Macro Quarterly Losing momentum, staying strong

After pricing in an economic recovery from the pandemic, investors are facing more difficult questions.

14 Jul 2021

Evan Brown

Head of Macro Asset Allocation Strategy

Ryan Primmer

Head of Investment Solutions

Lucas Kawa

Asset Allocation Strategist

Highlights

  • Investors are navigating an environment in which economic momentum is slowing to one where the rate of growth stabilizes well above trend.
  • Historically, these inflection points can be a source of market volatility. The stage of the cycle and Treasury market regime also contribute to our tactically cautious stance on equity beta.
  • We maintain our conviction in procyclical relative value trades in ex-US developed market equities, which have relatively attractive earnings outlooks and valuations.
  • In our view, the Federal Reserve’s responsiveness to inflation risks should leave the US dollar in a more rangebound environment, but select emerging market currencies can still outperform.
  • We believe that some asset classes, like global sovereign bonds, trade at levels that imply too much pessimism about the likely strength of the global expansion, providing opportunities for investors.

After pricing in an economic recovery from the pandemic, investors are facing more difficult questions: What’s next? What kind of expansion will this be? And how will inflation and growth outcomes be similar or different to previous cycles?

From a market perspective, in answering these questions it is important to differentiate between the rate of change and momentum. We expect the former, the rate of growth, will remain strong, in part because monetary and fiscal policy will remain accommodative. However, we believe that momentum will slow, because monetary and fiscal policy will soon be less supportive of growth than they are right now. In addition, pent-up demand following economic reopening should normalize to a more sustainable level.

Markets are forward-looking and in the process of navigating this change from an accelerating to decelerating growth environment. Historically, these inflection points can cause market volatility as investors try to assess the extent of the loss of momentum and the future equilibrium for the growth rate of activity. Typically, asset prices over-react to the underlying negative changes in the fundamentals during this period.

Outside of equities at the headline level, and particularly US stocks, there are indications that prices reflect this reassessment of the growth backdrop across various asset classes, though to widely different degrees. In our view, these cross-asset signals need to be taken seriously, which leaves us tactically cautious on equity beta. However, we suspect it will soon be time to fade these growth fears and increase equity exposure once cross-asset warning signals wane. In the meantime, we maintain our core, relative value procyclical equity positions in anticipation that ex-US developed market stocks have already more than discounted the extent of the loss in growth momentum and will meaningfully outperform once this transition phase runs its course.

Exhibit 1: Economic data no longer surprising to the upside in China and US

Source: UBS-AM, Bloomberg, Citigroup. Data as of 9 July 2021.

Exhibit 1: Economic data no longer surprising to the upside in China and US. Charts the Citi US Economic Surprise Index and the Citi China Economic Surprise Index from July 2020 through July 9, 2021.

Exhibit 2: Change in confidence surveys suggests global momentum peaking

Source: UBS-AM, Macrobond. Data as of July 2021.

Exhibit 2: Change in confidence surveys suggests global momentum peaking. Charts the Sentix Expectations - Current Situation Index and the Global Composite PMI 3M Moving Average from January 2003 through May 2021.

Approaching the peak

The world’s two largest economies, China and the US, led the surprisingly strong global recovery from the virus-induced recession. But in these nations, economic data is now failing to beat analysts’ estimates – and in the case of China, falling far short of them. For this reason, as well as their more attractive coupons, Chinese bonds are our most preferred among sovereigns.

Pessimism turning into over-optimism is a common feature of the progression from recession to recovery. It is a sign that these economies have exited the early-cycle environment and expectations – and asset prices – need to be recalibrated.

These two economies are driving the loss of momentum at the global level. Confidence surveys show a significant narrowing of the gap between assessments of current conditions compared to economic expectations. On the one hand, this development is a testament to the strength of the global recovery. But historically this is also associated with a peak in global purchasing managers’ indexes and waning economic momentum thereafter.

Tactically cautious

Many asset prices – such as copper and the US dollar – have adjusted in a manner consistent with a looming shift from accelerating to decelerating activity.

Global equities, and in particular US equities, are among the outliers in this regard. The stage of the cycle and Treasury market regime are suggesting that investors should be cautious on equities at the index level.

Exhibit 3: The worst Treasury market backdrop for equities

Nominals, reals, and breakevens all down over past three months

Source: UBS-AM, Bloomberg. Data from 1998 through July 2021.

Exhibit 3: The worst Treasury market backdrop for equities—Nominals, reals, and breakevens all down over past three months. Charts the weekly change between the MSCI US Index, MSCI EM Index, MSCI EAFE Index, DXY, and Bloomberg Commodity Index over the previous 3 months.

Exhibit 4: Year two of a bull market is often choppy

Major S&P 500 bottoms have been followed by a one-year resurgence and subsequent consolidation

Source: UBS Asset Management, Macrobond, All Star Charts. Data as of 9 July 2021.

Exhibit 4: Year two of a bull market is often choppy—Major S&P 500 bottoms have been followed by a one-year resurgence and subsequent consolidation. This is a series of four charts that track the S&P 500 Index during four bear markets and the 2 years afterwards. The charts cover the bear markets of 1974, 1982, 2003 and 2009.

The second year following a major market bottom and start of a bull market – which we believe this is – tends to include a period of consolidation in US equities. Investors, having weathered a negative shock, reach a point at which enthusiasm about the rally gives way to a reappraisal of the likely trajectory of earnings growth required to justify those equity valuations.

Moreover, the three-month rates of change for US 10-year Treasury yields, breakevens, and nominals have all recently turned negative. Of all the different permutations of these variables, this particular mix has historically been the worst regime for performance in equities and the highest for volatility (see Exhibit 3).

Soon time to fade the growth fears

Estimates for 2022 GDP growth in the US and Eurozone have remained firm even as US Treasury yields retraced a significant portion of their year-to-date advance. These forecasts, if realized, would mark the strongest annual growth for either region in the 21st century (excluding 2021).

The amount of fiscal stimulus to date is larger than it was in the aftermath of the 2007-2009 financial crisis, and the ensuing retrenchment will likely be neither as sudden nor severe. Household balance sheets are in a healthier position, and buoyed by excess savings. The outlook for capital spending is also robust given the magnitude of the growth in corporate profits.

In our view, sovereign bond yields stand out as an asset class that may have overshot to the downside in light of the vigor this economic recovery is likely to retain. However, we have to consider the implications for our broad multi-asset positioning if the warning being sent by bonds is indeed accurate, and have reduced risk at the margin accordingly.

Part of the rally in longer-term yields is attributable to the Federal Reserve’s heightened sensitivity to price pressures. This has seemingly reduced right-tail outcomes for both inflation and growth in the eyes of market participants, and we believe only the former is justified. Given our positive macro outlook, we are examining opportunities to go more underweight global duration. Looking to the cross-asset backdrop for broad signs of stability across asset classes – the dollar no longer going up, and copper and bond yields no longer going down – will guide us as to when it may be appropriate to add equity risk more aggressively at the headline level.

Exhibit 5: Growth looks to stay strong in 2022

10-year Treasury yield tracked against 2022 consensus GDP growth estimates

Source: UBS-AM, Bloomberg. Data as of 9 July 2021.

Exhibit 5: Growth to stay strong in 2022—10-year Treasury yield tracked against 2022 consensus GDP growth estimates. Charts the 10-year Treasury yield, 2022 consensus US GDP growth estimate and the 2022 consensus Eurozone GDP growth estimate from July 2020 through July 7, 2021.

Asset allocation

Investors are adjusting to a new phase of the expansion. We can’t say with certainty how long this transition period will last. While it is ongoing, different assets will over or under-react to the change of global economic momentum.

Global equities at the headline level have yet to register a meaningfully negative reaction to this inflection point. Therefore, we do not believe it is a prudent time to increase equity risk until other cyclically sensitive assets, such as copper and developed market sovereign bond yields, show more concrete signs of stabilization.

However, we retain our core relative value positions in procyclical equities such as Europe and Japan. Unlike global equities at the headline level, these positions have lagged recently. In our view, any future underperformance would be modest even in the event that investors remain preoccupied with peak growth and peak stimulus. Ultimately, we have confidence that global growth will stabilize above trend in the coming quarters, and that these are the regions that will

outperform as we emerge from this transition period and investors’ focus shifts to the robust run rate for economic activity. We believe that their recent underperformance is not a function of a deterioration in their underlying earnings outlooks relative to US equities. This fortifies our preference for these regions on a going forward basis.

We are actively looking for opportunities in other asset classes, like global sovereign bonds, where we believe that yields now embed too much pessimism about the shape and strength of the expansion.

In our view, the US dollar should be more rangebound, especially against G10 currencies, due to the Fed’s responsiveness to inflation risks. Since Asia is leading the loss of economic momentum, we stay short cyclical Asian currencies, as well as select G10 commodity exporters. Some emerging market currencies, such as the Russian ruble and Brazilian real, are well-supported by monetary tightening and retain the capacity to perform even in a trendless USD environment.

Asset class attractiveness (ACA)

The chart below 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 12 July 2021.

Source: UBS Asset Management Investment Solutions Macro Asset Allocation Strategy team as at 12 July 2021. Views, provided on the basis of a 3-12 month investment horizon, are not necessarily reflective of actual portfolio positioning and are subject to change.

The asset class attractiveness chart (ACA) 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 12 July 2021.

Asset Class

Asset Class

Overall signal

Overall signal

UBS Asset Management’s viewpoint

UBS Asset Management’s viewpoint

Asset Class

Global Equities

Overall signal

Light green

UBS Asset Management’s viewpoint

  • Our outlook for stocks over the next 12 months remains positive. The economic recovery is likely to continue this year on the back of additional global fiscal stimulus, still accommodative financial conditions, and progress on the broad administration of effective COVID-19 vaccines.
  • However, in the near term we expect a choppier environment for equities at the headline level, as is common during the second year of a new bull market. The equity risk premium is near the floor of the previous cycle, which may cap upside as policy risks start to become more two-sided and growth momentum peaks.
  • Given the magnitude of the equity rally in recent months, we see more upside in relative value opportunities that offer attractively priced exposure to what will still be a very robust global growth backdrop compared to beta exposures.

Asset Class

US Equities

Overall signal

Neutral

UBS Asset Management’s viewpoint

  • US equities continue to command premium valuations. The sectoral composition drives this dynamic, with a higher weighting towards acyclical defensive technology than other markets. This characteristic may not prove a boon in the event that investors aim to boost cyclical exposure. Accordingly, we prefer US equal weight to market cap indexes.
  • Continued strong earnings, robust balance sheets, and unprecedented support from the Federal Reserve should continue to support US equities, but fiscal/tax policy risks are becoming more two-sided.

Asset Class

Ex-US Developed market Equities

Overall signal

Light green

UBS Asset Management’s viewpoint

  • Non-US developed market equities are attractively valued and have significant exposure to the global economic recovery.
  • Earnings growth in Europe and Japan is poised to outstrip that of US, and this superior outlook is not well reflected by the recent relative performance of these regions.
  • Both earnings and valuations have more room to run in ex-US developed market equities.
  • Europe and Japan lagged on vaccine administration but are catching up, which should improve investor sentiment.

Asset Class

Emerging Markets (EM) Equities(ex. China)

Overall signal

Neutral

UBS Asset Management’s viewpoint

  • Robust growth in China even as stimulus ebbs, one of our macroeconomic themes, is a positive for the asset class, particularly for countries with the tightest economic and financial linkages. Resilience in industrial metals, even during a rally in sovereign bonds, is another leading indicator that points to a solid foundation for real activity.
  • However, EM equities continue to face near-term challenges that include a negative turn in forward earnings growth relative to DM, and less access to the most efficacious vaccines.

Asset Class

China Equities

Overall signal

Neutral

UBS Asset Management’s viewpoint

  • We expect gains in Chinese equities so long as there is no abrupt withdrawal of accommodation, but prefer international equities where the recoveries are less mature.
  • Policy actions designed to limit the power of major internet companies may linger as a headwind for this important pocket of the equity market.
  • The well-telegraphed deceleration in China’s credit impulse warrants close watching, as it constitutes a key downside risks to commodity prices and procyclical positions across asset classes.
  • The recent RRR cut may be an indication that the peak in credit tightening has passed.
  • The new US administration will be more predictable in its relations with China, while continuing the process of economic decoupling in areas of strategic importance. 

Asset Class

Global Duration

Overall signal

Light red

UBS Asset Management’s viewpoint

  • Long-term bond yields have retraced aggressively ahead of the turn in global growth momentum and signs of incremental hawkishness from the Federal Reserve. However, inflation risks remain tilted to the upside and global economic activity is poised to remain robust well into 2022.
  • As such, we expect increases in real rates and market-based measures of inflation compensation to contribute to a renewed rise in yields.
  • Sovereign fixed income continues to play an important diversifying role in portfolio construction, and remains particularly effective in hedging downside in procyclical relative value equity positions.

Asset Class

US Bonds

Overall signal

Light red

UBS Asset Management’s viewpoint

  • US Treasuries remain the world’s preeminent safe haven and top source of risk-free yield. The Fed’s responsiveness to inflation risks has undermined the appeal of curve steepeners until such a time that price pressures recede and economic activity remains elevated.
  • The looming peak in global growth, concerns about a potential Fed policy mistake, strong foreign demand, and over-extended short positioning have contributed to a sharp decline in US Treasury yields and flattening of yield curves.
  • We expect this to reverse going forward, with a combination of strong growth and inflation driving Treasury yields higher across the curve.
  • The Federal Reserve will likely lay out formal plans to taper its asset purchasing program by year end, and the extent of the deceleration in price pressures during the fourth quarter will play a key role in determining whether the removal of stimulus is expedited or delayed.

Asset Class

Ex-US Developed-market Bonds

Overall signal

Light red

UBS Asset Management’s viewpoint

  • We continue to see developed-market sovereign yields outside the U.S. as unattractive. The Bank of Japan's domination of the Japanese government debt market and success in yield curve control diminishes the use of the asset class outside of relative value positions. The potential for European fiscal integration and solid commitment to supporting economies during the pandemic are factors that may compress periphery spreads, but perhaps at the expense of rising core borrowing costs, as well.

Asset Class

US Investment Grade (IG) Corporate Debt

Overall signal

Light red

UBS Asset Management’s viewpoint

  • Spreads have fully retraced thanks to policy support and an improving economic outlook, while all-in borrowing costs are well below pre-pandemic levels. US IG is one of the few sources of quality, positive yield available and therefore a likely recipient of ample global savings. However, the duration risk embedded in high-grade debt as the economy recovers as well as the potential for spread widening should threats to the expansions arise serve as material two-sided risks that weigh on total return expectations for this asset class. 

Asset Class

US High Yield Bonds

Overall signal

Light green

UBS Asset Management’s viewpoint

  • We expect carry, rather than spread compression, to drive total returns in HY going forward. The coupons available will continue to attract buyers in a low-yield environment.
  • The asset class is more attractively valued and has less sensitivity to rising interest rates than IG bonds. 

Asset Class

Emerging Markets Debt - US dollar / Local currency

Overall signal

Neutral / Light green

UBS Asset Management’s viewpoint

  • We have a positive view on emerging market dollar-denominated bonds due to the balance of carry opportunity and duration risk.
  • Asian credit is enticingly valued and poised to perform well in environments in which growth expectations improve or plateau, so long as highly adverse economic outcomes fail to materialize.
  • The more rangebound environment for the US dollar removes one previous tailwind for the outlook for total returns in EM local bonds. 

Asset Class

Chinese Bonds

Overall signal

Dark green

UBS Asset Management’s viewpoint

  • Chinese government bonds have the highest nominal yields among the 10 largest fixed income markets globally as well as defensive properties that are not shared by most of the emerging-market universe. We believe that cooling domestic economic growth and inclusions to global bond market indices should put downward pressure on yields during the next 3-12 months.

Asset Class

Currency

Overall signal

 

UBS Asset Management’s viewpoint

  • The Federal Reserve’s signal of concern about inflation risks, as seen by the increase in the 2023 median for the dot plot, puts a higher floor under the dollar and meaningfully reduces the prospect of a retest of its late-May lows in the near term.
  • EM FX like RUB and BRL, which are supported by continued monetary tightening, are well-positioned to outperform even in a rangebound USD environment, while cyclical Asian currencies and select G10 commodity exporters are poised to struggle.

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