Recently, financial markets have had to digest some mixed signals from the US economy (August jobs report and retail sales, latest CPI). The Fed announced a potential tapering, but the overall approach will be gradual and the ‘not enough growth’ narrative will remain dominant. We see two mounting risks in the background. The first relates to China: the summer spread of the delta variant, the renewed regulatory wave, and the Evergrande saga. The deceleration in the Chinese cycle will trigger fiscal and monetary accommodation, as was witnessed in the PBoC’s latest move to avoid a liquidity crunch. Second is inflation in energy and food. The topic of rising energy prices is becoming hot in Europe, where gas prices have soared to record-high levels. Similarly, food prices are soaring and the issue is particularly critical for EM. The two topics are important with regard to addressing the evolution of inflation narratives and with respect to long-term commitments of governments to addressing climate challenge. Against this backdrop, we need to reassess some key convictions and see if they might be valid moving into Q4.
- Is it time to switch the risk allocation and become more defensive? Given rising inflation risk and weakening economic momentum, stagflationary risk is on the rise. Yet, accommodative CBs and lack of alternatives to equities mean once again that it is difficult to see the market capitulating any time soon. Nevertheless, given the impressive performance YTD and the risks that inflation will further make the headlines, we recommend staying neutral in terms of risk allocation, with some hedges in place. We remain constructive on credit. With tight spreads, investors should look for places that could perform well with rising rates ahead and reopening of economies or with lower duration risk (subordinated, HY).
- Is an equity value call still valid? The value vs growth preference has been a key call since the start of the reflation trade initiated by vaccine rollouts. Fears of delta variant outbreaks had somewhat led to a pause in this trend over the summer. Yet, we believe there is room for this trend to develop further in both the US and in Europe, where the growth vs value valuation gap is still wide on an historical basis. The more we advance with the value call, the more some specific themes start to emerge. In the US, the value space is comprised of interesting business cases related to innovation around renewable energy that could see a further boost from the economic policies under discussion by the Biden administration. In Europe, financials and industrials offer interesting quality stocks. Here, it will be key to assess the impact of rising energy prices on margins on a case-by-case basis.
- With looming tapering in the US and possible sticky inflation, what should investors do with their bond allocation? Fixed income (FI) might seem to be a dead asset class, but it’s not: it is being restructured in a way. It remains a key core component of investor portfolios, both for diversification purposes vs equity and for income needs. The short duration stance remains the key call. Investors should move away from a static benchmark approach (high duration risk) and embrace a more flexible allocation in the search for income. Pockets of value are available across the board in securitised markets in the US, peripheral in Europe, and selective EM bonds. Approaching the tapering period, investors should ensure that their core FI allocation is resilient to a more challenging environment.
- Are EM broken or do they still present opportunities for investors? So far in 2021, EM equity has significantly underperformed DM. A great chunk of this underperformance relates to China. The other reason has been the diverging path taken by economic activity amid slower vaccination campaigns in EM. While headwinds remain, with China investor sentiment still very weak in the short term, some political issues in LatAm and Turkey, and the Covid situation in Asia not yet normalised, the outlook is improving. Recently, economic momentum has started to improve in EM, with the economic surprise in EM outpacing that in DM starting from June. Allocation to EM could increase from a generally underweight position, but the move might accelerate only in the latter part of the year, when China regulatory issues could soften and the Covid situation in EM could become clearer. On EM bonds, the outlook is already more constructive, especially in HC credit and HY. With low yields across the board and a very gradual Fed approach to tapering, this space is attractive for investors’ search for income.
Moving into Q4, we see three main themes that investors should monitor: the evolution of the stagflationary narrative; developments on the green front following the COP26 meeting; and the regulatory wave in China. Overall, with the strong risk assets performance YTD and looming risks, it seems better to remain cautious: don’t chase the bulls but seek opportunities to rotate allocation towards less tight areas.
CB= Central Banks HC = Hard Currency, FI= Fixed Income, EM = Emerging Markets, DM = Developed Markets, YTD= Year to Date, HY= High Yield,