Market Summary by Brooks Macdonald - Q1 2021
While both the UK-EU trade deal on goods and the US fiscal stimulus bill were resolved at the end of 2020, the start of the new year has seen volatility in both equity and bond markets. Investors are trying to assess what COVID-19 vaccine rollouts and near-term additional US fiscal stimulus hopes mean for economic growth, inflation expectations and therefore monetary policy. Inflation is a topic that has been largely shrugged off over the last decade but has now become important as economists analyse whether the substantial fiscal and monetary support during the pandemic will merely act as a counter to deflationary risk or whether it heralds a new era of inflation. We have seen many false dawns around inflation since the 2008 global financial crisis so we retain some scepticism, but the fact the debate is happening at all is shifting expectations.
Following the surprise Democrat win in the two run-off Senate seat elections in Georgia in early January, control of Congress means an additional US fiscal stimulus in Q1 is likely to be larger than previously expected. This has created a concern in the sovereign bond market that the US Federal Reserve (Fed) may therefore be less accommodative as the US government would take over some of the heavy lifting. The US 10-year treasury has moved above 1% for the first time since the pandemic, and this has prompted a coordinated effort by US Fed Governors and the Fed Chair to push back against fears of an earlier-than-expected quantitative easing taper or interest rate hike. On balance, we expect the Fed, alongside other central banks globally, to wait until the economic recovery is well-established and inflationary pressures sustained until discussing any amendments to monetary policy. Equally the pandemic has created significant economic spare capacity (such as in the jobs market), which we expect will keep wage inflation pressures contained. The more optimistic economic outlook for 2021 has brought balance to the inflation debate however and this has changed inflation expectations, especially in the US.
Since the start of 2021 we have seen cyclical equities in vogue, out of fashion then back in vogue again. The fate of cyclical equities is inexorably linked to the vaccine rollout. The latest rise in cyclical equities has complemented, rather than come at the expense of, high growth areas such as technology which continue to hit all-time highs.
The second order effect of a return to more economic normality can be inflation. Our expectation is that medium term inflation will remain controlled post the pandemic, as it did pre the pandemic. The main determinant of this is how consumer demand recovers in light of elevated unemployment figures despite the support measures in place across the globe. Economic output gaps (where current output is below potential output) such as this can dampen any inflationary pressures in the short to medium term as they suppress wage price inflation pressures.
Balance is the watchword for 2021. While we retain our expectations that the post-pandemic world will remain one of low growth, contained inflation and low interest rates favouring growth stocks, we see room for periods of strong cyclical performance as markets price in a rosier backdrop. Given cyclical assets trade at a discount to more growth focused peers, this outperformance could be sharp. Asia ex-Japan equities trade at a valuation discount to the MSCI World as well as European equities. This is despite the high economic growth rates in the region and the good starting position in relation to COVID-19 case numbers and restrictions which have been far looser during H2 of 2020. This is giving the Asia ex-Japan region something of an economic head-start, as seen in the latest Chinese economic data. As we start the new year, we continue to highlight our barbell approach to asset allocation. In equities, this is expressed as a balance between the overweights to technology, healthcare and our positive US outlook on one side, versus our positive Asia ex-Japan outlook and our UK exposures at the cyclical end.
Important information
The performance indicated for each sector should not be taken as an expectation of the future performance. Investors should be aware that the price of investments and the income from them can go down as well as up and that neither is guaranteed. Past performance is not a reliable indicator of future results. Investors may not get back the amount invested. Changes in rates of exchange may have an adverse effect on the value, price or income of an investment. Investors should be aware of the additional risks associated with funds investing in emerging or developing markets.
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