Setting the course for H2 2021
The macro and policy transition we flagged last month is now more clearly underway. The pace of the recovery from 2020’s global recession looks set to peak in the months ahead, and central banks are now flagging less stimulus. This transition phase may bring more volatility and a period of consolidation for equity markets after strong gains during the past year.
Yet, as we move through 2022, we expect any policy changes to be modest and growth to normalise at a very healthy pace. This month we set the course for H2 2021 to best navigate the period ahead. We remain moderately overweight equities relative to fixed income but move further underweight government bonds and temper the cyclicality in our regional equity tilts.
The macro transition is underway…
It appears increasingly clear that the global growth cycle is approaching its peak. China led the world into the pandemic crisis (and recession) in early 2020, recovered most rapidly thereafter and now appears to have passed ‘peak growth’ in mid-2021, slowing to 8% in Q2 from 18% in Q1. Other key economies will likely follow a similar path over the coming year. After printing double-digit growth for Q2 (12%), the US will likely see momentum tempered during H2 2021, followed in 2022 by the UK and Europe, then emerging markets and Australia, where a later recovery also delays the peak in growth momentum.
It’s also clear that central banks have started down the path to a less dovish stance. Recent months have seen central banks acknowledge the faster-than-expected recovery and higher-than-expected inflation over the past year. Policymakers in Canada, New Zealand, the UK and Australia have formally announced a ‘tapering’ of their current liquidity policies (bond-buying) and the US Federal Reserve (Fed) has flagged it will do the same soon. In contrast, some central banks in emerging markets, where the flexibility to absorb the recent spike in inflation is low, have already begun lifting rates.
But casting an eye beyond the next couple of quarters, it’s almost certain that growth will normalise to a healthy pace in 2022, and major central banks are unlikely to have moved much (if any) away from near-zero policy rates this year or next. We expect the period ahead will still see very strong (but slowing) growth and reduced (but still abundant) policy stimulus.
Global growth momentum peaking H2 2021, but still
strong in 2022
Source: Factset, UBS and Bloomberg.
In July, the International Monetary Fund left its global growth forecast for 2021 unchanged at 6.0% (a 40-year high) and raised its forecast for 2022 to 4.9% (previously 4.4%, a 10-year high). BCA Research also highlights that Google mobility trend data for services sectors in developed countries is still 10-20% below pre-pandemic levels. This suggests plenty of scope for growth to strengthen, as does the combination of rapidly easing mobility restrictions and very large saving balances held by consumers.
For Australia, the July surge in the Delta variant of the COVID-19 virus has led to a sharp increase in mobility restrictions, largely in New South Wales (NSW). While this will likely cause growth to be weak in Q3, its containment by end-Q3 is expected to lead to a strong rebound in Q4 growth.
The key question for asset allocation is not whether growth is slower or policy tighter, but whether a global recession—the most prominent period where equity returns underperform bond returns—is on the horizon over the next 18 months. We see the risk of recession as low, and thus remain prepared to stay moderately overweight to equities relative to government bonds.
Making tactical changes to our asset allocation outlook
As psychologists often tell us, change (and uncertainty) creates stress. And the cycle is changing. Moreover, just at the time the world is transitioning to a slower phase of growth, market sentiment (and its psychology) is being confronted by a number of risks to the outlook which have increased:
- The race between Delta and vaccination - The spread of the Delta COVID-19 variant is seeing a pick-up in new cases. While hospitalisations remain low (due to the H1 2021 acceleration in full inoculation to about 50% in the US, Europe and UK), there are concerns the outbreak could still dent the growth recovery. In Australia and emerging markets, where vaccination rates are lower, mobility restrictions have been put in place.
- The debate between persistent and transitory inflation - The coming months will reveal the extent inflation proves sticky, threatening the outlook. For now, price (and supply chain) pressures remain concentrated in just a few areas (such as car prices and hotels). But the recovery’s strength has raised concern price pressures could broaden.
- The uncertainty of how central banks will behave - Can central banks stick to their dovish tones, or will they flinch at high inflation and start withdrawing stimulus too quickly? Is it the hiking of rates beyond 2022 that matters for growth and markets, or could the removal of liquidity (slower bond-buying) nearer-term be the catalyst for a correction?
- Simmering US-China tensions - While it’s no longer foreign policy by tweet, US actions reveal President Biden’s ongoing hard line on China, including adding companies to the entity list, doubling-down on Trump’s South China Sea policies, not relenting on tariffs and sanctioning individuals. As PIMCO notes, there’s always the risk this could boil over.
Over the past month, these risks appear to have led to diverging perspectives by equity and bond market participants. Equity markets (while more volatile) have largely ignored these risks and continued to grind higher (much as we anticipated). As we’ve penned previously, the strong momentum in earnings (now starting to be revealed in mid-year corporate reporting seasons) was always likely to provide some ballast. In contrast, bond yields have taken to heart the growth worries and retraced 0.5% to levels at the start of the year.
The world is on track to be
significantly vaccinated by end-2021
Source: Our World in Data as at 27 July 2021.
We continue to expect markets to be resilient. Into mid-2022, we expect equity markets to trend higher (though returns are likely to be more modest than the past year). Government bond yields are likely to move back toward 2%, but central banks remain nervous about tightening too soon, capping any sell-off. This largely relies on inflation and virus risks dissipating (and geo-politics staying contained), and markets ‘coming to terms’ with a new phase of growth that still has plenty of momentum and policy accommodation.
Given market uncertainties are likely to persist over the coming months, we are making some changes to our tactical asset allocation, while still maintaining our overweight to equities relative to fixed income. These moves reflect a desire to take a more defensive regional tilt in equity positioning, moderate cyclicality as the global growth cycle peaks while doubling down on our longer-term view that bond yields need to rise over time.
Tactical asset allocation changes
- Moving further underweight government bonds. A sustained recovery during 2022 should put upward pressure on real yields. Current US 10-year bond at 1.3% are inconsistent with forecasts for global growth over 4% in 2022 (after 6% in 2021) and inflation over 2%.
- Moving overweight short maturity. While short-term interest rates are unlikely to rise any time soon, defensive income is expected to outperform government bonds and may protect returns during periods of either rising yields or equity market volatility.
- Closing our US equities underweight by moving emerging markets underweight. US equities is a more defensive market and emerging markets have quickly become vulnerable to a stronger US dollar, rising virus cases and a peaking global industrial growth cycle.
Taking a look at the key asset classes
World equities have risen strongly this year, rising around 5% in Q1 and another 8% in Q2. This has been underpinned by the pick-up in activity as mobility restrictions eased sharply across the US, UK and Europe (with ‘re-opening’ or value sectors outperforming growth). Stronger earnings have delivered an improvement in valuations, as expected.
Looking ahead, earnings growth should remain strong through 2022, though growth concerns near term may weigh and earnings momentum may fade during 2022. Over the coming year, Credit Suisse is forecasting a 7-8% gain for the MSCI World Index. Passing ‘peak growth’ suggests more moderate returns will also support a more balanced overall sector and style positioning.
We remain in favour of European and UK markets where, relative to the US, more of the growth recovery lies ahead and valuations are more supportive. UBS continues to see significant upside to European earnings for 2022, while in the UK, the market is one of the most attractive from a valuation standpoint. We are relatively neutral US equities, which should provide defensive ballast should volatility arise while emerging markets are now less favoured, as growth peaks and China’s authorities appear increasingly activist.
For Australia, while the 28% return through 2020/21 was the strongest since 2006, it still lagged global equities. And with a likely delayed, but still durable, growth recovery and strong earnings upgrade cycle ahead, as well as a discount to global markets and recovery in dividends, we remain overweight domestic equities. Many domestic corporates are also likely to benefit from the ongoing acceleration in activity globally.
US 10-year bond yields have fallen from 1.61% at the start of June to 1.23% currently, with yields in other regions also falling. This suggests participants are mostly worried about risks to the growth outlook (and that they also believe that inflation will be transitory). However, we expect a robust recovery in growth and further falls in unemployment. We see central banks tapering their liquidity and positioning for 2023 rate hikes, underpinning a rise in US (and Australian) 10-year bond yields back toward 2% (or higher) by early 2022. We recommend staying short duration and looking to increase high quality income-bearing assets within fixed income portfolios.
Credit markets appear relatively expensive given tight spreads. However, the healthy return pick-up over bond yields should keep the market well supported, and we see the risk of rising default rates as relatively low near term.
While the growth momentum has peaked relatively quickly, it’s arguably still early in the economic cycle from an historical perspective. This supports allocations to private equity (and venture and growth capital), where we have a relative preference over hedge funds. We continue to favour real assets for their defensive bond-like returns and inflation protection, while valuations for commercial property should weather a moderate uplift in bond yields.
Outlook for commodities and the Australian dollar
Commodity prices have risen sharply over the past year or so, buoyed by a rapid recovery in global growth, as well as supply disruptions. In general, we anticipate commodity prices trending lower in the year ahead, albeit remaining elevated.
Energy prices should be well supported by a robust pace of activity, though increasing supplies now see analysts expecting Brent oil prices to drift lower from USD 0.75 to USD 0.70 in the year ahead. Metal prices are vulnerable to slowing China growth, as well as a period of strength of the US dollar as the Fed tapers liquidity. UBS expects iron ore prices to correct toward USD 125 per tonne (p/t) (from over USD 200 p/t), while other metals are seen falling as the growth cycle peaks (and a range of ongoing supply pressures ease over the coming year). Gold prices may benefit near term due to elevated volatility and inflation uncertainty. But through 2022, prices are likely to struggle if our central case view of an ongoing robust growth cycle emerges and real bond yields rise. UBS continues to see downside to the gold price, “as we get closer to year-end the macro environment continues to improve”.
Since peaking in February this year at almost US 80 cents, and still over 78 cents as recently as May, the Australian dollar has slumped to be just above US 73 cents. Over the coming months, as a risk-loving currency, the Australian dollar is likely to remain under downward pressure versus the US dollar, British pound and euro. Worries about weaker global growth will be top of the list. In addition, the relative ‘dovishness’ of the Reserve Bank of Australia (RBA) is likely to be highlighted near term as NSW battles its own pandemic crisis (and Australian growth slumps in Q3), compared with ongoing strong growth recoveries (and less dovish central banks) elsewhere in the world.
However, when investors realise that 2022 global growth is likely to normalise at a healthy pace, global vaccination rates have risen to levels mitigating the need for economy-wide shutdowns, and Australia re-joins the global ‘recovery party’, we expect the currency will start to rise again. For end-2022 CBA and UBS both forecast a rally back toward USD 0.80.
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Scott has more than 20 years’ experience in global financial markets and investment banking, providing extensive economics research and investment strategy across equity and fixed income markets.