Following the year-end rally, valuations of risk assets are marking a pause in the face of a number of headwinds. While in our view, valuations remain underpinned by ample central bank liquidity and the prospect, in the US, of further fiscal stimulus, we have become somewhat more cautious about the near-term outlook.
Further evidence of the rapid spread of the COVID-19 pandemic during the holiday period, along with the emergence of new variants of the virus, continue to lead authorities to reimpose strict lockdowns. In Europe, the Dutch government has extended the nation’s lockdown by three weeks and German chancellor Angela Merkel warned strict measures may last another 8-10 weeks. France, too, is moving toward a tighter lockdown, while the debate in the UK is focused on the need for more draconian measures. In Asia, the virus’s impact is still being felt, with Japan declaring a ‘soft’ state of emergency in Tokyo and the surrounding area.
These renewed restrictions, driven by worries about pressure on healthcare systems ( particularly evident across Europe and the US), are now expected to keep economic activity suppressed in the first quarter and delay the expected vaccine-driven recovery.
Rollouts of vaccines so far have been slow, with end-2020 targets missed in the US and progress only starting to accelerate towards ambitious goals in Europe. While the pace of vaccinations should continue to pick up, risks remain elevated. These include inefficacy against new virus mutations and mistrust among the population leading to a slow take-up.
In the US, Democrats have passed an impeachment article in the House of Representatives to hold President Donald Trump to account for the violence that erupted in the Capitol. We expect markets to continue to look through the political turmoil, however. The focus is more on continued support from the fiscal and monetary stimulus in place, ultra-low interest rates and vaccine distribution. Longer term, equity markets are supported by the prospect of unprecedented pent-up demand from a return to normal lifestyles.
Last week’s wins for the Democratic Party in the Georgia run-off Senate elections have led to greater expectations for more fiscal stimulus in the US. We expect about USD 1trn of further fiscal support to be enacted this year, including USD 350bn of stimulus cheques. This could push US annual growth to above 4% in 2021.
The reflation trade has driven a selloff in US Treasuries and pushed US 10-year breakeven rates of inflation to above 2%, driving a steepening bias in global bond curves. Base effects are also expected to push inflation higher, but there is little prospect of the Federal Reserve reducing its asset purchases until 2023.
Leading Fed policymakers have reiterated that the central bank’s accommodative stance should persist until there is substantial progress on its dual mandate of inflation and employment.
Against the current backdrop, support for equity valuations is being tested. We see some scope for further rotation into value stocks amid the prospect of higher growth and inflation. US equity risk premiums, which have fallen to below 15-year averages, may now act as a headwind to further gains, particularly for growth stocks. This comes on top of the possibility of tax increases and regulation by the new Democratic-led administration.
However, a vaccine-led recovery, particularly in the latter half of this year, could lift analysts’ earnings expectations for 2021 even further.
Similar to equities, value appears to have been squeezed out of credit spreads by the year-end rally. In our view, fundamentals support further limited spread compression with default rates expected to peak early this quarter at 7% and 6% in the US and Europe, respectively.
Monetary expansion by central banks globally and US real yields remaining in deeply negative territory continue to support gold prices. There is scope for the US dollar’s weakening trend to continue over the course of the year as the Fed reaffirms its accommodative stance.
Currencies that have so far lagged in the recovery, as well as cyclical and high-yielding emerging market currencies, should outperform amid improving terms of trade. Supportive financial conditions can continue to benefit emerging markets alongside the rollout of more affordable and less logistically challenging COVID-19 vaccines.
The key risk is now that the latest COVID-19 wave could prove more severe than expected, resulting in a more protracted downturn and further pressure on corporate fundamentals.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.
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