January 19, 2021
On 20 January, Joe Biden succeeds Donald Trump as the US President. In an unexpected turn of events, the Democrats managed to flip both Georgia Senate seats in runoff races earlier this month, meaning that Biden rides in on a Blue wave. The Democratic majority in all three branches of government, narrow though it may be, gives Biden a clearer, but not unimpeded, pathway when it comes to pushing through his agenda.
The President-elect has said that a rescue package to further foster an economic recovery in the US is his top legislative priority and he is approaching it with gusto. He recently unveiled a whopping USD 1.9tn economic rescue plan, which includes new direct payments to American households and aid for state and local governments. If passed through Congress, the package should serve as a bridge, keeping the economy ticking over until mass immunisation brings the virus under control. The promise of more large-scale stimulus, the roll-out of vaccinations, and ongoing support from central banks means we have kept a preference for risk assets i.e. equities over bonds. Regionally speaking, we continue to favour the US where the macro picture is sturdy and where risk surrounding the elections has subsided. We also favour China – the only major economy across the globe that avoided contraction in 2020. Its economy continues to rebound nicely due to internal demand, as well as rising demand for exports as the global recovery strengthens. Government support (detailed in the new five-year plan) is and will continue bolstering the domestic economy.
The US may have a new leader, but capital markets have their own ruler – interest rates, which are coming out of a years-long slumber. As has been demonstrated over the past weeks, interest rates touch almost every asset class. Fixed income investors betting that new stimulus measures will hasten the recovery and add more debt, ultimately resulting in higher yields, sent US Treasury 10-year yields past 1.1%. Rising bond yields have a domino effect in markets, making borrowing costs more expensive and pushing up the discount rate used to measure the value of equities versus bonds. As the economic recovery and inflation expectations pick up, rates will be paramount and must be carefully monitored. The risk is if they start galloping rather than rising in an orderly fashion, which could cause a shakeout, especially across risky assets. For now, we believe the ascent is under control, though we are beginning to prime our portfolios for an eventual departure from an ultra-low-rate environment in the US.
Our equity exposure mirrors our macro views; we give preference to the US and China, while remaining underweight on Europe, where corona-containment measures continue to hinder the outlook. Style-wise, for the coming months, we recommend a balanced allocation between growth and value. As the year progresses, the case for value stocks may become more pronounced (the catalysts being higher rates and steeper curves).
Our sector selection is progressively moving towards those that will benefit from the reopening of the economy and from fiscal stimulus– note that Biden intends to announce a broader economic recovery plan in February, including infrastructure spending and energy transition initiatives. We brought consumer discretionary (a sector enjoying strong revisions) up to overweight. Household saving rates are very high (double their pre-Covid level at 14%), paving the way for a boom in consumer spending once barriers related to coronavirus are removed (government-imposed and psychological). At the same time, we brought our IT exposure down to neutral. While the long-term structural theme of digitalisation holds, in the short-term, valuations in this sector are stretched and the market may take some respite, especially as economies start to reopen, making the stay-at-home theme less pertinent.
We are overweight industrials and materials, bringing a degree of cyclicality to our portfolios. Industrials offer a play on rising PMIs and potentially rising inflation and the sector should be a key beneficiary of large-scale fiscal stimulus. Materials is another sector enjoying strong earnings revisions. The jewel in the crown is the metals & mining sub-category which has the best revisions in the sector as commodity prices – especially for iron ore – have translated into earnings growth that outperforms stock returns.
While remaining underweight on European financials, we increased our exposure to US financials, bringing our position to neutral. Fundamentally, the sector is cheap and levered to rebounding growth. If we see rising rates, US banks will face a more benign operating environment, while European banks continue to grapple with negative deposit rates as set by the ECB.
As we wrote previously, we wish to strike a fine balance between value and growth stocks, because of course, we are not yet out of the woods in bringing the pandemic under control; setbacks may still arise and the Republicans may try to dilute Biden’s proposed fiscal package. The “growth” slant in our portfolio comes from an overweight on the healthcare and utilities sectors. The former has been given impetus from the pandemic, offers lower rate exposure, and is poised to have the best earnings growth for Q4 2020 (based on analyst estimates). The latter should benefit from increased focus on renewables and clean energy globally.
Our fixed income exposure was not changed. Naturally, as we expect rates to grind upwards, we are reluctant on government bonds and duration. Where Treasuries are held in a portfolio – mainly for diversification – it is preferable to hold inflation linkers. In the bond space, we give preference to investment grade corporates in developed and emerging regions. In the current low-yield environment, emerging market corporates are a sweet spot for those investors willing to step out of their comfort zone. The segment still has potential for spread compression while offering a shorter duration (i.e. they are less vulnerable as rates pick up) than EM sovereigns or US corporates.
Commodities and FX
We revised our stance on oil upwards to neutral. Prices are supported by fiscal stimuli and commitments from OPEC+ member countries to curb output. We expect demand to rise as economies reopen and the economic recovery ensues. We keep a layer of gold for diversification purposes, but its future prospects could be dented by a potentially quicker recovery and a (potential) sustained rise in real rates back to positive territory.
In the currency space, the yuan’s appreciation trend against the greenback continues and China’s trade and capital flow trends point to continued strength. The top performers next year should be the currencies of countries that have healthy current accounts, for example, Canada. On the contrary, the deteriorating current account deficit in the US continues to weigh on the dollar, underpinning our negative outlook on the currency.
This month, our asset allocation has been an exercise in preparing for a gradual uptick in rates as the economic recovery ensues (winged by new fiscal stimulus in the US and omnipresent central banks). This means we are positive on risk assets and reluctant on fixed income, especially duration. However, with markets priced for perfection, we are also cognisant that there may be setbacks along the way. To tackle this, we curate a balanced allocation between growth and value styles and a nuanced sector allocation which includes those companies that will benefit as economic growth picks up, as well as more defensive names. As always, diversification is key.
Author: Group Investment Office