Market Scenarios and Risks - May 2021

Monthly update

We note progress on the vaccine front despite logistics and side effects issues. In our central scenario, equities outperform on the back of abundant liquidity, improving fundamentals and accommodative monetary policy. Vaccine resistant virus variants, hawkish policy surprises and geopolitical tensions are the main sources of risks. Beyond 18 months, we expect (US) growth to revert to potential amid an higher inflation regime while stagflationary pressures will rise across Europe.
The balance of risks evolves over time. While it is premature to significantly de-risk portfolios while macro and micro fundamentals are still improving and accelerating, we believe there are narrower margins for a policy mistake or adverse events.

Monthly update

Risks are clustered to ease the detection of hedging strategies, but they are obviously linked. We have left the narrative and the risk of the central scenario unchanged this month.

1. A tactical pause in global economic momentum

• We are observing a tactical pause in the very strong rerating of global economic momentum that began in April last year.
• EPS revisions and economic surprises seem to have peaked from very elevated levels, signaling that expectations may have already been priced in and a pause in the recent optimism build-up may be due.

Investment consequences:

• In cross asset, the current “risk-on” stance is confirmed, although cautiousness is required on valuations both in absolute and relative value terms
• The recent upward trend in the USD could affect the pro-risk stance if it spills over into credit and triggers EPS revisions

2. US inflation to normalise, differing trends within the EA, Brazilian inflation to watch

• In the most advanced economies, inflation is set to move close to the CB target by the end of 2021.
• US inflation is rising faster than Euro Area inflation. Germany should see the highest peak in headline inflation, while Spain and Italy should be the laggards.
• EM inflation is visible on the cost side, magnified by currency weaknesses
• Looking at the historical evolution of US inflation indices, we envisage a high probability of a normal (CPI between 2-3%) to inflationary regime (CPI 3-6%) up to 2023.

Investment consequences:

• Risky assets perform best when inflation is at a “normal” level.
• In an inflationary environment, while equities continue to make positive returns (single digit), credit spreads tend to widen as central banks resume a tightening policy. Unsurprisingly Linkers offer a hedge in such a regime.

3. The cyclical rotation will continue

• The first indications from the Q1 earnings season sound promising, with consensus expectations moving significantly upward over the last two weeks. For the S&P 500, IBES foresees +31% vs. +24% on April 1. Idem for the Stoxx 600 with +56% vs. +47% respectively.
• In both regions, sectors that were the first to be hit last year, such as financials and cyclical consumer, are now leading the rebound. Even if these preliminary numbers are poised to fluctuate, this pro-cyclical pattern looks here to stay.

Investment consequences:

• The pro-cyclical rotation continues, is mature, but has further to go. Value may also be supported by stronger EPS growth going forward as well as some momentum.
• We are keeping a pro-cyclical positioning also on regions with an overweighting in EM, EMU, Japan and Pacific excl. Japan, neutral on the US and the UK, and an underweighting of defensive markets such as Switzerland in Europe.

4. China’s growth recovery to continue at a strong pace; reflation without high-flation

• We expect economic recovery to re-accelerate in sequential terms after the Q1 slowdown, driven by the services sector.
• Growth will be less of a concern for policymakers, leading to cautious fiscal/credit policy tapering plus targeted tightening in the housing market.
• Inflation should not be an issue for the PBoC in 2021. We expect PPI inflation to peak in Q2 amid moderating fiscal and credit impetus. CPI inflation should strengthen at a gradual pace in 2021/22, with core inflation staying below 3%.

Investment consequences:

• The transitory spike in inflation, re-acceleration of sequential growth and increased bond supply should cause upward pressure on government bond yields in Q2. We prefer to buy into yield pick-ups, if any, as yields are likely to hold stable 12m from now.
• As the liquidity tide begins to ebb, we remain selectively constructive on China’s equity market, favouring dividend stocks over growth stocks. Small caps also have higher upsides in the near term, benefiting from a broadening economic recovery.
• Lingering SOE and LGFV default risks continue to weigh on the credit market and prolong risk aversion.

5. Japan’s two-track recovery to continue, well-positioned in the global capex upcycle

• The vast contrast between domestic and overseas machinery orders in early 2021 suggests external capex demand remains the main driver of Japan’s recovery.
• Japanese corporate profits tend to move in tandem with the global manufacturing cycle. In light of the global manufacturing recovery, Japan’s profit growth should continue to bounce back.

Investment consequences:

• Japan remains a cyclical play, which should be favoured in a global recovery, while the Yen should weaken along with the potential increase in appetite for carry trades.
• We are keeping a slightly positive bias only as the risk is that the global recovery, once Japan and Europe join the US and China, could also be coupled with less upward pressure on the USD.