24 Nov 2020
6 min read
Head of Macro Asset Allocation Strategy
Head of Investment Solutions
Asset Allocation Strategist
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With the election behind us and a potential response to the pandemic in sight, we expect the nascent economic expansion to gain traction amid continued policy support and increased visibility towards the development of an effective and broadly available vaccine, which should also foster a decline from the extreme levels of market volatility that prevailed in 2020. While these developments will likely be positive for risk assets, the medium-term outlook for generating reliable, meaningful yield has never been more challenging.
The challenge for income generation
We believe that the overall macro environment is highly supportive of risk assets, and we have a bias towards procyclical relative value positions. The economic recovery is poised to continue and become more self-sustaining as medical innovations allow for the normalization of private-sector activity.
Real interest rates are negative across advanced economies, and are likely to stay that way through 2021 and beyond. We believe a less aggressive outlook for US fiscal stimulus limits the prospect of a sudden, significant rise in Treasury yields that would have spillovers across international markets. Investors will have to work harder to generate yield.
The appeal of opportunities in multi-asset hedge funds and alternative assets could increase in this low-yield-for-longer environment. Within the publicly traded universe, the progression of the global economic expansion coupled with the low level of yields on developed-market sovereign debt should likely push investors up the risk spectrum. In our view, this makes emerging market dollar-denominated debt, including Chinese government bonds, particularly compelling.
Optimistic vaccine scenario provides upside risk to divided government growth outlook
This chart tracks our projections for US gross domestic product growth for 2021 and 2022 compared to a baseline of the US GDP for 2019, under two scenarios: with a President Biden and a divided Congress and with an optimistic view of COVID-19 vaccine development.
US election impact
The results of the US election provide increased clarity on the economic outlook. President-elect Joe Biden is likely to take office with a Republican Senate. This combination should provide the US economy with adequate additional fiscal support, though not as much as would have been the case in the event of a united Democrat government. In addition, the likelihood of higher taxes has lessened considerably, removing one potential headwind to US earnings growth.
In our view, this election outcome will help foster sustained US dollar weakness, with the protectionism premium embedded in the world’s reserve currency ebbing in light of this change in leadership. We expect the Treasury curve to steepen over time as the expansion makes further headway.
But the potential for ongoing, substantial fiscal stimulus stateside has diminished materially, reducing the odds of a disorderly rise in bond yields that could foster dollar strength. Linked to this outlook for a softer US dollar, the across-the-board outperformance of emerging market assets is our highest conviction view, which is bolstered by the election results.
The virus and vaccines
COVID-19 remains a persistent risk that threatens to delay the timing and magnitude of the economic recovery, particularly in the near term. However, we foresee the impact of additional waves of the pandemic on activity to play out in the form of mini-cycles.
More adaptive public behavior, better health practices, and less draconian restrictions on activity may mitigate how much rising case counts weigh on the economic mobility. We think that the success of these measures in curtailing the spread of the virus will avoid the type of prolonged retreats in activity seen earlier this year and allow the normalization process to resume more expediently.
We expect regulators to potentially approve three vaccines for COVID-19 before year-end. Recently, we have seen encouraging phase three trial results from a prominent candidate that increases our conviction in this timeline and likely reduces left-tail scenarios in which a medical breakthrough remained elusive for an extended period.
By mid-2021, we expect a material share of the population across advanced economies to be inoculated. For most emerging markets, this process is likely to take longer. The development of therapeutics and advances in testing constitute upside risks that could allow for a swifter, broader normalization of activity. The myriad logistical issues that could delay the distribution and administration phases of vaccination serve as downside risks.
We prefer non-US developed market equities, which have more cyclical exposure.
Even as this process reaches its advanced stages, we would still expect high-contact portions of the services industry, including tourism, to operate well below pre-pandemic levels of capacity. This is why targeted fiscal support will still be needed to cushion the ongoing income stress faced by afflicted households and businesses during a drawn-out adjustment process.
We prefer US small caps to their large cap counterparts, which are more sensitive to the unfolding domestic recovery buoyed by progress towards a vaccine that facilitates a durable reopening. Third quarter earnings results showed that expectations run high for stay-at-home beneficiaries in the equity market, and we believe that the degree of improvement in operating performance in 2020 is unlikely to be matched next year.
Europe’s sounder foundation
Europe is in the midst of a seasonal wave of COVID-19 that has caused politicians to reimpose mobility restrictions across many nations. This disruption to the near-term growth outlook is well understood and largely priced in, in our view.
Going forward, we believe Ireland is a good leading indicator of the improvements in the virus outlook we expect across the continent. New case growth is declining, the lagged effect of government restrictions on activity that were enacted before other European countries. This pattern is indicative of the COVID-19 mini-cycle thesis outlined previously.
We prefer non-US developed market equities, which have more cyclical exposure. This view is in part informed by the sea change in European counter- cyclical policy relative to a decade ago. The common shock spurred higher cohesion between European Union member states, reducing the prospect of premature fiscal and monetary tightening that suppressed the recovery from the global financial crisis, and in turn, political tail risks.
While a step down from 2020, European budget deficits are slated to be larger in 2021 than at any time in the post-2009 recovery.
Attractive yield pick-up available in Chinese bonds, dollar-denominated EM debt
This chart tracks the JPMorgan Emerging Market Bond Index (EMBI) Global Spread and the China 10-year bond yield from 2016 through November 10, 2020.
The broad-based economic recovery is conducive to the outperformance of emerging markets. So too is the relative status of China’s economic comeback, which is in a more advanced phase than any other nation. The resilience in the world’s engine of production and strong credit impulse may continue to bolster global activity, as long as growth in total social financing, imports, and inventories does not moderate too briskly. In our view, this positive influence is a boon for the global market outlook in general, and for emerging markets as well as other procyclical assets in particular.
Beyond the aforementioned attractiveness of dollar-denominated debt in light of current spreads, we also favor emerging market currencies, which have outsized catch-up potential relative to other procyclical trades.
Traditional asset classes, and currencies
The Asset class attractiveness chart shows the views of our Asset Allocation team on overall asset class attractiveness, as well as the relative attractiveness within equities, fixed income and currencies, as of 6 November 2020.
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