This is an extract of our Asset allocation monthly - The Delta dilemma
During August, investor edginess increased. Financial markets partly reflected this with a decline in valuations of equities and commodities, a fall in long-term bond yields, and a rise in the US dollar during the first part of the month. Expectations about the US Federal Reserve's monetary policy partly explain these movements – and indeed their subsequent reversal – during the last week of the month, when US equity indices hit new all-time highs.
Technical indicators also played a part in the rebound in major equity indices in late August. In addition, the Chinese authorities’ decision to tighten regulations in sectors including technology, real estate, education, gaming and semiconductors unnerved investors and weighed on emerging Asian equities.
The Delta variant complicates matters
The primary source of concern, though, was the newest wave of the pandemic, which hit regions that had largely escaped previous waves. While research shows that vaccinations weaken the link between the number of new cases and hospitalisations in intensive care units, the greater contagiousness of the Delta variant means that achieving herd immunity will be harder.
The race between the virus and the vaccine is not over and the Delta variant is delaying a return to normal. Governments' reactions are ranging from strict lockdowns in countries that have opted for a ‘zero Covid’ strategy or whose health care systems are swamped, to incentives to accelerate vaccination via more or less coercive solutions.
Investors are concerned about the risks to global growth posed by the newest outbreaks, to say nothing of the risk of new vaccine-resistant Covid variants appearing. Pandemic risk justifies the continuation of restrictive measures, particularly on travel, in countries where the proportion of the population vaccinated is still low.
Even in the absence of significant new restrictions, the health situation may ultimately weigh on business and household confidence and thus on economic activity. The longer the epidemic stays with us, the greater the negative effects on production (stress in supply chains, potential squeeze on margins, elevated prices), and the longer consumption of services stays low.
Fixed Income: Changing tone at the US Federal Reserve
Since the June meeting of the Federal Open Market Committee (FOMC), several comments from members of the committee have confirmed investors' intuition that flexible average inflation targeting was not going to result in the Fed tolerating, or even seeking, a long period of well-above-target inflation.
Nearly one million jobs were created in June and July and the Fed is not far from considering that the ‘substantial progress’ needed to begin tapering its quantitative easing (QE) has been made. The impending tapering announcement was the notable feature of the minutes of the late July FOMC meeting and of Jerome Powell’s speech at virtual Jackson Hole in late August.
Even if this timing is delayed by the latest outbreak of Covid-19, particularly in southern states of the US where vaccination rates are still low, the shift towards less accommodative US monetary policy seems inevitable.
What’s the scenario for equities?
While global economic growth may have peaked in the Spring, the subsequent slowdown, which could be aggravated in Q3 by the Delta surge, should not threaten the overall recovery. Demand for goods remains strong and services consumption is set to accelerate as economies re-open.
Since the end of the first lockdown, company earnings have consistently (and by a wide margin) exceeded expectations, contributing to a rise in equity valuations. Given the economic environment expected for the coming months, the earnings outlook remains favourable in the medium term even if expectations for the upcoming quarter may be overly optimistic. The earnings support is crucial and should allow equity markets to continue to rise despite high valuations for some indices. The impressive stock market performances since the trough in March 2020 and the new records being set by the indices are not in themselves destabilising factors.
A continued rise in equities implicitly assumes that the gain in long-term yields will remain limited and orderely, as central banks are keen to avoid a repeat of the ‘taper tantrum' of the spring of 2013, when the US 10-year T-note yield rose from 1.80% to 2.80% in four months. Indeed, the key driver of equity multiples is the discount rate, i.e. the real yield. The current real yield level is low (see exhibit 2) and any sharp rise could provoke a swift de-rating of equities.
Our asset allocation
Vaccines are proving to be effective against the Delta Covid variant by limiting the severe effects of the disease. More and more countries are opting for a ‘living with the virus’ approach. This strategy may be more favourable (or at least less unfavourable) for global growth.
In addition, the number of new contaminations appears to be peaking, which should allow investors to refocus on economic factors. Growth and inflation indicators will be closely watched by investors because they will likely elicit responses by the central banks, not least the Fed. The less dovish direction of US monetary policy is quite clear, but the timing of any move by the Fed will be highly data dependant.
We remain convinced that, beyond short-term hiccups, the medium-term economic environment is favourable for a continued rise in valuations of equities, although probably at a slower pace than earlier in the year.
The broad lines of our allocation reflect our convictions: Overweight developed equities, underweight duration. Market conditions in recent weeks have led us to make some adjustments and, as we enter the last phase of 2021, the number of active positions is quite low and we will monitor market conditions in order to diversify.
Equities still look attractive versus bonds to us, despite the all-time highs reached in recent weeks, even if absolute valuations (e.g. P/E ratios) appear high. We are bullish on the US via US value stocks, which are cheaper than the mega-cap-heavy S&P 500 and still have room to catch up.
We kept our overweight position in Japanese equities as they look attractive relative to other markets. We are neutral on EMU equities with a relative trade (long EMU small caps versus large caps). We recently re-entered an overweight position in emerging market equities as a tactical trade based on positioning and technical factors.
In July we added to our underweight position in US government bonds and we have kept our underweight in EMU bonds. We closed our overweight in emerging market local currency debt as both the fundamentals and technicals have become less supportive of this trade.
At end-August, we increased our overweighting of commodities after the correction posted during the summer and are looking for entry points to increase it further as we are bullish on commodities over the medium term. We are long gold as it can be seen as a currency that cannot be debased by central banks and offers protection against inflation risk.
For a full analysis of our latest asset allocation and the positioning in various asset classes, click here
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.