. Gold’s role is more ambiguous as the commodity excels when inflation depresses real yields, but struggles when inflation expectation recedes.
- HY corporate debt has the advantage of both relatively shorter duration and higher yields, which counter the negative impact on returns from rising UST yields. The ongoing economic rebound should also keep default rates low.
- EM fixed income had a challenging first half, partly due to the rebound in the U.S. dollar (USD). Greater USD stability in 2H 2021 against EM currencies should help EM debt improve its return. However, individual market challenges imply active selection is a must.
- Investors should continue to diversify their equity portfolios globally. Europe has enjoyed strong performance in 1H 2021, and we expect the ongoing cyclical sector rebound to provide more impetus.
- Asian equities have lagged this year due to policy normalisation in China and new waves of infections in some of the region’s economies. Exports should still be well supported, while patience is needed for domestic demand to recover as current infections are being brought under control.
- In terms of sectors, cyclicals should ride the economic tailwinds and the strength of the earnings outlook. Still, be mindful of rising raw material and wage costs. Higher inflation costs could add pressure to the profitability of downstream manufacturing industries in the near term.
- UST yields could consolidate in the near term but may push higher over the medium- to long-term trend. Investors should think short duration on fixed income while opting for higher-yielding debt.
Asia down but not out
- Hopes of a quick recovery in Asia are being dashed by a resurgence of COVID-19 cases and the slow vaccination rollout across the region. Recent spikes in infections remind us that even locations that have done well in controlling the pandemic previously are not immune in the absence of higher vaccination rates.
- The U.S. and Europe may be ahead in vaccination rates, but we expect their recovery to benefit Asia as global demand rises.
- The recovery has been uneven and this is likely to continue. China has led the way, but other Asian economies will follow as they benefit from pent-up consumer demand and the pandemic eventually recedes once more.
Asia is lagging behind but this won’t last forever
Asia has been lagging DM performance as resurgent COVID-19 cases dragged down the economic outlook and investor sentiment for several Asian markets.
- Asia has been falling behind economies such as the U.S. and UK because of the region’s relatively slow vaccination rollout. Equity performance compared to other DM economies has suffered, but this situation should improve as vaccination rates increase with supply over the course of the year. We expect the growth differential to developed markets to narrow and Asian equity performance to close the gap.
- A possible peak in credit and activity in China, alongside regulatory uncertainty, has weighed on the Chinese markets. But we still believe China will lead the recovery in Asia. The overall global recovery and pent-up demand is a positive for Asian exports and trade in general.
How worried are we about inflation?
Rising inflation, especially in the U.S., has led to worries that ultra-accommodative policy support will soon end.
- Despite some higher-than-expected inflation numbers from the U.S. recently, much of this inflation is transitory and normal for a recovering and growing economy. However, if inflation remains elevated, driven by a strong labour market and rising wage growth, this may renew the focus on the pace of policy tightening.
- In Asia, inflation is a minor concern, with most of the pick-up coming from base effects and higher commodity prices.
- Rising input prices are likely to put cost pressure on businesses. However, this currently does not appear to be the case. Profit margins in Asia are rising, which is normal in the early part of an economic recovery and should lead to higher earnings and performance.
Other factors to keep in mind
Other drivers of Asian equities still look favourable, but there are some risks.
- Valuations are currently not cheap at this level on a P/B basis, but they are still relatively undemanding when compared to the U.S. and European markets. Current levels are above long-term averages but not extremely so.
- EM and Asian equities tend to be inversely correlated with the USD. A stronger USD would suggest poorer relative performance. Our outlook is for the USD to weaken on the projected increase in U.S. spending, but there is a risk of USD strength if we see an unexpected early start to the Fed’s tapering and a shift in interest rate differentials.
- Asian markets will likely catch up but diverging intra-region performance will continue. China and other locations involved in electronic supply chains, or with an electronic product bias, are deriving a greater benefit from increasing global demand. Although the share of U.S. and European demand for Asia’s goods is not as high as it once was, it remains an important driver.
- Earnings are expected to improve. Profit margins are rising despite worries over inflation and higher input costs.
- Asian equity valuations are not outright attractive from a historical perspective, but relative to the U.S. and other major regions, they are undemanding.
Income beyond fixed income
- The struggle to find income is not new, but is currently complicated by expectations of rising government bond yields and heightened inflation, creating risks for holders of core government bonds or longer duration assets.
- The strengthening economic recovery has bolstered the earnings outlook. This should lead to a recovery in dividends as companies return capital through higher dividend payouts.
- For those looking for potentially more stable income streams with a lower correlation to equities, alternatives, such as real estate and infrastructure, present predictable inflation-linked income options.
Fixed income to low income
Years of financial repression by central banks as well as longer-term secular forces have created a downdraft of income in the traditionally held parts of the fixed income market.
- There are still sources of income within the fixed income market, such as U.S. HY bonds or EM debt, or the relatively newer China government bonds. But investors must be more selective in their allocations given market and idiosyncratic risks to these assets.
- Meanwhile, the risk/reward of holding higher-quality fixed income assets, such as core government bonds and IG debt, has become less appealing as higher duration assets are susceptible to capital losses as interest rates rise.
Divide(n)d we stand
The popularity of growth stocks, traditionally lower dividend payers, has reduced the dividend component of total shareholder return.
- In the U.S., for example, 22% of the 10.2% average total return since 2002 came from dividends. In the last five years, this number has fallen to 14% given the boom in U.S. growth stocks. However, the change has not been as swift in Asian markets as dividends have still accounted for 24% of total returns in the last five years (28% since 2002).
- This trend may be starting to turn as elevated valuations in growth sectors greatly diminish return prospects and investors rotate towards value and higher dividend payers.
- In the depths of the COVID-19 pandemic, dividend forecasts collapsed alongside earnings expectations. Regulatory changes also prevented some companies from paying or increasing dividends during the period. However, a V-shaped recovery in many economies has led to a sharp increase in dividend forecasts, which are noticeably stronger in Asian markets.
Looking beyond bonds for income means considering non-traditional assets. Alternative assets present their own challenges but offer similar characteristics for income and portfolio diversification.
- In recent years, investors have been increasing their allocations to alternatives as such assets offer the prospect of increased returns, steady income and, in some cases, bond-like diversification.
- Real assets, such as infrastructure, real estate and transport, are assets that have steady cash flows that can translate to higher income. The contractual nature of these cash flows, often with high-quality counterparties, leads to more predictable income streams and lower return volatility.
- These assets may also be an inflation hedge as the cash flows are indexed to rising inflation rather than having to absorb it.
- Some segments of the bond market can still be tapped to provide income in portfolios, such as HY bonds and EM debt. However, investors will increasingly have to look beyond the bond market for income.
- The strength in earnings growth means companies can reward shareholders with higher dividends as well as reinvest for growth. Higher-yielding equity markets are trading at elevated valuations, and this is an option that should be considered.
- For investors who can allocate to illiquid assets, the stable cash flows from real assets, such as infrastructure, transport and real estate, may be a viable source of reliable income and bond-like portfolio diversification.
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