April started on a positive note for financial markets, after an exceptional first quarter, with divergent fortunes for equities and global bonds. Going forward, the progression of the recovery will likely be the key market driver, leading to greater divergences. Last year, the ‘first in, first out’ theme benefitted China and the country is now clearly on a growth path again and will continue to be the global growth engine in the medium term. In coming quarters, the focus will be on avoiding bubble areas. The idea is to engineer stable loan growth, targeting specific sectors, such as innovative technology and manufacturing, to further support the economic recovery and avoid overheating.
While markets digest the next phase in China’s growth strategy, the recovery runner’s baton has been handed over to the US, where GDP growth looks set to rise to levels not seen since the 1980s.
However, the extraordinary expansion of the US will be an additional cause of divergences. Rising Treasury yields and a strengthening dollar will weigh on potential growth prospects for the most vulnerable EM, which risk being left (further) behind in the aftermath of the crisis. Some idiosyncratic stories are also resurfacing (Turkey, Argentina and, to a lesser extent, Russia, due to sanctions, and Brazil).
With China in ‘control’ mode and the US already well-advanced regarding market expectations, the next area that could enjoy extensions of bullish sentiment is Europe. From a macro standpoint, Europe will lag the two global growth engines and will take years to return to pre-crisis GDP levels. From a market perspective, European stocks should benefit from strong global growth. In addition, the reacceleration of the vaccination campaign and positive profit forecasts may now trigger further upside.
Concerning investment themes, our main convictions include the following:
- At the overall asset allocation level, stay risk-on. Do not increase risk further, but play some rotation in preference to riding the new recovery waves. Risk assets continue to be favoured in a cyclical recovery and due to still-accommodative central banks in DM. This bodes well for equities, with a focus on those that are most cyclical and regions (Europe) where the reopening of economies will drive further acceleration that is not yet priced in. US markets can still perform well, but here avoiding hyper growth areas is paramount, as well as not becoming trapped into riding any excess euphoria that is building up. The possible rise in corporate taxes could impact the profitability of some sectors and businesses and this situation should be carefully scrutinised.
- In bonds, relative value is king. Stay cautious on duration and overweight in credit. The biggest move in Q1 was the selloff in US bonds. In the coming weeks, the environment could become less challenging, as part of the yields repricing has already occurred. Nevertheless, an improving economic backdrop continues to call for a prudent duration stance and a positive stance on credit – in particular, regarding high yield, which continued to be favoured in an environment of improving fundamentals. Different growth and inflation expectation paths for the US and Europe are driving different speeds in adjustments in rates, opening relative value opportunities for active investors. In the search for higher yield, EM bonds continue to be an area of interest, with increasing selection as divergences are intensifying.
- In equities, continue to play the rotation towards value and cyclicals. This rotation towards equity will continue. The summer earnings season will further test the trajectory of the recovery, but until then, vaccines rollout and economic reopening will be the main triggers for a further upside leg in this bull run. With regard to EM equities, Asia remains the key area to play cyclicality.
All in all, the investment environment remains benign, but the consensual view of a recovery may itself prove to be a risk. Confidence is high, euphoria is limited to certain areas (cryptocurrencies, IPOs, SPAC) and this could last for a while, due to the ample liquidity in the system. There is no short-term catalyst for a change of direction. This could be a deterioration in the virus cycle, but this seems highly unlikely while vaccination campaigns accelerate globally. The second catalyst could be an inflation surprise, with central banks behind the curve. Investors should take this seriously, once the sentiment fades and most of the acceleration is behind us.