The fast view
- We believe the dynamics of the unfolding recovery, together with ongoing monetary and fiscal policy support, are far more important considerations than the US election.
- As the recovery gains traction, we can continue to expect bonds to sell off as longer-term yields rise.
- We are at a point in the cycle that should continue to favour equities over other growth assets.
- A softer dollar should help to drive emerging market currencies and assets. This is predicated on a continued decline in real US interest rates as the Federal Reserve keeps rates locked down and inflation rebounds.
Looking through the election, as we did in 2016, again seems to have been the right decision. In any event, the result was a constructive one for markets. The “blue wave” failed to materialise. The erratic Mr Trump was not re-elected and is likely to have been replaced by a centrist Democrat who, provided the Republicans retain one seat in the Senate in the Georgia run-off, will be obliged to pursue a bipartisan tack at least until the mid-term elections and possibly beyond, holding in check the left wing members of his party. The level of the turnout and the narrowness of the result indicate that the latter were the real losers of the election. History suggests that markets tend to like gridlock in the US.
But the influence of political results is often exaggerated and inversely correlated with the amount of media attention. We believe the dynamics of the unfolding recovery, together with continuing monetary and fiscal policy support, are far more important considerations than the election. After all, it is fundamentals, not politics, that drive markets. On this front, despite the spike in cases across both Europe and the United States, and the media attention it has generated, economies continue to recover. Somewhat ironically, China – the source of the pandemic in the first place – has enjoyed the strongest recovery. Asia more broadly has followed a similar path. Indeed, the level of the Chinese credit impulse as a percentage of GDP is similar to that which drove global recoveries in 2012 and 2016. The improving cyclical environment has been reflected in positive forward corporate earnings revisions.
Figure 1: China’s credit impulse (as a percentage of GDP)
Source: Bloomberg Economics China Credit Impulse, as at 30 September 2020.
Another reason for “looking through the election” was the risk of an upside surprise in the form of a vaccine. As if on cue, pharmaceutical giant Pfizer’s recent announcement of a COVID-19 vaccine is potentially a game changer. At 90%, its efficacy rate in trials is unusually high by vaccine standards. This and similar vaccines in the pipeline, should greatly increase investor confidence in the possibility of a return to a much more normal economic environment over the course of 2021 and a sustained recovery. True, it will be a while before vaccines are generally available, so we could be in for a bumpy ride in the northern hemisphere winter in terms of COVID-19 cases and hospitalisations, but markets are likely to continue to look through shorter-term negatives.
Steeper yield curves
As the recovery gains traction, we can continue to expect bonds to sell off as longer-term yields rise. Sure, central banks will continue to run low or zero interest rate policies, which will pin down the short ends of yield curves, but yield curves are not particularly steep currently and have scope to rise further. Government bond valuations remain extremely poor and are likely to deteriorate further as inflation rises sharply over the course of the next 12 months. The impact of base effects is already becoming evident despite the deflationary effects of the pandemic.
In this context, the US Federal Reserve’s shift last year towards a more symmetrical policy in respect of its inflation target, implies that the central bank actively wants inflation to overshoot its 2% target. Although there is scope for credit spreads to narrow further in investment-grade and high-yield debt, rising long-term interest rates could easily offset the benefit of higher carry.
Rotation, rotation, rotation
In our view, the recent steepening of yield curves serves to confirm an important inflection point in equity markets, which have been characterised by an extraordinary divergence between large cap growth and cyclical value stocks. Sure, equity markets have recovered from the trough in late March but the rally has been very narrow as investors treated the FAANG stocks – Facebook, Amazon, Apple, Netflix and Alphabet (Google) – as a safe haven, given their continued discomfort with COVID-19-related uncertainties. The prospect of a more broad-based recovery signalled by steepening yield curves has marked the beginning of a rotation away from the stocks that had formerly led the market recovery into the cyclical laggards. Market breadth – lacking hitherto – is now set to broaden as confidence in the recovery builds. Beaten-up financials and industrials look set to benefit, as should markets outside the United States, which have performed poorly.
We continue to strategically favour Chinese and Asian equities, where valuations remain attractive and secular growth prospects strong. Small and mid-cap stocks should also benefit.
Investors seeking a “safe haven”
A softer dollar...
A softer dollar should help to drive emerging market currencies and assets. This is predicated on a continued decline in real US interest rates as the Federal Reserve keeps rates locked down and inflation rebounds. We continue to favour the renminbi and Asian currencies more generally where more orthodox monetary policies are set to prevail, but pressure should also ease on the emerging market “carry” currencies as liquidity headwinds abate.
...and a harder renminbi
The shortage of diversifying defensive assets remains a challenge. Gold is a hold – as confidence in a continuing recovery builds and support for safe-haven assets declines. Conversely, higher US inflation and a weaker dollar remain supportive factors. However, the renminbi remains our preferred defensive asset as monetary policy settings in China continue to diverge from those being pursued by Western central banks. Although classified by the investment industry as an emerging currency, China is a strong creditor nation pursuing policies that are consistent with a hard currency.
In conclusion
We are at a point in the cycle that should continue to favour equities over other growth assets. Within equities, our allocations have been progressively pivoting to more cyclical markets and sectors for some time in the expectation of new leadership emerging. Recent price action seems to be confirming this and our conviction continues to rise. We will continue to run historically low exposure to bonds on both cyclical and strategic grounds.
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