The recovery playbook
The ongoing recovery and rising yields still favour risk assets such as equities, corporate HY debt and EM fixed income.
Recovery has peaked for the U.S. and China, and there is more in store for Europe, as well as Asia and other EM economies, as vaccination rates increase and infections recede. This implies relatively modest returns for equities at the index level, but ample opportunities among sectors.
Higher U.S. Treasury (UST) yields still pose a challenge for fixed income. HY corporate bonds and EM debt remain viable sources of income generation.
Recovery is still positive for risk assets but moderate returns
The different recovery stages call for a more diversified approach on global equities.
China and the U.S. are likely to have gone through the strongest period of their recoveries, but their growth paths have solidified. This implies rotation within the indices would be critical in return generation rather than at the benchmark level.
Europe is in a sweet spot as the region is emerging from the latest wave of infections at a time when vaccination rates are accelerating. The European Recovery Fund should also provide some fresh growth momentum.
Asia and emerging markets may require more patience and differentiation. The export sector remains in solid shape, but domestic demand will take longer to revert back to the long-term trend as vaccination rates remain a critical ingredient.
Rotate and repeat
With rising yields and the ongoing economic recovery, tactical investors will favour cyclical sectors.
Rising government bond yields have supported cyclicals, including financials, materials and industrials, while technology (tech) has come under pressure. We expect this to continue in 2H 2021.
Strategic investors may look to build their tech portfolios during this period of underperformance, given the sector’s long-term track record. In the U.S. and China, tech leaders are under regulatory scrutiny, but this presents opportunities for the sector’s smaller players.
Rising labour and raw material costs are a concern for manufacturers. Downstream players in the supply chain are currently in a more vulnerable position. Materials and energy could be useful as a hedge against inflation and higher prices.
The grind higher
US Treasury yields are still expected to rise over the long term as recovery solidifies, alongside the possibility of inflation staying higher for longer.
US Treasury yields are expected to rise in the medium term on the back of higher real yields. Sustained inflation could add to this scenario. Short duration is one way to protect investors from such a scenario. Gold’s role is more ambiguous as the commodity excels when inflation depresses real yields but struggles when inflation expectation recedes.
HY corporate debt has the advantage of both relatively shorter duration and higher yields, which counter the negative impact on returns from rising UST yields. The ongoing economic rebound should also keep default rates low.
EM fixed income had a challenging first half, partly due to the rebound in the U.S. dollar (USD). Greater USD stability in 2H 2021 against EM currencies should help EM debt improve its return. However, individual market challenges imply active selection is a must.
Investment implications
Investors should continue to diversify their equity portfolios globally. Europe has enjoyed strong performance in 1H 2021, and we expect the ongoing cyclical sector rebound to provide more impetus.
Asian equities have lagged this year due to policy normalisation in China and new waves of infections in some of the region’s economies. Exports should still be well supported, while patience is needed for domestic demand to recover as current infections are being brought under control.
In terms of sectors, cyclicals should ride the economic tailwinds and the strength of the earnings outlook. Still, be mindful of rising raw material and wage costs. Higher inflation costs could add pressure to the profitability of downstream manufacturing industries in the near term.
UST yields could consolidate in the near term but may push higher over the medium- to the long-term trend. Investors should think short duration on fixed income while opting for higher-yielding debt.
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