Investors’ views on the outlook for growth have gone from acceleration to anticipation of the coming peak, while on inflation, expectations have moved from a pick-up – transitory or otherwise – to concern that central banks might appreciate an overshoot of their targets less than previously thought.
This is an extract from our mid-year outlook
The pandemic, of course, is not over – as evidenced by the race between governments’ vaccination pushes and the spread of often more infectious variants. A Covid variant that is resistant to current vaccines, and the re-imposition of lockdowns that could entail, is one of the key risks to our outlook.
FIXED INCOME – US
Two factors will determine the path of US Treasury yields:
- The persistence of recent inflationary pressures
- The timing of steps by the US Federal Reserve to taper its support for the US economy.
The outlook for the US labour market will be a key determinant of whether price increases persist. As generous fiscal and monetary policy support returns the economy to full employment in the first half of 2022, we expect the job market to go back to generating solid wage gains of around 3.5% a year, resulting in a period of persistent, cyclical inflation.
How will the Fed react? We believe that while an inflation overshoot may be an objective, there is no commitment to it. If the Fed is less tolerant of inflation overshoots, there are several implications:
- A more hawkish Fed weakens the rationale for pricing an inflation overshoot into longer bond maturities, or an inflation risk premium. So, 10-year breakeven rates should be closer to 2.3% than 2.6%, and longer-dated nominal Treasury yields should be lower.
- To head off upside inflation risks, policy would be normalised more quickly: asset purchases are wound up sooner; rate rises come earlier and less gradually. So, there is more upside to the front end of the yield curve.
- Markets will become increasingly sensitive to employment and inflation data as investors look for progress towards the conditions for tapering of the quantitative easing (QE) to begin.
The primary risk to this outlook is the rapid spread of the Delta variant. This could unsettle investors and support a bid for Treasuries.
We expect QE tapering to start in early 2022 and rates to be raised from March 2023.
FIXED INCOME – eurozone
With an improving labour market and strengthening sentiment, the recovery in eurozone demand will likely pick up in the coming months. Additional support should come from the extension of government fiscal responses and spending from the Next Generation EU (NGEU) fund.
Eurozone inflation will likely breach the ECB’s 2% target amid near-term supply shortages and bottlenecks, and positive impacts from the economic reopening. In the longer term, however, we expect spare economic capacity and a downward shift in inflation expectations to weigh on inflation.
Slower QE asset purchases by the ECB amid improving economic activity should cause yields to rise, but net negative bond issuance, thin trading liquidity and growing concerns about the spread of the Delta variant should ‘have a negative effect on yields.
Slower asset purchases by the ECB will likely reduce central bank demand for peripheral eurozone bonds. And concerns over the forthcoming elections in Germany and France, leading to risks to the pro-European agenda, will not be favourable to this segment.
EQUITIES – Style and size
We expect equities broadly to rise given the solid earnings outlook, but to see more variation in the returns between countries, sectors and styles depending on moves in interest rates.
For US value stocks, returns have been poor since mid-May as expectations for economic growth and inflation have plateaued. Factors supporting value outperformance from here include the delayed reopening of the economy: the expected earnings recovery will now play out over a longer period. Earnings expectations should thus rise for longer.
Valuations also favour value stocks. The largest sectors in growth indices have high valuations, not just tech but also healthcare and industrials, while they are less elevated for the main components of the value index.
Restrained inflation expectations could limit the outperformance of US small-cap stocks. A peak in growth typically limits small-cap outperformance, while strong returns of mega-cap tech stocks boost the larger-cap indices. European small caps may see more upside given that the cyclical momentum should be sustained for longer in Europe as the region’s economies reopen more slowly.
EQUITIES – Geographic allocations
US equities should modestly outperform European equities through the rest of the year. Aiding the US is a much stronger growth outlook thanks to greater willingness to remove lockdown restrictions, better progress on vaccinations, and the benefits of fiscal stimulus. US equities are admittedly expensive compared to those in Europe, but superior US earnings growth typically overcomes this barrier.
Europe has the Next Generation EU funds to look forward to. The recovery in European earnings has lagged that in the US, though much of this is due (as things often are) to the dominance of the US tech sector. Consequently, European equities have more room to catch up.
More cyclically oriented countries such as Japan and emerging markets (EM) should outperform. EM equities were historically more value oriented, but the growing weight of China in the EM index means the growth style has come to dominate. Recently, however, China has been a drag on overall EM performance as Beijing stepped up its scrutiny of the country’s tech companies and as corporate bond defaults rose.
We nonetheless expect China’s tech sector to recover given its strategic importance and excellent medium-term growth prospects. As vaccination rates rise, a fuller reopening should allow corporate earnings growth to accelerate broadly across emerging markets.