Too much optimism?

Increasingly widespread vaccinations should support the economic recovery from COVID-19, and thus a risk-on stance in financial markets via equities (global small-caps) and Asian high yield credit. Even though vaccinations are likely to be rolled out more slowly in most emerging markets, we see attractive value in their equities. They are historically more cyclical in nature, and should hence benefit from a solid global growth recovery. Likewise, oil prices should rise and the US dollar should weaken. Further opportunities may be found outside listed equities in private markets, such as in dislocated credit markets.

In our upside scenario, a faster and broader global economic recovery would push emerging market equities and EURUSD significantly higher still. We would expect broad US dollar weakness amid continued easy monetary and fiscal policy. The EUR and GBP should benefit. High grade bonds and the safe-havens gold and Japanese yen would likely suffer.

The downside scenario would be negative for risk assets due to repeated economic growth setbacks. Commodities and the euro would also weaken. Assets or strategies that should perform better under such circumstances should include gold, dynamic asset allocation strategies, long duration Treasuries, and option structures.

CIO maintains a constructive view on risk assets such as equities and credit, while remaining cautious toward high grade bonds.

In the base case, stronger growth and moderately higher inflation in 2021 should benefit global equities. In the context of ultra-loose monetary policy, credit is likely to generate positive returns as well. In equities, we like cyclical sectors such as energy and materials; technology-enabled themes like fintech, greentech, and healthtech; and the more attractively valued market segments like small-cap stocks. In credit, we see the most value in Asia high yield.

In our downside scenario, a taper-tantrum event could trigger a correction in many traditional asset classes including equities, bonds, commodities, and gold. The US dollar would likely appreciate, with volatility-linked instruments benefiting as well. According to CIO's simulations, emerging market assets and the safest fixed income segments (government bonds and investment grade credit) would take the longest to recover. Developed market risk assets are likely to retrace most of the capital losses over a six-month horizon.

In our upside scenario, CIO's base case recommendations would likely outperform our central projections and offer even stronger returns to investors this year. High-quality bonds would underperform on a six- to 12-month horizon.

Base case: Improved policy predictability could boost investor sentiment. This should be positive for risk assets in general, including both global equities and credit. We think this environment should be particularly positive for emerging market and Chinese equities.

Downside case: Our downside scenario would significantly increase the risk of a bear market in 2021. High-quality bonds have offered some protection in the past, but they may be a less effective hedge today as interest rates are close to all-time lows. Safe-haven currencies such as the Swiss franc and the Japanese yen would likely appreciate alongside gold. US-China: Equity sectors exposed to the trade conflict (e.g. industrials and materials) would suffer more than defensive sectors such as consumer staples and healthcare. US-Iran: Global equities have fallen on average about 15% during previous oil price shocks, but recovered within six months. In credit, high yield and emerging market bonds have suffered the most, but recovered within three months. The worst-hit markets would likely be high-yielding crude importers. In the past, the US dollar initially appreciated as investors sought a safe haven, but then weakened on higher oil prices.

Upside case: Risk assets could gain from an easing in tensions, while yields on safe bonds could rise. Emerging market currencies would also benefit. Improved US-China relations would benefit regions and sectors impacted by tariffs in emerging markets as well as the Chinese yuan. Chinese stocks should further benefit if the threat of delisting Chinese companies from US exchanges were to recede. If improved US-Iran relations lead to lower oil prices, it would help sectors such as consumer discretionary and staples, due to lower input costs and higher disposable income. The high-yielding crude importers could also benefit.