As we enter the last quarter of 2021, we believe that these are likely to be the main areas of focus for investors over the next 12 months, writes Maria Municchi, Multi Asset Fund Manager with M&G Investments.
- Growth and how this is affected by further COVID-19 developments
- Tapering and the influence of the US labour market and inflation backdrop
- Crucially, how sustainability is woven into global policy
Following the economic reopening that has occurred during 2021, following the COVID-19-induced downturn of 2020, GDP growth has been exceptional and contributed to positive earnings trends across countries and sectors.
However, we have recently observed some softening in the growth data, both from a sentiment perspective and an earnings revision standpoint. Manufacturing PMI readings descended from their peaks earlier this year in developed economies, though remaining healthy and well above the 50 threshold denoting economic expansion. Interestingly, China’s sentiment indicator, as measured by the Caixin PMI, has now dipped below the 50 mark, indicating some contraction in economic activity. Earnings revisions have softened somewhat, particularly in emerging markets in East Asia and elsewhere.
Overall, we believe that growth will continue to be affected by COVID-19 developments. However, further progress is likely to differ significantly across countries as, while most developed countries have now vaccinated a significant proportion of their population, many emerging markets are lagging behind and might be forced to introduce further lockdowns. This would not only affect the global economy but might also have a more significant impact across the value chain, with the potential for ongoing disruption to manufacturers across the globe.
While growth risks still lie ahead, supportive monetary policy is still in place in most countries to balance those risks. However, some of these accommodative policies look likely to be reined in in the near future. While a normalisation of accommodative policy is overall a positive growth signal, the fear of a more abrupt policy change might trigger market volatility.
The market is expecting the US to start tapering its monetary policy towards the end of 2021. However, as Fed chairman Jerome Powell reminded us in a recent speech at Jackson Hole, the actual timing and scale of it will depend on a number of factors.
First of all, the state of the labour market in the US; although unemployment has decreased significantly in the past year, it is still elevated relative to pre-COVID levels and labour force participation is still lagging despite unemployment benefits having now largely expired. High frequency employment data also remains volatile, with the latest payroll numbers significantly lagging expectations. Overall, given the current state of the US labour market, a rapid and steep increase in rates still feels premature.
Secondly, inflation will continue to play a key role in the Fed’s tapering strategy. After reaching peak levels in the US earlier this year, inflation remains relatively elevated as economies reopen but COVID-related supply chain issues and labour market imbalances persist. However, current inflation is mainly considered to be temporary, because structural factors for deflation such as technology, globalisation, and possibly demographic, remain in place across the globe.
Different elements of sustainability, from renewable energy to carbon emissions curbs, to social cohesion efforts, are starting to be woven into global policy. The better understanding and measurability of positive and negative effects on third parties enables governments (and investors) to monitor and, in some cases, influence, behaviour across sectors and asset classes. It is crucial for investors to understand how these trends might affect outcomes within financial markets.
For example, the Biden administration is working to pass a new US$4 trillion bill in Q4 2021, which will provide additional spending and incentives targeted to infrastructure but also climate change mitigation and adaptation projects, as well as social support. Depending on the outcome of the negotiations, the spending efforts could partly be financed by tax increases. The balance between incentives and disincentives will play an important role going forward in the efforts to achieve a more sustainable economy and will have a significant impact on the financial outcomes of different sectors and asset classes.
Strategic and tactical asset allocation
In the current environment, our key strategic observation is that, despite historically low yield levels across asset classes, equity markets remain more attractive over the long-term than fixed income exposure.
Equity risk premia increased slightly over the summer months as equity gains were well-supported by earnings growth and bond yields retraced somewhat. This provided us with an opportunity to reduce our exposure to government bonds slightly, shifting the portfolios more towards equities. Tactical investment opportunities are currently more muted, and we observe investors’ sentiment generally being cautiously optimistic (as they closely monitor the Delta variant).
Overall, we are somewhat more cautious on duration than previously but expect yield rises to be limited and for government bond exposure to remain a good diversifier should the growth outlook deteriorate. We see some longer-term opportunities in sustainability trends, including renewables, circular economy and social housing. We are also finding more prospects in thematic emerging market bonds, due to recent issuance and the weakness experienced in the last few months.
We continue to closely follow those key areas and to observe changes to market and investor behaviour in the coming months. However, we are positioned to benefit from a continued economic recovery and long-term growth in specific areas, while retaining some diversification and having the ability to make more tactical changes to our portfolios should opportunities occur.
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