2021: Light at the end of the tunnel

The year 2020 has been a difficult one with defensive assets outperforming cyclicals. We expect the opposite in 2021. Despite short term Covid-related risks, recent vaccine news provides valuable light at the end of the tunnel. Unfortunately, some cyclical assets have already priced-in a lot of economic recovery. So, should we focus on economic momentum or on valuations? We do a bit of both within our Model Asset Allocation and reduce credit exposures in favour more cyclical assets, especially real estate, equities and industrial commodities. Cash remains our diversifier of choice. On a regional basis we favour emerging markets (EM) and Europe (including the UK).

Defensive assets have outperformed so far during 2020, with gold being the star performer. Recent years with a similar pattern have been immediately followed by a reversal, with cyclical assets coming to the fore. Though this recession has been like no other, we suspect that pattern will be repeated in 2021.

We could stop there and simply favour cyclical assets within our Model Asset Allocation, which is certainly the preference of colleagues at Invesco’s Global Market Strategy Office (GMS). However, our analysis is clouded by concern about near-term Covid-related economic deceleration, the hope a game-changing early rollout of effective vaccines and the fact that risk assets have already rebounded sharply.

We draw upon a base case economic scenario constructed in partnership with the broader Invesco community (including Chief Economist John Greenwood). This allows for deceleration during the coming winter months but not global recession. We also consider upside (“V” for vaccine) and downside (double-dip) scenarios.

Recent good news on vaccine trials has shifted our subjective probabilities in favour of the upside scenario. This further underlines our bias towards assets such as equities, real estate, high yield credit (HY) and industrial commodities, which we expect to outperform in the early stages of an economic recovery. However, it also shifts our preferences away from regions and assets that have performed well during the pandemic (China and technology stocks, say) towards those that have performed less well (Europe, non-Asia EM, real estate and travel & leisure stocks, say).

Effectively, the greater the economic momentum, the better we expect “value” assets to perform. However, finding value is difficult, especially given the rally in risk assets since spring lows. Luckily, asset allocation is more about relative value (though there is always cash when all other assets are expensive). On a relative basis, given multi-century lows in policy rates and bond yields, we find more value (and hope) in risk assets, especially real estate. This further encourages our preference for cyclical assets.

A further layer of support comes from policy makers. We think fiscal policies will remain supportive over the coming quarters, which could lessen economic risks. On the monetary front, we do not foresee any change in policy rates at major central banks and expect asset purchase programmes to remain active. However, tapering of those purchases could happen during 2021, which may bring temporary market volatility.

Despite the stability of central bank rates, we expect long bond yields to rise. In our base case scenario this would be a modest change (US 10-year yield rising to 1.35%) but would be more aggressive in our upside alternative. We believe that cyclical assets would focus more on economic growth than on rising government bond yields and therefore anticipate upside in those categories. Our base case projections were based on 30 October 2020 prices and have been overtaken by subsequent events (vaccines). However, we believe the analysis is directionally valid given the shift in our subjective probabilities towards the upside scenario.

Optimisations based on those base case projections suggest maximum allocations to real estate, commodities and cash; zero allocations to investment grade credit (IG), HY credit and gold but are less clear on government bonds and equities.

Real estate is our favourite asset category based on valuations (yields) and the potential for an operational rebound (especially in the “V” for vaccine scenario). We boost the allocation to the maximum allowed 16%. Likewise, we take commodities back to the maximum 4% (from zero), with a focus on industrial commodities and agriculture. The optimisation results are not so clear for equities, given the recent rebound. However, led by cyclical considerations (and our GMS colleagues) we move to a slightly Overweight 50% versus a Neutral 45%, with a focus on non-US markets. To balance all those risk assets, we maintain a maximum 10% exposure to Cash, our diversifier of choice.

IG has been our all-weather choice during 2020 but we now feel less need for its stability, especially given that spreads have normalised and that yields are at historical lows. We reduce it from the maximum 20% to zero. We also reduce the allocation to HY but leave it at a Neutral 5% out of respect for its cyclical qualities. We leave government bonds at an unchanged 15%, well below the Neutral 25%. We think gold is expensive, even before treasury yields rise, and leave it at a zero allocation.

From a regional perspective, bearing in mind the recently increased likelihood of an early vaccine rollout, our emphasis is upon EM and Europe (including the UK). Europe faces several short-term hurdles (Brexit and lockdowns) but we think it has most to gain in our upside scenario. China is introduced to our Model Asset Allocation.

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