Tactical asset allocation update: March 2021

Despite some recent volatility, our assessment of the macro backdrop this month is unchanged. We expect the global economy to remain in an expansionary regime, with growth above its long-term trend and continuing to improve. Growth is accelerating in the developed world across all major countries, including regions that recently experienced setbacks due to new stringent lockdown measures such as the eurozone and the UK. Consumer and business confidence surveys in these regions are showing improvements in expected demand, goods orders, and production trends, suggesting potential for pent-up demand and a rebound in the next few months. Similarly, Japan continues to follow the global recovery, with improving activity in the manufacturing and trade sectors. As mentioned last month, emerging Asia continues to slow on the margin, settling around its long-term trend after leading the recovery.

In the past couple of weeks, markets experienced a meaningful repricing in higher bond yields, which negatively affected most asset classes across equity and fixed income. This recent spike in rates represents a technically driven acceleration in an otherwise more benign, fundamental trend that started in the third quarter of 2020. In our opinion, a continuation of current trends would represent a premature pricing of the end of the current monetary policy regime and liquidity environment, something the U.S. Federal Reserve (Fed) and other central banks have explicitly ruled out in their communications thus far. While we continue to favour a short duration stance, we expect yields to stabilize and potentially decline in the short term. Last month we discussed how these technical corrections are to be expected and could represent valuable buying opportunities under the premise that the global cyclical backdrop remains favourable, as we believe to be the case. As previously outlined, we expect credit spreads to remain low and stable in the expansion regime, possibly preventing short-term technical corrections in equity markets from turning into more enduring, fundamental bear markets.

The negative impact on risky assets has been most evident in emerging markets across equity, fixed income, and currencies, bringing back fears and memories of the broad-based emerging markets sell-off of 2013-2015, triggered by then-Fed Chairman Ben Bernanke’s “taper tantrum” and fueled by the commodity bear market that saw brent oil prices decline from $100 to $35 a barrel.¹ We believe analogies with that period are misplaced. At the time, emerging markets suffered from large current account deficits, expensive valuations, and a commodity-induced “terms of trade” shock. Their vulnerability was also exacerbated by extended investor positioning given large capital inflows seeking higher yields in the preceding four years (2009-2013). Today, external funding positions are broadly balanced, commodity prices are on a cyclical rebound, and valuations are attractive across equity, fixed income, and currencies as emerging markets have been largely out of favour for the past decade.

Our global risk appetite framework suggests market sentiment is still improving despite the recent spike in volatility and sell-off in global bond yields. We believe the most attractive opportunities to take advantage of this potential overshoot in yields are in cyclical risky assets such as emerging markets, value, and small-mid cap equities.

Investment positioning

This expansionary regime is supportive for equity and credit premia, cyclical factors, and risk assets more broadly. We expect equities to benefit from improving earnings and falling volatility, and to offer the best total return potential as spreads on lower-quality, risky credit have now compressed below historical averages. This is consistent with historical cycles.

• Within equities, we favour emerging markets and developed markets outside the U.S., driven by improving risk appetite, attractive valuations, and a supportive global cycle. Despite its recent strength, we continue to foresee a weakening U.S. dollar trend, historically supportive for emerging markets via capital inflows and easing of financial conditions. We remain tilted in favour of (small) size, value, and momentum factors.
  
  
• In fixed income, we favour risky credit despite the compression in spreads. While the total return potential on credit assets has clearly diminished given lower yields, volatility tends to decline in this stage of the business cycle, with credit offering attractive income generation and risk-adjusted returns. We are overweight U.S. high yield, bank loans, and emerging markets debt, local, and hard currency, at the expense of investment grade credit and government bonds. We favour U.S. Treasuries over other developed government bond markets. Overall, we are overweight credit risk² and underweight duration versus the benchmark, expecting yields to rise and the curve to steepen in a more orderly fashion compared to the sharp increase of the past few weeks.
  
  
• In currency markets, we maintain an overweight exposure to foreign currencies, positioning for long-term U.S. dollar depreciation, also supported by positive growth surprises outside the U.S. Within developed markets we favour the euro, the yen, the Canadian dollar, the Singapore dollar, and the Norwegian kroner, while we underweight the British pound, the Swiss franc, and the Australian dollar. In emerging markets, we favour the Indian rupee, the Indonesian rupiah, the Russian ruble, the Turkish lira, and the Brazilian real. We expect the emerging markets foreign exchange carry trade to play “catch-up” sometime in 2021, having lagged in performance compared to most recovery trades in 2020.