As we turn the page on an “interesting” 2020, 2021 has started off with a bang. Risk assets have taken off in the early weeks as Democrats, via Kamala Harris’ tie-breaker voting power, take control of the Senate in a clean sweep of the Georgia run-offs.
Equities rallied on expectations for further fiscal stimulus, with the S&P/ASX 200 and U.S. S&P 500, at the time of writing, up over 1.5% each to start the year. Emerging markets have had an even better time of it so far. Initial public offerings, cryptocurrencies and select equities have seen some stellar gains which indicate some level of froth building in the market.
Cyclical commodities have started the year with a bounce as well, with oil up 10% to U.S. $55 per barrel based on Brent crude prices, as OPEC+ cut further thanks to Saudi Arabia. Copper was marginally higher, whilst iron ore prices have surged to U.S. $170.
Yields have risen strongly in the U.S. thanks to fiscal stimulus expectations, with the U.S. 10-year yield surging past 1% and is currently sitting close to 1.1%. 10-year yields for most other countries have followed slightly higher but largely remain well-supported by the view that central banks will continue to remain very accommodative, with many major bond markets such as Japan and Germany budging just 0.02% higher. The Australian 10-year yield was one of the bigger movers, with yields up over 0.1%, sitting in-line with U.S. yields at close to 1.1%.
The Australian Dollar is roughly flat since the start of the year at 77 cents to the U.S. Dollar, though it has touched the 78 cent mark several times in the past few weeks.
The past month has brought several key geopolitical risks to an end, with the Brexit deal being agreed upon, U.S. Congress approving a $900 billion stimulus bill and the Democrats sweeping up the Georgia run-offs to achieve a 50:50 split in the U.S. Senate, with Democrats holding the slimmest of margins as Vice President Kamala Harris would have the swing vote in any tie.
Economic data domestically has been very encouraging, as activity indicators have been strong across both manufacturing and services, whilst job advertisements have been surging. Retail sales, though with a lag of a couple of months, have also shown strong consumer demand.
In U.S. and Europe, the view is not as rosy. The surge in new cases has pushed various areas into renewed lockdowns, hurting services and consumer spending, with European service activity indicators back in contraction. U.S. also saw employment fall in December for the first time since the steep drop in April.
Over in China, growth remains strong but momentum seems to have peaked as credit growth and activity indices have shown signs of moderating in the latest readings.
Moving forward, the pandemic remains a key variable for economies, with global vaccination efforts underway. Especially for countries that do not have spread under control, the speed with which they can distribute vaccines will be key to the recovery, with longer closures likely to result in more permanent job losses.
With the ‘Blue Wave’ also coming to fruition, U.S. stimulus will also be key to both economic and inflationary outlooks. Biden has already tabled a $1.9 trillion proposal in addition to the $900 billion recently approved, whilst expectations are also for another huge stimulus bill for infrastructure initiatives.
In the near term, markets also have earnings season to look forward to. Whilst earnings in the U.S. and Europe may be hurt by renewed lockdowns, investors are probably hoping for more companies to begin issuing guidance again, as a sign that the uncertainty around the pandemic is lifting. Domestically, the earnings season is likely to be stronger, especially for those with more domestic exposures, whilst global earners could see some pain flow over from the renewed lockdowns overseas.
As we have learnt several times this year, a lot can change within days or weeks, however, as Howard Marks puts it, “we may never know where we’re going, but we’d better have a good idea where we are”. Therefore, based on the information that we currently have on hand, we have detailed our views on the investment markets and how we are positioning ourselves in the current environment, though it is almost a given that these views can and are likely to change as new information comes to light.
Vaccine news has been better than expected and most developed countries are now expected to return to normal by the end of 2021. A more sustainable move towards normalisation, coupled with strong support on both fiscal and monetary sides can be viewed as pillars for a very supportive environment for assets globally and across the risk spectrum. More fiscal stimulus is expected from U.S. and Europe, whilst monetary policy is likely to remain extremely accommodative for the next few years.
With the strong run-up since November, we see a risk that market sentiment is overstretched which may result in a near-term correction. This sort of volatility is part of a ‘healthy’ investment market and we remain optimistic that the supportive environment outlined above will mitigate the risk of a prolonged downturn unless one or more of the pillars fall over.
Despite the supportive backdrop, we do see high valuations across the board relative to historical levels, therefore, long term returns across the spectrum are likely to be lower moving forward. These expectations have been coming down as fixed-income yields continue to fall whilst equity multiples rise.
Source: AMP Capital
With such low prospective returns over the medium term, we remain slightly underweight equities and overweight cash. Although we think that on a relative valuation basis, equities are not expensive compared to the traditional fixed income universe of government and corporate bonds, we do find alternative fixed income as a more attractive segment on a risk-adjusted return basis.
Central banks have been very vocal in their intention to keep interest rates and yields low for the next few years as they try to support the economic recovery and break the trend of structurally low inflation.
As a result, bond yields likely to remain within a range as central banks will step in with bond purchases through their quantitative easing programs if yields start to rise, though yield curve steepening may occur to some extent. With nominal yields already around 0% and real yields (nominal yields minus inflation expectations) already negative in most countries, we expect bond returns to remain depressed in the medium term and see this environment as unattractive for traditional fixed income. Approximately 70% of the global fixed income market yields less than 1%.
Investment grade credit has recovered strongly, with credit spreads back in-line with pre-COVID levels which are some of the tightest spreads in history. As government yields are lower, this means that many areas of investment grade now provide little real return, with yields barely in-line with inflation expectations.
To earn income above inflation expectations in traditional fixed income markets, investors would have to look towards the high yield credit market, or so called junk bonds. The surge in liquidity supplied by central banks is helping to stem credit defaults, certain segments of the high yield market will likely continue to experience fallout effects from the pandemic well into 2021 and beyond. We still see some opportunities here, but we would stress the need to be selective and have positions in our models through good active managers.
Whilst we find traditional fixed income generally unattractive, we do see attractive returns in many of the alternative fixed income segments as these sectors have largely been left out of central bank asset purchasing programs. Areas such as direct lending, senior loans, commercial real estate debt and relative value strategies provide opportunities to earn attractive risk-adjusted returns. However, like high yield, we believe that investors need to rely on good managers that conduct comprehensive due diligence and have a strong risk management framework in place.
Putting all of the above together, our fixed income models are currently underweight traditional bonds and overweight alternative fixed income opportunities, and we remain neutral overall in our allocation to this asset class, primarily due to the relative attractiveness of alternative fixed income opportunities.
We are optimistic on the recovery of the Australian economy next year and see strong potential for the economy to outperform other developed countries in returning to pre-COVID levels, as Europe and the U.S. who have experienced much larger economic drawdowns and had far more difficulty with the pandemic. Indeed, Australian business confidence and consumer sentiment have shown a sharp rebound in recent months which lends weight to this view.
China remains a major driver for domestic growth despite the strained relationship as per recent headlines. Australia remains a key supplier for China, with recent trade restrictions focussed around products where substitutes from other countries are more readily available whilst key exports like high grade iron ore are not so easily replaced.
We see potential for Australian Equities, with its higher proportion of financials and resources, to outperform US equities in the near term as rotation to more cyclically exposed sectors continue as these companies have earnings that are more leveraged to the recovering global economy.
In particular, we are positive on the resources sector as expectations remain low and valuations are still cheap relative to other areas of the market.
Source: Macquarie Research, Factset, December 2020
However, while we have added to exposure here in the last couple of months, we remain slightly underweight Australian equity relative to our strategic targets as overall valuations look expensive and we continue to believe that there are better opportunities available in the much larger global equity market over the medium term, particularly in non-US markets.
Overall, the global recovery in economies and earnings, in conjunction with the fiscal and monetary support from policy makers globally, drive a positive outlook for equities. We expect a rotation in leadership to cyclical sectors over the next year and are adding to these exposures. However, we do not see major issues for so-called ‘growth’ companies despite some comparing the current market to the 2000 internet bubble.
Unlike 2000, low-interest rates are likely to remain for the medium term and many of these companies have strong balance sheets and large free cash flows. This is a very different situation to the 2000s, though we do admit that valuations are not cheap and there are pockets of irrational exuberance. Therefore, we remain invested but continue to advocate for a selective approach based on careful fundamental analysis.
Looking at the different markets included in our International Equities investment universe, U.S. equity valuations stand out as expensive across all sectors.
Even when adjusting for higher bond yields in emerging markets, the U.S. continues to stand out as an expensive market relative to history.
As a result, we remain overweight non-U.S. markets, primarily in Asia and other Emerging Markets.
Emerging markets are not just attractive from a valuation standpoint, these markets are also more sensitive to a global economic recovery, with a larger portion of cyclical exposures relative to the U.S. market. Earnings growth are also expected to be higher in the longer run on higher excess capacity and productivity gains.
Our overall allocation to international equities remains largely neutral relative to our strategic targets, but within the international equity allocation, we are underweight U.S. equities, offset by an overweight to Emerging Markets.
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This month’s perspective highlights that market sentiment on all asset classes is constantly changing. It is important for us to quickly recognise any threats, to preserve your investment capital or to identify early investment opportunities to maximise any return advantages. At Partners Wealth Group we don’t get complacent with the current state of play and constantly monitor investments and your portfolios.
If this article has raised questions regarding your personal situation, please contact your Partners Wealth Group advisor directly or on 1800 333 143.