The big shock, the big hope, the big illusions
2020 has been an unprecedented year in modern history, with the Covid-19 pandemic leading to the deepest global recession post World War II that has affected the most countries simultaneously since the 1870s (World Bank). This big shock is not going to reverse completely, and the old normal will not return as it used to be. Hopes for a fast vaccine distribution, a further fiscal push, and for decreasing geopolitical tensions are all driving the reflation narrative. As a result, despite the recession, most markets are closing the year with positive performances. Entering 2021, the reflation phase may continue, but investors will have to assess four factors to play the rotation, avoid bubbles, and build resilient portfolios.
Factor 1. Recent market rally is based on blind faith in the success of vaccines and on the brave assumption that everything will be as before. This is the first source of risk – not only because the production, and dissemination, of vaccines on a large scale is not a trivial endeavor, but also because markets are assuming that a large majority of the population will be vaccinated. The idea of normality being just around the corner is a chimera, and this will bring up all the issues associated with this scattered restart. For investors, distribution of a vaccine should further support recovery and the case for favouring equity vs HY credit. In this rotation, Value will benefit the most while investors should stay cautious in the most crowded growth areas, where a significant bubble could be under pressure in a reflation environment.
Factor 2. Fiscal and monetary policy are keeping the economic system going, but what has been put in place so far is insufficient – especially on the fiscal side – but also not always well directed or calibrated. Any withdrawal of measures is unthinkable; on the contrary, CBs will be called upon to do more, and the risk of a policy mistake is underestimated by the market. On the other hand, some inflation pressure will eventually materialise. At the beginning of 2021, 10Y Treasury yields are now above 1%, the highest level since last March. Should the recovery drive some higher inflation, yields could rise further, with some possible domino effects on markets. Again, we do not expect to see high inflation tomorrow, but buoyant housing markets, supply chain relocations, and a huge amount of savings waiting to fuel pent-up demand could rapidly change the zero inflation narrative forever. It’s likely that the Fed will intervene in case of any quick move in yields in a sort of curve-control mode. Investors should be watchful of inflation to avoid being trapped in the long-duration trade, which is increasingly risky. We recommend a balanced approach to duration and investors should consider exposure to US inflation which could be first to materialise in a weak dollar scenario.
Factor 3. The recovery path is being led by China. It is leading the way out of the crisis as the only big economy to fully recover in 2020. In 2021, China should continue on this trajectory of faster growth compared to the RoW, lifting EM Asia and with a positive feedback loop, especially with Europe, given the strong trade links with China and Asia. Investors should consider entering 2021 with an allocation to EM, and Chinese and Asian equities. In fact, despite the strong performance seen in 2020, there is room for further growth, in our view, especially in areas more linked to internal demand.
Factor 4. The key risk today in the market is the consensus itself. The skyrocketing negative-yielding debt will push the search for yield to the extreme. The temptation to go down in quality is high as well as to make all the same low-interest-rate forever bets. But, this is dangerous, if we consider the scarce market liquidity in the system. For investors, credit selection is paramount, but it is key to look across the board to search for yield. Including investments in private markets, for investors with the appropriate time horizon, will provide a wider and diversified spectrum of opportunities. In addition, investors should balance the appetite for yield in HY and EM bonds (including LC) and credit with exposure to government bonds as liquidity providers and diversifiers in asset allocation.
Investors will enter 2021 with a positive backdrop for equities. Lower expected returns in bonds amid low interest rates and tight credit spreads mean that investors will have to embrace higher risk (higher equity) to reach their return targets. Volatility could also return in ‘stop-and-go’ phases related to vaccine distribution. This reminds us of the importance of adding further sources of diversification with uncorrelated investment strategies and keeping some hedges in place. The outlook is positive, but the road to recovery will likely be bumpy. Fasten your seat belt and watch out for a 2021 full of opportunities.