Multi-Asset Solutions Monthly Strategy Report
Global markets and multi-asset portfolios
Exhibit 1: Mas asset class views from March strategy summit
Risk assets adjusting to a higher rate world
Last week’s move in bond markets puzzled many market watchers: strong economic data failed to push up bond yields, as short covering and global demand for U.S. Treasuries pushed U.S. 10-year yields down toward 1.50%. In our view, the yield moves last week underline the idea that there is now more symmetrical risk in bond markets, rather than the notion that bond markets are discounting concerns about the recovery.
Over the first quarter of 2021, U.S. bonds buckled under the pressure of an improving economic outlook. U.S. 10-year Treasury yields started 2021 at 91 basis points (bps), 40bps higher than their crisis lows. Then came a 44bps selloff, the worst quarter for U.S. Treasuries since the fourth quarter of 2016. Despite the turmoil, global stocks advanced 3.7% in Q1, suggesting that yields rose for the right reason – growth – rather than because of imminent policy tightening.
U.S. 10-year yields now appear to be settling into a new range, likely between 1.50% and 2.00% with risks rather more symmetrically balanced; last week saw something of a test of the lower end of that range. In this new range, we believe that yields better reflect the balance between improving growth and accommodative policy as well as the marginal demand that emerges as yields edge higher.
At the beginning of 2021, many market participants believed that the Federal Reserve (Fed) would push back on rising yields, but the reality turned out to be more nuanced. Certainly the Fed reiterated its commitment to low policy rates, but it made no comment on longer dated U.S. bond yields. As policymakers commit to easy policy and signal tolerance of steeper curves, we reassess the implications for asset allocation.
In our view, the positive growth environment and new information from policymakers argue for a continued pro-risk stance and stronger conviction in a duration underweight. For equity markets, the steeper curves that drove the cyclical and value rotations in the first quarter probably have some room to run, in turn lending support to regions such as Europe and Japan, at the expense of U.S. large cap stocks and emerging market equity.
Modest underweight on duration
At our last Strategy Summit, we moved to a modest underweight to duration (Exhibit 1). Even though yields have risen over the last quarter, we expect a further rise as economic data continue to improve and as policymakers move gradually but inexorably toward tapering emergency asset purchases. The first quarter taught us many things that are relevant to bond markets. First, the U.S. has a greater-than-expected appetite for fiscal stimulus, raising the prospect of sustained infrastructure spending and higher budget deficits for some years to come. Second, the Fed will allow longer dated yields to track growth higher even as it demurs on raising short dated policy rates. Finally, faster vaccine rollouts and greater resiliency to confinement measures have speeded up the economic recovery. All these factors support higher yields.
Crucially, though, we expect yields to carry on rising for the “good” reasons of growth and so do not see higher risk-free rates as an impediment to our pro-risk stance. Moreover, in our positive growth base case we assign a low probability to a premature tightening of financial conditions stemming from an abrupt withdrawal of monetary stimulus or a disorderly rise in bond yields. In fact, it seems more likely that dovish forward guidance will keep real yields lower than growth data would warrant.
The inflation environment also influences the duration outlook. In the next few months, we forecast a sharp pickup in inflation due to base effects, transient supply change disruptions and the release of pent up demand as economies reopen. But then inflation is likely to be tamed by underlying structural forces (such as slow-moving services-driven inflation, ongoing slack in the labor market and technology). When we decompose market pricing for inflation expectations, we find that front-end breakeven inflation rates are already pricing a sharp rebound in inflation and longer-dated breakevens have reflated back to and in some cases above pre-recession levels. We thus do not expect inflation breakevens to rise much further and nominal yield increases should be driven by a repricing of real yields.
The combination of growth and policy is broadly supportive for equities, and as global growth gradually catches up to the U.S. over 2021, corporate earnings should rebound strongly. Traditionally an environment of strong global growth is positive for emerging market equities. However, given the rates backdrop and the current makeup of the emerging market equity complex (which has shifted over time), we believe EM equities will continue to struggle in 2021.
EM equity no longer the best global growth proxy
We see three main headwinds for EM equities. First, growth-style equities now dominate the index, with the combined share of the technology, communication services and consumer discretionary sectors at around 50%, up from less than 30% a decade ago (Exhibit 2). In contrast, over the same time frame the share of the once-dominant value/cyclical areas of energy, materials and industrials has fallen below 20%. This sector makeup is likely to prove a headwind to EM index performance over coming quarters if —as we expect—accelerating growth and rising real bond yields drive further rotation toward cyclicality and value-style equities, and away from growth.
Growth-style equities now dominate the EM index
Exhibit 2: Weight in em index
Second, the largest country by far within the EM universe is China, accounting for around 40% of the MSCI EM index. As China is well ahead of any other major economy in recovering from the COVID-19 recession, policymakers are increasingly pivoting from supporting growth to reining in excessive debt growth and property prices. That’s likely to prove a headwind for EM equities as a whole.
Third, should we see further U.S. dollar strength in the coming months, as bond yields rise and U.S. growth surges amid the prospect of massive fiscal stimulus and economic reopening, it could present a headwind for EM stocks. The direct impact of the currency may be diminished now that the asset class is so dominated by relatively stable Asian economies, but even so signs of further dollar strength are likely to deter EM equity demand, at the margin.
After weighing the pros and cons, we keep EM equity at neutral. We express our global equity overweight principally through cyclical and value geared regions like Europe and Japan and, in the U.S., small cap equity.
Asset allocation implications
Broadly our portfolios reflect a pro-risk view and remain overweight equities and credit with moderate underweights in duration. Our quantitative models this month increased their pro-risk tilt as the stock bond signal moved higher driven by improving strength in technical factors. While improved valuations boosted the duration signal, it still remains negative. Elsewhere, despite some recent underperformance, the model retained a preference for U.S. small cap over large cap while the conviction to hold EM over DM equities declined further and is now close to neutral.
With the U.S. economy re-opening and vaccination rollouts moving quickly, confidence in growth is building. However, some uncertainties remain in other regions—notably Europe, which we expect to pick up by mid-year. Improved conviction on growth has allowed equity volatility to fall at the index level, with the VIX now below 17. Optically this lower volatility environment would argue for larger position sizes. But it isn’t clear whether the volatility truly reflects continued style and sector rotations and volatility under the surface. Instead, we have higher conviction that this creates a more favorable environment for alpha creation within equity markets.
Growth is likely to be supportive of credit spreads as well as equity returns. However, with riskless rates so low and spreads already tight the capacity for further gains is constrained. This leads us to pare credit longs and focus further on a diversified equity exposure.
Overall, we expect a good earnings season and continued positive macro data surprises to support a risk-on tilt. But as summer approaches we are mindful that higher equity indices and higher yields could create an incentive for some investors to de-risk portfolios. It is probably too early to see this flow yet as the strong price action in stocks last week demonstrated. But once earnings season is through, the temptation to trim risk ahead of the summer lull could prove a headwind for stocks later in the second quarter.