Macro update
We believe the global economy is healing, and we expect its upward growth trajectory to continue for the reminder of the year. Based on our macro regime framework, the global business cycle remains solidly in a recovery regime, with growth below trend and expected to improve over the next few months. The recovery is strengthening in its depth and breadth. Our leading economic indicators suggest growth is gaining momentum. Trade activity within Emerging Asia is rebounding strongly, providing further evidence the global manufacturing cycle is normalizing— supported by rebounding orders and demand in the developed world.
Global market sentiment continues to improve, as evidenced by broad-based outperformance of risky assets over defensive assets in both equity and fixed income markets. Improving risk appetite tends to correlate strongly with improving growth expectations, suggesting market participants expect the recovery to continue for the reminder of the year.
Figure 1: Leading economic indicators suggest the recovery is strengthening and is now shared across regions around the world.
Figure 2: The recovery should continue into year-end, as growth expectations and market sentiment continue to improve.
The impressive rebound in global equity markets has been extraordinary, despite record contraction in GDP and rising Covid-19 contagion rates during the summer months. We attribute this steady improvement in risk appetite to a few key developments and risk factors:
- Vaccine research: While the discovery, production and distribution of a vaccine is still months away and subject to uncertainty, market participants have responded positively to preliminary results from multiple vaccine studies around the world (Oxford, Moderna, etc.). In other words, markets are discounting a high probability that COVID-19 is actually a good candidate for a vaccine, despite the uncertainty on the timeline, and that some form of meaningful positive development is to be expected.
- Declining mortality rates: COVID-19 contagions have increased around the world, a well-understood price to be paid for the reopening of economies. However, mortality rates have declined meaningfully compared to the first half of 2020, suggesting that a combination of more prudent social behavior (distancing, masks, etc.), and a better prepared healthcare system will likely reduce the need for a new round of lockdowns, therefore reducing the risk of another severe contraction in global GDP.
- Monetary policy support: Lower policy rates, sizable asset purchases from major central banks and expectations of low long-term bond yields in the future (i.e. forward guidance) contributed to a steep decline in discount rates for future cash flows, boosting prices, valuation and market sentiment.
- Fiscal policy support: After the initial rounds of fiscal support in the first quarter, market sentiment has been boosted by additional policy initiatives around the world. In particular, the creation of a European Recovery Fund was of utmost importance to potentially reducing the threat of a new European debt crisis and the re-emerge of Euro break-up risk. On the other hand, the market is currently digesting the loss of fiscal impulse in the United States, caused by the expiration of the first round of benefits and the impasse in Congress on a new round of fiscal support, which we expect to eventually materialize at around $1.5-2.0 trillion.
Investment positioning
We believe this remains a very constructive environment for risk assets. We maintain a higher risk posture than the benchmark1 in our Global Tactical Asset Allocation model, sourced through an overweight exposure to equities and credit at the expense of government bonds. In particular:
- Within equities we hold large tilts in favor of developed markets outside the US and emerging markets, driven by more favorable cyclical conditions, attractive local asset valuations and an expensive US dollar which, in our opinion, is in the early stages of a long-term depreciation cycle. The confluence of these medium and short-term drivers increases the potential for long-term capital inflows in non-US equity markets. As a result, we hold a large underweight to US equities, especially in quality and momentum stocks, given our tilts in favor of value and (small) size factors. The underperformance of small and mid-cap value stocks versus large cap quality and momentum stocks continued to be one of the most prominent and surprising features of this market recovery. Rational economic explanations for such a divergence can be found in the technology-driven nature of the COVID-19 recovery, as well as the declining interest rate environment, both favoring quality and momentum stocks over value and small/mid-cap companies. However, even a modest recovery in the global earnings cycle for small and mid-cap value companies can lead to positive impact on prices, given high operating leverage and attractive valuations. Hence, we maintain our factor exposure tilted towards value and size.
- In fixed income, we maintain an overweight exposure to US high yield credit, emerging markets sovereign dollar debt, and event-linked bonds at the expense of investment grade corporate credit and government bonds, particularly in developed markets outside the US, given what has been a negative yield environment. Overall, we are overweight credit risk and neutral duration[i] versus the benchmark.1
- In currency markets, we maintain an overweight exposure to foreign currencies, positioning for long-term US dollar depreciation. Focusing on a combination of attractive valuations, cyclical conditions and yield, within developed markets we favor the Euro, the Canadian dollar and the Norwegian kroner. In emerging markets, we favor the Indian rupee, Indonesian rupiah and Russian ruble.
