Macro update: March 2021
Welcome to our monthly macro update. Here we provide an overview of our current market views, and our recommendations for strategic portfolio positioning.
Are rising bond yields a threat to equities?
Low bond yields have been key to our conviction in equities this year due to cheap borrowing costs affording a greater number of corporate projects, so does the increase in bond yields throughout February pose a threat? This depends on the factors driving yields higher, which we will explore in more detail. Yields can move higher as a function of run-away inflation fears or that central banks will have to raise rates soon (i.e. the ‘wrong’ reasons). However, they can also move higher due to improving growth expectations and investor preference for risk assets over government bonds (i.e. the ‘right’ reasons). While inflation is seeing some near-term pressure, our view remains a longer-term rise in inflation is unsustainable without lower levels of unemployment. Recent US employment data was weaker than expected, and the US unemployment rate remains almost twice as high as pre-Covid-19 levels. This we believe will restrict inflation in the medium term and require central bank policymakers to keep interest rates low for some time yet.
We are comfortable that rates are rising for the ‘right’ reasons, highlighted by the stability of credit assets which act as a truer barometer of risk. Rising yields in themselves aren’t prohibitive of rising equities until they start to weigh on economic activity from higher borrowing costs. And with further economic stimulus over $1.9Tn set to be announced in the US, equities look set to benefit in the near term.
US Treasury 10 year & US High Yield Credit
Source: Bloomberg, 2 March 2021
Snapshot of views
Bond yields rose throughout February, but do higher yields pose a threat to equities? We don’t think so, for now, as yields are rising for the ‘right’ reasons. Improving growth expectations are causing yields to rise while credit assets, the truer barometer of risk, are proving resilient. The economic environment is still positive for equities, and we continue to believe inflationary pressure may be short- lived while there are higher levels of unemployment. With equity valuations still lofty, market corrections are in the limelight. However, we remain confident that improving economic conditions in the second half of 2021 will flow through to increased company earnings and ultimately to shareholders.
Our preference for sectors and companies tied to the market cycle remains, albeit we can increase defensive exposure as and when volatility materialises. February also saw record flows into equity funds, most notably into the US. While this is a vote of confidence for US equities, it can lead to crowded corners of the market. This stresses the importance of a dynamic equity allocation to allocate to regions with attractive risk and return trade- offs, in this case global companies outside the US.
Does volatility suggest investor apprehension?
We previously cautioned the Covid-19 recovery would be turbulent and result in market volatility, and in that respect, markets have behaved exactly as expected. Bouts of volatility have materialised in both January and February 2021 leading to temporary market corrections, but it is important to note that equity market volatility is the norm, not the exception. Since 1960, the average yearly S&P 500 high-to-low decline has been c.14%, yet over 75% of those years have resulted in positive equity returns. But with increasing talk of assets being overvalued, are we at risk of a more sustained decline? Last month’s Macro Update discussed how equities would benefit from earnings growth, and we are already seeing evidence of this. Earnings growth has outpaced P/E growth year to date (the ratio of a company’s price to a company’s earnings), a reversal of 2020.
We expect this trend to continue if economies re-open, providing equity markets with a stronger footing. Earnings growth will likely support those companies that suffered the most in 2020 and benefit cyclical sectors (those sectors more exposed to the economic cycle). While our underlying thesis that cyclical companies will outperform still holds, we may increase allocations to defensive companies and, when prudent, reduce equity exposure.
Source: Bloomberg, 2 March 2021
Are record equity inflows a cause for concern?
A record $58bn flowed into equity funds in the second week of February 2021 as vaccine rollouts and further stimulus improved investor sentiment. Technology focussed funds were the primary beneficiaries, with the US the most favoured region. While this reflects the consensus view that equities will be the core drivers of returns this year, we should be wary of overexuberance. This is exactly why we believe asset allocation within equities is crucial. We will continue to be tactical around the equity allocation to access regions, sectors and styles that provide the best risk and reward tradeoffs, for example, our current preference for non-US equities which have more cyclical sector exposure as shown in the asset class views.
Net February Fund inflows per region
Source: Bloomberg, 2 March 2021
Source: River and Mercantile
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