We expect the global cycle to move into an expansionary regime, with growth above its long-term trend and continuing to improve. Our leading economic indicators continue to improve across regions despite the meaningful increase in COVID-19 infections and more stringent restrictions on mobility in some parts of the world. Improving growth momentum is most evident in the U.S., now in an expansion regime, while developed markets outside the U.S. continue to lag in the speed of recovery given mobility restrictions in the eurozone and the UK. While consumer sentiment and spending in the developed world have been somewhat impacted by restrictions over the past couple of months, capex spending, manufacturing orders, and international trade have improved. In emerging markets, our leading economic indicators are signaling that Asian economies are slowing and settling around their long-term trend growth rate while the growth momentum is picking up in the rest of the emerging world.
This is not a surprising development from our perspective given that Asia led the global recovery after the first wave of COVID -19 infections. Market sentiment continues to improve, as evidenced by the broad-based outperformance in risky assets across geographies and sectors, signaling improving growth expectations (Figure 1).
Figure 1: The global cycle moves to expansion, with improvements across the developed world, led recently by stronger momentum in the U.S., while emerging Asia settles around trend growth
We believe the macro backdrop remains supportive for equity and credit premia, cyclical factors, and risk assets more broadly. As the economy moves to an expansion phase, we expect equities to benefit from improving earnings and to take the lead in terms of total return potential as spreads on lower-quality, risky credit have compressed below historical averages. This is consistent with historical cycles. In particular:
- Within equities, we continue to favour emerging markets and developed markets outside the U.S., driven by improving risk appetite, attractive valuations, and a supportive global cycle. We continue to foresee a weakening U.S. dollar trend, historically supportive for emerging markets via capital inflows and easing of financial conditions. We remain tilted in favour of (small) size, value, and momentum factors. Despite the typically negative correlation between momentum and the former two factors, we expect the transient nature of momentum to gradually shift toward a more balanced composition, less dominated by mega-cap, quality stocks, and reflecting the recent outperformance in smaller-capitalization,1 value-oriented equities
- In fixed income, we remain constructive on risky credit despite the compression in spreads. While the total return potential on credit assets has clearly diminished given lower yields, as the cycle moves from recovery to expansion financial markets volatility tends to decline, turning the investment case for credit from capital appreciation (i.e., spread compression) to income generation. We are overweight U.S. high yield, bank loans, and emerging markets debt, local, and hard currency, at the expense of investment grade corporate credit and government bonds. We favour U.S. Treasuries over other developed government bond markets. Overall, we are overweight credit risk2 and underweight duration versus the benchmark, expecting yields to rise and the curve to steepen in an orderly fashion, similarly to what we experienced in the past six months.
- In currency markets, we maintain an overweight exposure to foreign currencies, positioning for long-term U.S. dollar depreciation. Within developed markets we favour the Euro, Canadian dollar, Singapore dollar, and Norwegian kroner, while we underweight the British pound, Swiss franc, and Australian dollar. In emerging markets, we favour the Indian rupee, Indonesian rupiah, Russian ruble, and Colombian peso. We expect the emerging markets foreign exchange carry trade to play “catch-up” sometime in 2021, having lagged in performance compared to most recovery trades in 2020.
Figure 2: Expansion results in a shift towards equities and a reduced overweight to cyclicals and credit
1 Source: Bloomberg L.P. performance referenced reflects the Russell 2000 index versus the Russell 1000 index from the period Oct. 31, 2020 to Jan. 30, 2021.
2 Credit risk defined as DTS (duration times spread).