What can investors expect of the remaining eight months of this turbulent year? LGT argues for a cautiously optimistic stance and expects equities to prevail, central banks to allow inflation to stay above trend, and European and Japanese equities to prevail over their US counterparts. Find out why.
By Stefan Hofer, Chief Investment Strategist, LGT Private Banking Asia
Global equities extended their stellar run of last year into the start of 2021, with stock indices in the U.S., Europe and Japan breaking new record levels. Some market participants have therefore turned more cautious, especially given the prospects of higher inflation (partly because of Covid-19 related stimulus) and rising interest rates.
The bearish camp argues that the prevailing low-interest-rate environment has been a boon for global equities, and therefore a reversal could be detrimental to portfolio returns. This may be particularly for the technology sector, which enjoyed a secular bull run over the last decade.
Market Liquidity is Abundant
We take a more optimistic stance, whereby our basic investment outlook is for virtually all central banks to stay accommodative for at least this year. Indeed, the global economy is still recovering from the COVID-19 pandemic, with very high levels of unemployment in many economies prompting further fiscal support measures alongside loose monetary policy.
We acknowledge that some investors are skeptical vis-à-vis market optimists, as there appears to be a significant «disconnect» between rising equity values and the real economy that is mired in the effects of lockdowns and social distancing.
However, as market liquidity remains abundant, and may not reverse any time soon, investors are to some degree «forced» to actively search for investment vehicles that can deliver superior returns over cash (which yields almost no return).
Equities Over Fixed Income
The traditional asset allocation decision rests on determining the balance between equities and fixed income. We have advocated for equities over fixed income over the past several years, and even with a global pandemic, are hard-pressed to change this view.
While bond yields have risen from a very low level, their absolute levels remain depressed in a historical context. As we assume that the low-interest-rate environment will linger, the upside for fixed income instruments is thus extremely limited.
Having said that, fixed income should remain as an integral part of the overall asset allocation, which continues to provide diversification benefits and lower volatility than stocks. However, solely from the perspective of expected future returns, we argue that equities should prevail, also in 2021.
Higher Inflation May be Tolerated by Central Banks
Fiscal conservatives argue that with further government support in the pipeline and the global economy already on a recovery path, consumer prices may eventually skyrocket. Such a scenario may prompt sudden policy tightening from central banks, potentially causing risky assets to correct significantly.
However, we take comfort that central banks, especially the Federal Reserve in the U.S., will allow inflation to stay above trend for a period, so long as unemployment continues to fall from current very elevated levels.
That is not to say that this strategy is without risk from a policy perspective – but given the very high social costs of joblessness around the world, central bankers appear more tolerant of inflation to achieve full employment again.
Market Leadership Matters
Inevitably, interest rates will rise at some point. However, financial markets are likely to take this in their stride, so long as policy normalizes for the «right» reasons. From a pure valuations point of view, higher interest rates translate into higher discount rates for future cash flows, which results in lower equity valuations, ceteris paribus.
It can be argued that the recent move in bond yields reflects better economic prospects, in our view. Corporate earnings should therefore improve down the road, which may hopefully «offset» the impact of higher interest rates.
In addition, while select sectors and regions may lag the broad market because of higher bond yields (e.g. tech sector, U.S. equities), there are other parts of the market that can benefit from higher interest rates.
For example, cyclical sectors such as financials and commodity sectors (e.g. materials, energy) tend to fare better with rising interest rates. In terms of regions, European equities and Japanese equities may also perform well given their cyclical characteristics. In sum, the prospect of rising interest rates, to us, matters more in terms of market leadership, as opposed to overall market direction.
Our Investment Strategy for 2021
For this year, the containment of the COVID-19 pandemic remains key to the global economic outlook. Judging from the progress of vaccinations, the rollout is promising in key economies, especially in the U.K. and the U.S., while continental Europe is due to catch up.
Our baseline view is for a critical mass of the global population to be vaccinated by the end of the second quarter, which should make lockdowns and social distancing measures redundant, allowing the global economy to normalize as soon as in the second half of the year.
Consumer and business spending should pick up as well. Therefore, we maintain a «risk-on» stance to financial markets and advocate a more cyclical and higher beta positioning for this year, preferring European and Japanese equities over their U.S. counterparts.
