Delta-Fed 26

As we approach the midpoint of 2021, it is worth taking a quick look at the first half of the year and thinking about the potential key drivers for the next six months and beyond. The first half of the year was largely packed with good news. The distribution of vaccines helped to start the containment of COVID-19. Fiscal stimulus in the U.S. added more momentum to its economic recovery, to the point of raising concerns over inflation. This kept fixed income returns on the back foot while equity saw a rotation toward value and cyclical sectors. In China, the recovery is starting to normalize alongside its monetary and fiscal policy. 

Looking ahead, we believe three things are worth paying attention to: how the Delta variant of COVD-19 could impact the economic reopening and recovery; the Federal Reserve’s (Fed’s) policy normalization; and the geopolitical interactions around the United Nations Climate Change Conference Summit.

Delta is about change

The progress of vaccination is going to drive the pace of recovery. The U.S. and the UK have led this race in the first half of the year, and their economies are going through a robust recovery now. Europe and China have also accelerated their progress in recent weeks. While vaccine hesitancy around the world could prevent these economies from reaching the 60-70% vaccination rate that is needed to achieve herd immunity, a higher level of vaccination combined with effective testing and tracking programs should help to contain the pandemic. 

One question mark is whether the Delta variant of the COVID-19 virus could challenge this progress, given it is more transmissible. Data so far suggests those infected are mostly the unvaccinated. For those who are vaccinated but still got infected, the severity of their illnesses is relatively mild. Instead of just looking at infection numbers, governments will also need to look at hospitalizations, severe cases and deaths to adjust their lockdown policies. 

For the rest of Asia, after a slow start, vaccination momentum is picking up in Hong Kong, Japan and South Korea. Unfortunately, in a number of southeast Asian economies, such as Indonesia, Malaysia and the Philippines, the rate of inoculation is still low, partly due to availability problems. This should accelerate in the second half as they receive their delivery of vaccines. 

Overall, the global economic recovery should continue, but the pace will vary. For those economies at the forefront of this recovery, their central banks will need to start thinking about reining back the aggressive monetary stimulus. 

The Fed thinking about changes

China already began this normalization earlier in the year. While the People’s Bank of China has kept interest rates unchanged, the overall pace of lending growth has decelerated toward the pre-pandemic level. This has dampened market sentiment in recent months and triggered concerns of liquidity problems for some financial institutions and real estate developers. While China has allowed more companies to default on their debt, official intervention is still likely if a default jeopardizes the stability of the financial system.

The attitude of the Fed will be critical in setting the markets’ tone. In its June Federal Open Market Committee (FOMC) meeting, committee members revised up their 2021 economic growth and inflation projections significantly to reflect the reopening of the services economy. More importantly, more members are expecting the first policy rate increase to come in 2023, instead of after 2023. We also expect the Fed to start scaling back its asset purchase program in early 2022. 

This means U.S. government bond yields are likely to rise further even though the reactions since the June meeting have been negligible. Higher interest rates are not necessarily bad for equities. In fact, data shows that U.S. and global equities can still generate positive returns in a rising yield environment, which coincided with periods of economic and corporate profit recovery. The challenge would be for those assets that do not generate any income, which includes gold and cryptocurrencies. Equities with high valuations are also vulnerable, since part of their expensive valuation is supported by ample liquidity, which is now gradually being withdrawn. This could point toward a more choppy time for U.S. technology companies. 

Everyone is talking about climate change

The third event to watch out for is the United Nations Climate Change Conference in Glasgow, also known as COP26, that will take place at the end of October. Climate change is dominating both national and international policies. U.S. President Joe Biden’s infrastructure proposal includes a significant upgrade to the U.S. renewable energy industry and infrastructure. The European Union’s recovery fund is supposed to facilitate a green recovery. China is also stepping on the accelerator in developing its renewable energy sector for both its domestic need to reduce greenhouse gases and the international demand for a green energy solution. 

This conference is going to be important to see whether major economies are collaborating to fight climate change, or too busy blaming each other. It is also important to see if greenhouse gas emissions could be used as a new form of trade barrier, where more polluting sectors or countries could see their products hit with additional tariffs or face greater import restrictions. China and the U.S. have pledged to work together on this global issue, but geopolitics can still dominate the execution of this plan. 

Still good enough to generate returns in 2H 2021

Overall, the global economic recovery and policy backdrop should still be solid enough to generate positive return. Equities are still in a relatively more attractive spot given the potential for bond yields to rise and corporate earnings to offer more positive surprises. For fixed income, short duration, high yield bonds are still the preferred way to generate income. This includes high yield global corporate bonds and emerging market fixed income.

For equities, we are still advocating a globally diversified allocation. Higher yields in the U.S. should continue to support the rotation toward cyclical, even though the differentiation between growth and cyclical is less prominent compared with 1H 2021. Europe could continue to offer positive surprises given its economic reopening. For Asia, more patience is needed for the Association of Southeast Asian Nations (ASEAN) since its vaccination progress will take more time to show effect. China could gain more momentum once policy normalization is better digested by the market and regulatory changes for the tech sector settle. 

Global economy:

• The Fed’s June FOMC meeting was an important turning point. Its updated Summary of Economic Projections shows a greater number of committee members are forecasting rate increases to start in 2023. 2021 economic growth and inflation forecasts are also revised higher to reflect a robust recovery and some supply side bottlenecks.
  (GTMA P. 30)
• President Biden has made progress in gaining support from Republicans on his infrastructure project. However, the scale of this fiscal package is likely to be significantly smaller than originally announced with few, if any, changes to corporate tax rates. Meanwhile, over 130 countries are supporting the 15% global minimum tax, even though national parliamentary approval is needed for many countries, including the U.S.
  (GTMA P. 22)
• The UK has seen a pickup in COVID-19 infections, largely due to the Delta variant. This variant has affected mainly the unvaccinated. In Asia, the outbreak has eased in India and Japan, but new cases have been rising in Indonesia and rebounding in Thailand and Malaysia. Their authorities are hoping vaccine delivery in coming months will help to contain the virus.
  (GTMA P. 24)

Equities:

• June has been more supportive of developed market equities than emerging markets, partly reflecting the more encouraging outlook on vaccination in the U.S. and Europe compared with Asia and broader emerging markets. The S&P500 was up 2.3% in the month and the Stoxx60 up 0.8%. Lower U.S. Treasury (UST) yields also helped to boost tech stocks, with the NASDAQ up 5.6% in the month.
  (GTMA P. 32)
• Asian markets are still led by South Korea and Taiwan, benefiting from the rebound in global tech equities. These are also the markets with robust earnings outlooks. China A-shares (CSI300) were down 2% in the month. ASEAN markets were down on the back of the lack of progress in keeping infection numbers down.
  (GTMA P. 32)

Fixed income:

• Despite a more hawkish Fed forecast on the policy rate outlook, the 10-year UST yield fell to below 1.5%, a low point since early March. On the other hand, the shorter end of the curve reacted more with the 2-year UST yield rising 10bps to 0.25%. This reflects that investors are starting to price in policy normalization at the short end of the yield curve. Yet they see inflation as a temporary issue, which helps to keep the long end of the curve anchored.
  (GTMA P. 56, 58)
• A combination of falling risk-free rates (UST yield) and spread tightening helped U.S. investment grade (+1.7%) and high yield (+1.23%) deliver positive returns to investors. Emerging market debt performance was mixed as the high yield portion for both sovereign and corporate credit saw a credit spread widening and hence underperformed the investment grade segment, which also had a longer duration.
  (GTMA P. 52, 54, 60, 62)

Other assets:

• Oil prices gained on the back of slow supply growth by the Organization of the Petroleum Exporting Countries. The West Texas Intermediate hit USD74 per barrel, the highest since October 2018. In contrast, industrial metals, such as copper and aluminum, continued to correct with the Chinese authorities looking to stamp out speculative activities. The prospect of higher rates by the Fed has pushed gold prices lower, from USD1,900/oz to below USD1,800/oz.
  (GTMA P. 73-75)
• A more hawkish Fed has driven the U.S. dollar stronger even as the long end of the yield curve has failed to lift off. The U.S. dollar gained against both developed market and Asian currencies in June. Most developed market currencies, apart from the Japanese yen, lost around 3-4% versus the U.S. dollar. In contrast, Asian currencies’ losses were modest, with the Thai baht (-1.6%) and Indonesia rupiah (-0.5%) as the underperformers.
  (GTMA P. 70, 71)