Halloween ‘ghosts’ of Fed tapering, the Evergrande crisis, and the earnings season did not scare the markets. The Fed telegraphed its message well: while keeping the option to adjust tapering depending on the state of the economy, it reiterated the “transitory” inflation narrative. The BoE proved more dovish than expected, actually keeping rates unchanged (‘benign neglect’) regarding inflation risk. As a result, nominal yields declined and real yields fell to near new record lows. Although CBs are sticking to their temporary wording, our view, in contrast, is that the latest CPI readings support the “sticky” narrative.
On equities, the earnings season has overall been strong. Another area for concern, the possible default of Evergrande in China, was averted once again and we expect policy intervention to kick in to avert a default again, if necessary. In the US, even as President Biden reappointed Powell as Fed Chair to ensure continuity in monetary policy, he confirmed Brainard as the Vice Chair. But some volatility will likely return amid Democrats’ efforts to pass the Social Infrastructure Bill through the Senate (due to be passed before 13 Dec.). The path looks uncertain, as does the final total amount of the package.
Lastly, we have entered a new Covid wave, with some risks from variants. Moving into the winter season in Europe and the US, cases will rise. However, we don’t expect this to derail the growth outlook, thanks to vaccination campaigns, but we await clarity on the Omicron variant. On the other hand, it is difficult to see any significant upside after the recent highs in equities: Santa Claus gifts have arrived already. Range-bound equity markets and volatile bonds, with reduced liquidity across the board, is the most likely scenario through year-end. Against this backdrop, we keep our neutral stance in equities and short duration view in core bonds, and a mildly positive view in credit and peripheral bonds. In terms of portfolio construction, targeting real returns will be the name of the game.
- Overall asset allocation will continue to favour equity, as no other choices are available moving to a late cycle. The equity stance will likely shift from neutral to a tactical overweight once the economy reaccelerates in Q2/Q3 2022. But the need for hedges will remain high as the risk of policy mistakes is on the rise. We also recognise that equity exposure has risen to a peak in the cycle, favouring DM and in particular the US, where valuations are now extreme. With the recovery broadening towards EM, where allocation has fallen below strategic targets and return potential is higher, we expect investors to start to reallocate towards these markets in the search for attractive valuations. Overall in equities, areas of bubbles persist. We don’t know which companies lack pricing power (swimming naked) because discrimination on this basis is yet to happen in markets. So, investors should favour quality/value, dividend names and stocks that indicate sustainable pricing power (not easy to measure).
- Credit with higher yields and short duration may be the best means to navigate high inflation, but selection will be key as default rates will start to bottom out as financial conditions get less supportive.
- Real assets will be favoured, as they can help in terms of inflation protection. There are many opportunities in this regard. On private debt, the floating rates available in this market and the liquidity premium may help with seeking income opportunities that are more resilient to possible increases in core yields in a market in which financing demand is on the rise. Infrastructure investing is also seeing strong momentum amid opportunities linked to the energy transition and this is also generally an asset class that provides inflation protection. Private equity is key to financing the recovery and to seeking higher potential returns. Real estate could also offer selective opportunities in the recovery phase.
- Some ESG risks are becoming real. The COP26 meeting highlighted the need for urgent action on emissions reduction. The China-US last minute deal could mark a further reacceleration of this trend, which could lead to a rising demand from investors and eventually translate into higher market prices in a positive feedback loop.
We believe investors face a meagre real returns outlook for the next three years. In our view, a 60 equity/ 40 aggregate bonds portfolio’s real annual return could be close to zero both in the US1 and Europe2 . The investment puzzle for the future is how to increase real return potential. This will require grasping opportunities where available across all asset classes, as the real value left in the market is not abundant, underscoring the need for investors to maintain a wide arsenal of instruments.
1. 60% S&P 500 and 40% US Aggregate Bond. Assumption of 3.2% inflation.
2. 60% MSCI EMU and 40% Euro Aggregate Bond. Assumption of 2.1% inflation.