This is an extract of our Asset allocation monthly - Dots matter
Reading between the dots
The latest ‘dot plot’ published after the June meeting of the US Federal Open Market Committee (FOMC), showing the participants’ assessment of the appropriate future level for the federal funds rate, had 13 out of 18 FOMC members foreseeing a rate rise by the end of 2023. The median value indicated an increase by 50 basis points (bp).
This was more than most market participants had expected: they had called for stable rates or only one rate rise by 2023. What was particularly interesting was that the 2023 rate dot moved, but the forecast for core inflation in 2023 did not.
The message from the Fed seems clear: the central bank is more sensitive to, and more willing to lean against, the risk of too much inflation than investors are.
That revelation posed a challenge to the reflation trade.
In a sense, however, the market had anticipated the Fed would eventually conclude that policy rate increases were necessary, just perhaps not quite yet. Expectations for the level of fed funds in two years’ time had shown two 25bp increases since early March when the US Senate passed President Joe Biden’s USD 1.9 trillion stimulus package.
Despite the Fed’s subsequent insistence that rate rises were more distant, the market’s expectations did not wane.
A relatively subdued reaction
The market reaction to the FOMC news was significant, but some of the initial moves have unwound. At the front end, the current level of the fed funds rate in two years is only 9bp above where it was in early April and is consistent with two rate rises. Further out, five-year real yields jumped and five-year break-evens fell, but both have more or less retraced those moves.
However, not everything is back the way it was. Very long yields are down, and have continued to move lower, with the 30-year nominal yield below 2% at the time of writing, having been above 2.40% in mid-May.
US bond yields should rise
With the rally in yields that followed the Fed meeting, we saw an opportunity to implement a short position in US Treasury yields. We expect rising yields to be the primary driver of any nominal yield move and therefore we have also implemented a short in US real rates.
Inflation expectations are not far from the post-Global Financial Crisis average, while real yields remain near historical lows despite the looming taper of the Fed’s quantitative easing (QE) programme and the message in the dots that the FOMC will respond to evidence of rising inflationary pressure.
Equity reflation trades
Even as rates rise, we anticipate ongoing gains for equities through the rest of the year, albeit at a slower pace than in the first half. It is worth keeping in mind that continued robust earnings growth, combined with more modest price gains, will inevitably reverse some of the expansion of the price/earnings (P/E) ratio that has occurred this year.
How strong are the foundations of the reflation trades such as value versus growth given the new interest rate outlook?
We are more confident that cyclical sectors, regions and countries (such as emerging markets and Japan) will continue to outperform given that the key driver is the global economic recovery as opposed to the level of interest rates.
The relative performance of cyclicals has nonetheless been lacklustre over the last few months, though this is at least partly due to a lagging car sector, hindered by semiconductor shortages, while the traditionally more defensive healthcare sector has outperformed thanks to restored access to non-Covid related procedures.
Value stocks have underperformed growth stocks recently by more than one would expect given that Treasury yields have in fact risen slightly. Since 11 June, the Russell 1000 value index has dropped by 1.7% while growth gained 4.2%. Value has been held back primarily by financials as the market anticipates higher funding costs for banks, but a more hawkish Fed and a rollover in leading indicators have also weighed on performance.
The gain for growth shares, however, was very concentrated in technology in a way much more reminiscent of the performance of US equities before the pandemic when mega-cap tech accounted for the bulk of the broad index returns. While tech makes up about 50% of the growth index, it contributed more than two-thirds of the recent returns.
We do not expect a return to the pre-pandemic equity return pattern quite yet. As longer maturity yields rise, value stocks should resume their outperformance. Valuations are still heavily in value’s favour; the z-score of the relative forward multiple of value versus growth is -1.1, which is not much higher than the peak discount level of -1.4 from last August.
The earnings outlook remains supportive. Forward earnings-per-share (EPS) estimates for growth stocks are already 25% higher than pre-pandemic levels, while for value they are just 4% higher and momentum is good.
Our asset allocation
The market environment is now trying to reflect the timing of Fed tapering/tightening as well as the ‘peak data’ theme.
Amid a debate on whether the focus should be on the level or marginal change in macroeconomic data, we have seen a rotation out of the reflation trade post-FOMC, through the outperformance of US equities through the growth part and a flatter US yield curve.
The repricing of the Fed terminal rate to sub-2% levels is raising questions about the steady state for a US economic expansion, with lower potential GDP growth and longer-term inflation expectations implied by these levels.
In our view, the loose stance of fiscal and monetary policy (notably in the US) should support risky assets and higher bond yields. Cyclically-sensitive assets have the potential to outperform in the second half of 2021.
Growth in other major economies that have been hit by Covid (e.g., Europe and EM ex Asia) should accelerate as vaccinations lead to reopenings. Our medium-term scenario continues to favour risk and equities given the fundamental factors and the economic policy support.
We have kept our allocation to risk broadly unchanged over the past month at the level of our long-term risk target. Our net equity exposure remains overweight versus our benchmarks via positions in US value, EM equities, Chinese equities and Japanese equities against an underweight position in EMU large caps.
The regional equity exposure seeks to find a balance between the ‘growth/quality’ and ‘value/cyclical’ styles that helps insulate against interest rate volatility, while providing a diversified allocation.
Elsewhere, we are overweight risky assets such as commodities and EM local debt, and we hold other positions to diversify portfolios such as long gold.
For a full analysis of our latest asset allocation and the positioning in various asset classes, click here
*Please note that this publication will take a break for the summer. The next issue wil be published in September.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.