Monthly macro update – October 2021
Snapshot of views
While equities have been our highest conviction allocation this year, we view credit markets as a more useful indicator of economic health. As a result, we will be watching our credit conditions indicators closely to evaluate the impact of less supportive policy. Sovereign bond yields have risen ahead of policy withdrawal. In line with our upgrade of sovereign bonds last month, we view yields more fairly valued. So how might reduced policy support impact markets in the future? Typically, the withdrawal of stimulus coincides with below average equity market performance, however, it doesn’t inevitably follow that equity returns are negative. Our base case is that equity returns will be positive over the coming months, although more muted than we have seen recently. With minimal compensation from credit, we still expect equity returns to outperform both high quality bonds and other return seeking assets.
What can we learn from credit conditions?
We have discussed our equity views at length throughout the year, given our high conviction allocation. However, this does not mean credit has played an inferior role in our research. In fact, during periods of equity weakness, credit spreads (the additional yield that investors receive over a risk-free bond) have an important influence on returns. The corporate profitability owned by shareholders through equities is inherently linked to the health of credit markets.
So, what have credit conditions shown us over the past month, during a period of weaker equity performance? While credit spreads have increased, they remain close to their long-term lows, supporting cheap capital expenditure for companies. In part, this is a by-product of explicit central bank support, but it is also evidence of the confidence investors have in the ability of companies to remain profitable and meet interest payments. Reduced central bank support may hurt credit markets in the future, and we are closely watching our credit conditions indicators for signs of this.
The tightness of spreads also has implications for buy and maintain credit mandates, and we remain underweight in our asset class views. In general, this supports delaying investment, in favor of allocating at higher spread levels in the future. However, this approach requires careful consideration of client-specific cash flow needs. By delaying, we will forego current yield. This delay could potentially outweigh the benefit of waiting for higher spreads in the future.
Source: R&M Proprietary Indicator, 10/14/21
Are sovereign bond yields set to rise further?
Sovereign bond yields have soared in the past month as inflation expectations rose and we edge closer to the withdrawal of policy support. But with yields now close to pre-pandemic levels, where do we expect them to go next? As central banks purchase fewer sovereign bonds, in theory there will be less demand and cause bond yields to rise (all else being equal). However, this view omits that sovereign borrowing will also fall as governments reign in fiscal support, reducing supply. We expect this reduction in supply to at least match the fall in demand. The pace of the rise in yields has been akin to Q1 2021, where yields rose too much, and a period of consolidation followed. Although still low by long-term standards, current yields present an opportunity for clients who are looking to reduce an underhedged position. We upgraded our sovereign bond asset class view last month to neutral, reflecting our view that sovereigns appear more fairly valued and portfolios no longer need to reflect a specific underweight.
Source: Bloomberg 10/14/21
What could be the impact of central banks withdrawing stimulus?
The Federal Reserve has indicated that they plan to reduce bond purchases in the coming months, so how could this impact asset returns? Historically, reducing policy support has coincided with below average equity market performance, and this would come as no surprise given extremely strong equity returns over the last 18 months. However, it doesn’t necessarily follow that equity returns will be negative. Our base case is that equity returns will be positive over the coming months, although more muted than we have seen recently.
Does this information prompt a change in asset allocation? More limited upside may warrant a slightly lower equity allocation, or increased downside protection, but with minimal compensation from credit, we still expect lower equity returns to outperform both defensive and other risk assets. As a result, our view is that equities continue to represent the best use of the available on risk budget.
Source: Bloomberg 10/14/21
Investment advisory services are provided by River and Mercantile LLC, an investment advisor registered with the US Securities and Exchange Commission. It is a subsidiary of River and Mercantile Group PLC, a U.K. corporation.
The information and opinions contained in this document do not constitute investment advice and is provided for background purposes only. References to specific securities are provided solely as illustrative examples of the River and Mercantile LLC analytical methods, and are not a recommendation to buy or sell such securities. This information is subject to updating and verification. Portions of this presentation are based on data provided by third parties whom River and Mercantile LLC deems to be reliable; however, River and Mercantile LLC cannot guarantee the accuracy and completeness of the information.
PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE RESULTS.
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