Today, over 15 months after COVID-19 outbreak was declared a pandemic the virus still poses a threat to the markets. Another new variant forces cities into lockdowns and travellers into quarantines. However, some countries, such as Singapore, are already overcoming the COVID-19 situation and declaring an end to contact tracing and other measures taken as soon as there are enough people vaccinated. Therefore, the focus is on the real economy: a rapid recovery that has been observed in some countries makes investors nervous, as it might bring high inflation and early tapering. The ambitious spending plans proposed by the US president require financing, which introduces an additional risk factor: an increase in corporate taxes that would hurt companies’ profit margins and thus result in lower yields to investors.
Tactical Asset Allocation
Economic recovery is now evident around the globe in the data as well as in the markets. PMIs in Europe and the US suggest that both regions’ business activity is strongly expanding: both services and manufacturing figures in the regions are significantly above 50. Unemployment and initial jobless claims are slowly but steadily falling - although in the labor market, there is still a lot of room for improvement. In Europe, unemployment was 8.0% in April, but is expected to have stalled at this level in May. In the US, initial jobless claims were stuck around 400k in June, almost twice the average pre-pandemic level, and unemployment was 5.8% in May, slightly below the April level of 6.1%. However, both regions’ unemployment figures are elevated relative to the pre-pandemic levels.
Therefore, monetary and fiscal support continues for now. The US Fed has just started hinting at the beginning of a tapering discussion and recognized the fact that the economy is expanding at a greater than expected pace. As recovery and vaccination progress in the EU is lagging the US, the ECB is staying dovish. Moreover, to provide further support to the region, the first payments from the EU Recovery Fund have been handed out at the end of June. Overall, while the US is experiencing its peak post-pandemic growth and inflation right about now, Europe is likely to be at this stage in the second half of the year. The latest year on year CPI growth reading of 2.0% in May technically exceeds the central banks’ target of just under 2%, while in the US, CPI rose by 5% over the same period - high above the target of the 2% average. In both regions, inflation is stronger than it has been in many years, but more is yet to come for Europe. Thus, with the backdrop of noticeably rising prices – sparked up by pent up demand and supply bottlenecks and amplified by the base effect - the main question on investors’ and economists’ minds is whether inflation is going to pass with the recovery normalization or whether we are entering a new higher-inflation environment.
In Q2 US Treasury yields started to stabilise. After the 10-year yield peaked at 1.75% in late March, they traded sideways and closed Q2 at around 1.50%. Although inflation fears have been confirmed by higher-than-expected CPI data, 10yr rates did not react. On the contrary, even after a more hawkish tone at the latest Fed policy meeting, were the central bank signalled that interest rate hikes will now begin in 2023, instead of 2024, 10yr yields dropped unexpectedly below 1.50%. It seems that the market is accepting the Fed’s mantra that higher inflation will prove transitory.
All eyes are on the Fed, looking to get signals of the timing of its monthly bond purchases reduction. At current levels (UST 10yr at 1.5%), we see a larger probability of higher yields than lower ones. Although “the taper tantrum “-scenario is heavily discussed and might already be reflected in prices, it needs to be tested by the market. Therefore, we stay cautious on duration and prefer the short end.
The environment for Fixed Income investors remains challenging. At current yield levels we avoid locking them in for longer. However, we think that the economic recovery allows us to add some credit risk. Bonds from the energy, materials and financial (AT1’s) sector still offer some additional spread. We feel comfortable going down the credit curve picking up some names from the BB segment.
As the economy recovers, credit fundamentals are improving and therefore expected default rates are declining. Consequently, rating upgrades are more likely. That is why we like a well-diversified credit portfolio with a bias towards cyclical names. We stick to our strategy as we believe in a full recovery of the economy. Sure, new variants (Delta) of the COVID-19 virus can delay the recovery scenario, but not destroy it. Macro data and Fed comments will be closely watched for the rest of the year. Therefore, we expect volatility in Fixed Income coming more from the rates, than the credit side.
The highlight last month was set by the Fed. The correction on the stock markets is related to the surprisingly hawkish tones of the Fed. Although the US monetary watchdogs have not yet given a clear signal for tapering, the discussion about tapering has begun. However, the timing of taper remains uncertain. The US central bank wants to have more data, particularly on the labor market, before it is confident that “substantial further progress” has been made. Analysts believe that two to three good labor market reports will be enough to give the go-ahead for a reduction in bond purchases in August or September, either already at the end of the year or at the beginning of next year. In the meantime, investors have digested the hawkish tones, and the financial markets, similarly to the Fed, see inflation only as a temporary event.
We believe the equity markets can live with this course of action, as monetary policy will remain expansionary and growth-supportive for a considerable time yet. This also means that the earnings outlook for companies should remain very positive. However, the risks for the equity markets will increase if the rise in inflation proves to be more persistent and monetary policy has to react to this. There are a few indications of this at present. By contrast, key interest rate hikes as a normalization of monetary policy due to a faster than previously expected achievement of employment targets and sustained good growth prospects are not a problem for the equity markets. Nevertheless, with the emerging change in the course of US monetary policy, the path for the stock markets is likely to become bumpier.
For the time being, equities are faced with an unusual configuration: high but falling growth, high but falling inflation, and tightening financial conditions. There are a few sectors that perform in all three states of the world, namely Energy, Pharma and Telecoms. We are keeping our neutral stance and becoming more selective on the cyclical exposure.
In the FX space, the USD was the major winner after the Fed has given hints of the tapering discussion. It has surprised us since there was fundamentally no change nor any shift in monetary policy. Whether it is a gamechanger remains to be seen. Fed’s Powell defied consensus expectations that the topic about tapering would be raised only at Jackson Hole or the September meeting. While the medium-term upside risk for the USD has risen, analysts continue to regard the global recovery environment, which should persist in 2H, to favor risk-on and export-driven currencies. As for the EURUSD, we think the upside is rather limited for the next month or two and expect rather range trading within 1.18 – 1.20.
Gold took a hard hit as the Fed communicated that tapering and rate hikes could start sooner than expected. Same as in G10 currencies, the price pressure was driven by stronger USD and higher US 10Y yields. The yellow metal should arguably serve as an inflation hedge but for the time being, we may see further price pressure. Investors could consider a reduction in their tactical long holding but keep their strategic positions.
A spike in COVID-19 infections as a result of the Delta variant of the virus has caused a minor wobble in the oil price. While it is certainly sensible to pay close attention to data, the probability of countries returning to full-scale lockdowns is low. As usual, with oil near the top of the recent trading range, sentiment is more than usually susceptible to news flow that threatens the prevailing positive supply and demand narrative. The OPEC+ seems likely to consider additional easing of productions cuts. Even with the expected increase of 500kb/d, the market would remain in deficit this year, limiting material downside risk for oil.
Hedge Funds strategies closed all in positive territory in May. Some macro strategies were flat when Event Driven strategies performed well. We expect this development to have continued within June due to benign markets. The return of CTA strategies with an impressive performance of 8% year-to-date surprised us most despite of the positive markets. Year-to-date, Long/Short equities as well as event-driven strategies outperformed the other strategies and profited from their high correlation to risk-on assets. Private markets were also profiting from a benign market environment. Most strategies were up within the last months. Nevertheless, dispersion between the different funds has never been wider than this year since the financial crisis. It pays off to focus on well-established and connected fund managers in order to catch a superior performance. Most of the strategies profit from the increased appetite for mergers and acquisition as the uncertainty about the future fades away.
Note: This report is published by Clarus Capital Group AG
Roger Ganz, Head Asset Management, Clarus Capital Group AG
Dejan Ristic, Partner, Clarus Capital Group AG
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