2021 Multi-Asset Outlook
Multi-asset insights: Nanette Abuhoff Jacobson, Global Investment and Multi-Asset Strategist; Daniel Cook, CFA, Investment Strategy Analyst
Thematic insights: Nick Samouilhan, PhD, CFA, FRM, Multi-Asset Strategist
Views expressed are those of the authors and are subject to change. Other teams may hold different views and make different investment decisions. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional or institutional investors only.
Is the market rotation for real?
Encouraging vaccine data, policy support, and gradually reopening economies make us more confident in taking a pro-risk stance over our 12-month time frame.
Safe, effective vaccines could be the catalyst for a durable rotation from growth- to value-oriented exposures.
Within equities, we prefer Europe, Japan, EM, and smaller caps, and think cyclical sectors are attractive relative to growth sectors.
We think rates will drift higher and find some credit spreads attractive relative to government bonds.
Downside risks include broad lockdowns as a result of a second COVID-19 wave, a spike in rates, and waning policy stimulus. Upside risks include another major dose of stimulus.
Remarkable, painful, unsettling, hopeful… 2020 brought a roller-coaster ride of emotions, not to mention economic and market volatility. As the end of the year approached, the global economy was on its way to climbing out of the deepest hole ever. Markets, meanwhile, had moved forward, mostly on the strength and relative safety of US equities, growth stocks, gold, and fixed income, and then taken a baby step toward cyclical leadership at the end of the year. So, with the US election behind us (though court challenges, recounts, and Senate runoff elections are still to come as of this writing), COVID-19 cases spiking in Europe and the US, fiscal stimulus on hold in the US, and very encouraging vaccine data being announced, what is the investment thesis for 2021?
Over our 12-month horizon, we think vaccine news, reopening economies, and still-strong policy support will predominate and mark a turning point in the market narrative. Seeing a surer path to a safe and effective vaccine, we are more confident in an economic recovery in 2021 from still very depressed levels (Figure 1) and think this will be the catalyst for value to outperform growth, as well as for sovereign rates to rise somewhat. We expect a range of value-oriented exposures to outperform, including non-US developed market equities (versus US equities), emerging markets (EM), cyclical sectors such as financials, consumer discretionary, materials, and industrials, and smaller-cap equities. In sync with these views, we see the US dollar weakening too. Given large output gaps and low levels of valuations, sentiment, and positioning in these areas, we think a rotation will be an enduring theme in the coming year.
We remain moderately bullish on credit given the demand for yield, central bank support, and fair spread levels. We are not concerned about inflation over the coming 12 months given the sizable global output gaps, and thus see commodities as a source of funds (though precious metals could be a complement to fixed income for diversification purposes). Our pro-risk stance on emerging markets incorporates our expectation that China’s recovery will continue to migrate from the industrial to the consumer side of the economy and that some other emerging markets will potentially benefit from a better developed-market backdrop, a weaker US dollar, and low valuations.
Equities: Leaning toward value
We have tilted our view on equity exposures away from the US and toward Europe and Japan. Japan’s domestic economy has benefitted from some fiscal stimulus and a mild experience with COVID-19. That combination has led to healthy balance sheets for both corporates and households. Moreover, we expect Prime Minister Suga to slowly ramp up economic reforms and the Bank of Japan (BOJ) to continue to push for reflation.
In Europe, the manufacturing side of the economy has performed well throughout the COVID-19 crisis but the services side has lagged badly. As Europe endures a second wave of infections, we anticipate further lockdowns in the near term. However, our optimism about a vaccine and the fact that European consumers have the most room to rebound make us bullish on an economic recovery in 2021. Taking these macro views into account, as well as attractive valuations, we think it may be time for investors to reconsider their long-standing underweights in Europe and Japan.
We are now moderately bullish on EM equities on the back of China’s relative economic strength shifting from the industrial sectors to the consumer, and a more constructive outlook for some other large EM countries. President Erdogan’s pick for the new central bank governor, a former finance minister, is a positive development in Turkey. Brazil’s current account surplus has actually improved during the pandemic and inflation is at record-low levels. While EM countries’ debt relative to GDP has increased, interest rates are low and some monetary easing is a possibility. Differentiation in EM remains key; for instance, we prefer countries whose economies are tied more to manufacturing than to tourism.
We are lowering our long-standing positive stance on US equities to neutral. US equity markets are dominated by growth and technology, and we think a vaccine will unleash pent-up demand that could make value-oriented plays more attractive, particularly if interest rates rise somewhat, as we believe they will. We think the economy, which has been hit hard by COVID-19, will rebound as it reopens, benefiting more cyclical areas (Figure 2). The rebound should be supportive of US equities overall, but given the market’s concentration in relatively expensive areas, such as technology, we are left with a neutral stance.
Rates and credit: Higher rates, for the right reason, should be fine for spreads
We believe that a cyclical recovery in 2021 will mean slightly higher yields in longer maturities while central banks will keep short rates pinned. The prospect of higher government bond yields augurs slightly worse for credit relative to the past, from a total return perspective. If higher rates are a result of better real growth, however, and rate moves are mild, then spreads should tighten. Valuations remain at median levels versus history and demand for extra yield remains strong. Figure 3 shows that with the growth of the ECB’s purchases of European government bonds and corporates, European asset allocators are being forced to increase their foreign debt purchases. This appears to be an additional source of US credit demand. Despite its longer duration, the US investment-grade market could benefit from this dynamic, so we seek a neutral posture.
We remain moderately bullish on high yield and think spreads could potentially tighten 50 – 100 bps more over the coming year. With the Fed’s support, US high-yield defaults have been lower than expected — 8.5% as of September 30 — and Moody’s has lowered its peak default rate to 11.1% from 14.4% for March 2021. We expect a drawn-out default cycle with slightly elevated defaults relative to the long-term average of 4%. We prefer high yield to bank loans given the prospect of short-term yields staying at zero for several years.
We continue to view securitized assets as a way to express a positive view on residential housing, but remain cautious on commercial property, such as malls and offices, where we see enduring stress. Low mortgage rates, declining unemployment, and millennials’ growing demand for housing are potential tailwinds for sectors like workforce housing and credit-risk transfer.
Our view on EM debt has also improved to neutral. As with equities, we see a better developed market backdrop supporting EM. We believe there are attractive opportunities in the higher-yielding local rates and currency markets in Latin America funded by the safer, lower-yielding Asian countries. We also continue to see opportunities in Central and Eastern European local debt.
We, like the markets, are optimistic that a safe, effective vaccine will be ready for distribution as early as the first quarter of 2021, so a disappointment on this front or broad lockdowns as a result of the surge in cases could derail the global recovery and reverse the rotation from growth to value that we expect.
As of this writing, some US election risk remains given that President Trump has not conceded to President-elect Biden and the Trump campaign has filed lawsuits in several swing states challenging the election results. We don’t see much chance of those lawsuits succeeding, but note that any prolonged period of uncertainty could negatively affect markets. Geopolitical risks have gone up as well, as Trump has taken a more aggressive foreign-policy stance recently.
Higher yields also present downside risk and not just for fixed income investments. Extremely low yields and central bank commitments to keep them that way for several years have supported risk assets and justified lofty valuations, including in mega-cap technology names whose high future earnings are considered worth more today in light of lower discount rates. A spike in rates would likely damage markets broadly, particularly if the episode were accompanied by a sudden lack of liquidity.
We are watching closely for signs that the COVID-19 crisis inflicts lingering damage on the global economy. If worries about another surge restrain consumer spending and the savings rate grows, the expansion we expect could disappoint. Additionally, to the extent that changes made to adapt to the pandemic (e.g., remote work and education) become permanent, the impact in areas like office space and business travel could reduce the likelihood of returning to pre-pandemic economic activity levels.
Given our moderately bullish stance, an upside risk is that the global recovery is stronger than we expect. In that case, asset classes even more levered to a recovery, such as natural resources and industrial metals, could be bigger beneficiaries.
Looking beyond the election — The markets have moved past the US election and are now more focused on the path of COVID-19, the vaccine, and the global economy. We think an effective vaccine will be the catalyst for a cyclical recovery in 2021.
Leaning toward value in equities — With a better cycle, we prefer non-US equities and other value-oriented exposures such as cyclicals and smaller-cap equities. We prefer financials over energy given the slow recovery we expect in business travel and the structural headwind of the shift to renewables. We believe there are opportunities in companies with depressed valuations in cyclical sectors that have adapted to the pandemic and seen improvement in medium-term fundamentals. In addition to financials, sectors we find attractive include REITS, materials, health care, aerospace/defense, and transport, which all have value-oriented characteristics.
Seeing some value in credit — Spreads have narrowed but are still around median levels. Given the Fed’s unprecedented support for credit, we think spreads will continue to grind tighter. Structured credit is not the target of Fed credit programs, but the market offers exposure to the improving US residential housing market, a dynamic we think will persist through the recovery.
Diversifying with high-quality bonds — We think agency mortgage-backed securities and high-quality government bonds can potentially boost a portfolio’s diversification and liquidity if the recession is deeper or longer than we expect. We think taxable investors should consider municipal bonds given attractive valuations.
Enhancing diversification with precious metals — Given rock-bottom fixed income yields, we think precious metals can potentially play a role in boosting portfolio diversification and mitigating the effects of a stagflationary environment and geopolitical tensions.
Turn the page: A thematic playbook for 2021
A key starting point for investing is to understand the macroeconomic outlook, as it is from this cyclical perspective that many asset allocation decisions are made. (See my white paper, “The dawn of divergence and the art of subtlety,” for some of my latest macroeconomic views.) In addition, there are often powerful secular forces at work that may provide opportunities for enhanced portfolio diversification and return potential.
The challenge for asset allocators is that compelling secular themes and trends can be hard to spot and incorporate, as they typically do not fit neatly into a conventional investing framework. Instead, they require focusing on the “bigger picture” of underlying structural changes that are occurring across the global economy, which in turn need catalysts to propel them.
As we approach 2021, the most obvious catalyst for structural change is the profound impact of COVID-19 on the global landscape. Looking at the crisis through a secular lens, its onset has accelerated and reinforced many long-term, seismic shifts in how we live and work.
Hopefully, 2021 should see the pandemic’s grip on the world begin to loosen, enabling the reemergence of many “non-COVID” dynamics in driving asset price action. In addition, as the initial acute shock of COVID starts to fade and give way to a more chronic management of it, its impacts on particular countries, sectors, and companies should begin to differ.
Broadly speaking, I believe COVID, and its multiple ongoing fallouts, has ushered in three types of secular opportunities for discerning investors to pursue increased portfolio diversification — beyond just playing the global cyclical recovery — in 2021.
Sector and thematic
From an investment standpoint, one useful way to measure COVID’s continuing secular impact is through the relative performance of different sectors of the global economy. For example, some of the major lifestyle and workplace changes spawned or accelerated by COVID are likely to turn certain sectors, such as health care and technology (Figure 1), into secular “winners,” at the expense of others. By contrast, industries such as tourism, for example, may remain challenged and struggle to thrive going forward, even if their activity manages to return to 90% of pre-COVID levels.
While some of these thematic sector-level trends have already become apparent in 2020, I believe they may have further to go as the many structural changes wrought by COVID grow more entrenched. As such, related investments in areas like health care and technology, as well as disruption and innovation more generally, are likely to present attractive long-term opportunities rather than just shorter-term tactical plays. Investors might seek to benefit by positioning their portfolios accordingly in the months to come.
Finally, I would be remiss if I did not acknowledge the continued importance of sustainability and related investment opportunities. To some degree, 2020’s unprecedented global health crisis may have temporarily taken investors’ focus off environmental, social, and governance (ESG) issues, but these issues are not going away and, in fact, are likely to loom even larger in the coming months and years. Ironically, if indeed we see redoubled efforts on the ESG front in 2021 and beyond, COVID-19 may be partially responsible. For example, as one industry conference participant put it earlier this year, “COVID-19 has been like watching climate change in fast forward.”
Opportunistic fixed income
In 2020, at the country level, virtually every nation was impacted to some degree by COVID and, by and large, reacted to the crisis in a similar manner via economic lockdowns and policy stimuli.
In 2021, I believe this commonality of national impacts and responses should begin to break down. While all countries fared about the same with a “blanket-lockdown” approach to COVID, the move to a targeted “test-and-trace” process advantages countries with better public-health infrastructures. Likewise, the continued support required to offset subdued private-sector activity favors countries with stronger public finances. The makeup of a country’s economy will also matter, as economies heavily reliant on tourism, for example, will face stiffer headwinds than those more focused on services. At the same time, non-COVID dynamics whose dominance was largely subsumed this year should resurface in 2021, such as long-term structural development in emerging markets (EMs) and political populism.
At the company level, waning government cash-flow support against a backdrop of challenged consumer spending may worsen the default cycle, with many firms likely being unable to meet their contractual payments given reduced social mobility and economic activity.
It is this gradual fading and evolution of COVID’s imprint over time, along with the comeback of other (non-COVID) fundamentals, that leads to my second area of investment opportunity in 2021. Specifically, I expect to see more pronounced country-level divergences in the period ahead, creating opportunities for dynamically run fixed income strategies that can nimbly tilt allocations among various global currencies, interest rates, and credit sectors (e.g., high yield, EM debt, bank loans, and securitized assets, to name a few) — each with potentially distinct return drivers — as market conditions warrant.
Lastly, a similar divergence pattern is also likely to take shape at the individual company level, exposing differences among many corporate business models. While this became apparent to some extent in 2020, I suspect that many of these company-level differences were obscured by markets’ broad beta moves (both down and up) and generous government-policy support.
In 2021, I believe this is likely to change amid a return to company-specific fundamentals taking a bigger role in driving price action, such as quality of balance sheets, business models, and firm management. This is the third area of secular investment territory that I believe COVID has opened up, with greater divergences among companies creating numerous opportunities for bottom-up investors. And while these opportunities may also be available to long-only portfolio managers, it is primarily in the alternative investments space (e.g., hedged equity, private equity, multi-asset, and absolute return fixed income strategies, among others) that I think they can best be exploited.
How so, for example? In the case of a long/short equity strategy, being able to “go long” good companies and “short” poor companies allows investors to isolate fundamental factors and dynamics, instead of just avoiding the poor companies altogether (as most long-only strategies would typically do). While likely beneficial to any strategy that seeks to capitalize on fundamentally driven differences across companies, I would highlight the credit markets as offering the greatest opportunity set here in today’s environment. This bias reflects the centrality of cash-flow disruption to the current economic downturn and how well masked it was by government policy support in 2020.
about the authors
Nanette Abuhoff Jacobson
Global Investment and Multi-Asset Strategist, Boston
As a global investment strategist, Nanette shares her views on market trends and opportunities with subadvisory clients as well as their sales organizations and major broker-dealers and distributors. As a multi-asset strategist, she consults with clients on strategic portfolio issues and works with investment teams across the firm to develop relevant investment solutions.
Daniel Cook, CFA
Investment Strategy Analyst, Boston
As an investment strategy analyst, Daniel analyzes and interprets markets and translates this work into investment insights for clients. He also consults with clients on strategic asset allocation issues and works with investment teams throughout the firm to develop relevant investment solutions across asset classes.
Nick Samouilhan, PhD, CFA, FRM
Multi-Asset Strategist, Singapore
As a multi-asset strategist, Nick collaborates with investment teams across the firm to help our clients generate better investment outcomes. In this role, he assists clients with strategic and dynamic asset allocation decisions, market insights, manager selection, portfolio design and risk management.
ACTIONABLE IDEAS 2021
This is an excerpt from our 2021 Investment Outlook, in which specialists from across our investment platform share insights on the economic and market forces that we expect to influence portfolios in the year to come.