A new investment order

New playbook needed

The traditional business cycle playbook does not apply to the pandemic. We see the shock as more akin to that of a large-scale natural disaster followed by swift economic restart. Early in the crisis, we assessed that the ultimate cumulative economic losses – what matters most for financial markets – would likely prove to be a fraction of those seen in the wake of the global financial crisis (GFC).

This view was conditional on robust policy support to tide households and businesses through the income shock. The early results of Covid-19 vaccine trials give us greater confidence in this framework. They suggest the economic restart can re-accelerate significantly in 2021 as pent-up demand is unleashed. Markets will likely be quick to price in a full economic restart given the better visibility on the outlook.

Restart challenges

The U.S. and Europe face challenges in the very near term: A resurgence of virus cases may result in outright economic contraction. Risks of policy fatigue are rising, especially in the U.S., and ongoing policy support is vital to limit any permanent economic scarring. Yet positive vaccine news is a game changer in that we now know we are building a bridge to somewhere, providing clarity for policymakers, companies and markets about getting to a post-Covid stage.

Whole portfolio resilience

As a result, we favor looking through any near-term market volatility. We increase our overall pro-risk stance by upgrading equities on a tactical basis, and take a sectoral approach. We like tech and healthcare due to the pandemic’s transformative shifts – and balance this with a preference for prime beneficiaries of the economic restart, such as emerging market (EM) equities and U.S. small caps. We are overweight Asia ex-Japan equities and Asia fixed income on the region’s effective virus response, and favor assets exposed to Chinese growth.

The policy revolution has big implications for our strategic views as we see a more muted response of nominal yields to a higher inflation regime. Central banks appear committed to limit any rises in nominal yields even as inflation picks up. Investors will need a new playbook to navigate this. We underweight government bonds and maintain a higher strategic allocation to equities than in typical periods of rising inflation.

Sustainability is a key component of our views as we see a tectonic shift to sustainable assets playing out over decades. Contrary to past consensus, we expect this shift to help enhance returns. Private market exposures are one way to pursue portfolio resilience with a sustainable lens.

Read our full 2021 Global Outlook PDF report

Directional views

Strategic (long-term) and tactical (6-12 month) views on broad asset classes, December 2020

Asset	Strategic view	Tactical view
Equities
We are neutral on equities on a strategic horizon given increased valuations and a challenging backdrop for earnings and dividend payouts. We tilt toward EM equities. Tactically, we have upgraded equities to overweight as we expect the restart to re-accelerate and rates to stay low. We like a barbell approach: quality stocks balanced with selected cyclical exposures.

Credit
We are neutral on credit on a strategic basis because we see investment grade (IG) spreads offering less compensation for any increase in default risks. We still like high yield for income. On a tactical horizon, we see the economic restart and ongoing policy support helping credit perform, even amid tighter yield spreads and the wind-down of some emergency credit support.

Govt Bonds
The strategic case for holding nominal government bonds has materially diminished with yields closer to perceived lower bounds. Such low rates reduce the asset class’s ability to act as ballast against equity market selloffs. We prefer inflation-linked bonds as we see risks of higher inflation in the medium term. On a tactical basis, we keep duration at neutral as policy accommodation suppresses yields.

Cash
We are neutral and use cash to fund overweights in equities and credit. Holding some cash makes sense, in our view, as a buffer against the risk of supply shocks that could drive both stocks and bonds lower.

Private markets
Non-traditional return streams, including private credit, have the potential to add value and diversification. Our neutral view is based on a starting allocation that is much larger than what most qualified investors hold. Many institutional investors remain underinvested in private markets as they overestimate liquidity risks, in our view. Private markets are a complex asset class not suitable for all investors.

Note: Views are from a U.S. dollar perspective, December 2020. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding any particular funds, strategy or security.

Our granular views indicate how we think individual assets will perform against broad asset classes. We indicate different levels of conviction.

Tactical granular views

Six to 12-month tactical views on selected assets vs. broad global asset classes by level of conviction, December 2020

Equities

Asset		Tactical view
United States
We have upgraded U.S. equities to overweight. We see the tech and healthcare sectors offering exposure to structural growth trends, and U.S. small caps geared to an expected cyclical upswing in 2021.

Europe
We have downgraded European equities to underweight. The market has relatively high exposure to financials pressured by low rates. The region faces structural growth challenges, even given potential for catch-up growth in a post-vaccine world.

Japan
We are underweight Japanese equities. Other Asian economies may be greater beneficiaries of more predictable U.S. trade policy under a Biden administration. A stronger yen amid potential U.S. dollar weakness may weigh on Japanese exporters.

Emerging markets
We are overweight EM equities. We see them as principal beneficiaries of a vaccine-led global economic upswing in 2021. Other positives: our expectation of a flat to weaker U.S. dollar and more stable trade policy under a Biden administration.

Asia ex-Japan
We are overweight Asia ex-Japan equities. Many Asian countries have effectively contained the virus – and are further ahead in the economic restart. We see this region’s tech orientation allowing it to benefit from structural growth trends.

Momentum
We keep momentum at neutral. The factor could face challenges in the near term as a resurgence in Covid-19 cases and risks of policy support create potential for choppy markets.

Value
We are neutral on value. The factor could benefit from an accelerated restart, but we believe that many of the cheapest companies - across a range of sectors - face secular challenges that have been accelerated by the pandemic.

Minimum volatility
We are underweight min vol. We expect a cyclical upswing over the next six to 12 months, and min vol tends to lag in such an environment.

Quality
We are overweight quality. We like tech companies with structural tailwinds and see companies with strong balance sheets and cash flows as resilient against a range of outcomes in the pandemic and economy.
Size
We are overweight the U.S. size factor. We see small- and mid-cap U.S. companies as a key place where exposure to cyclicality is likely to be rewarded amid a vaccine-led recovery.

Fixed income

Asset		Tactical view
U.S. Treasuries
We are underweight U.S. Treasuries. We see nominal U.S. yields as staying rangebound, but real yields declining amid rising inflation expectations. This leads us to prefer inflation-linked over nominal government bonds.

Treasury Inflation-Protected Securities
We are overweight TIPS. We see potential for higher inflation expectations to get increasingly priced in on the back of structurally accommodative monetary policy and increasing production costs.

German bunds
We are neutral on bunds. We see the balance of risks shifting back in favor of more monetary policy easing from the European Central Bank as the regional economic rebound shows signs of flagging.

Euro area peripherals
We are overweight euro area peripheral government bonds despite recent outperformance. We see further rate compression due to stepped-up quantitative easing by the European Central Bank and other policy actions.

Global investment grade
We have downgraded investment grade credit to underweight. We see little room for further yield spread compression and favor more cyclical exposures such as high yield.

Global high yield
We have trimmed our overweight in global high yield. Spreads have narrowed significantly, but we believe the asset class remains an attractive source of income in a yield-starved world.

Emerging market - hard currency
We have upgraded hard-currency EM debt to neutral. We expect it to gain support from the vaccine-led global restart and more predictable U.S. trade policies.

Emerging market - local currency
We have upgraded local-currency EM debt to neutral. We see catch-up potential as the asset class has lagged the risk asset recovery. Easy global monetary policy and a stable-to-weaker U.S. dollar should also underpin EM.

Asia fixed income
We are overweight Asia fixed income. We see the asset class as attractively valued. Asian countries have done better in containing the virus and are further ahead in the economic restart.

Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index. Note: Views are from a U.S. dollar perspective. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast or guarantee of future results. This information should not be relied upon as investment advice regarding any particular fund, strategy or security.

Preparing for higher inflation

Rising inflation in the medium term is core to our investment views, but we believe this will have very different effects than in the past.

The “new nominal” is not simply about our expectation for a higher inflation regime in the next five years. It means stronger growth in the near term, and eventually higher inflation - without the typical rise in nominal bond yields. As a result, we see very different market implications than in the past. Previous episodes of rising inflation were costly for investors, leading to higher interest rates that pressured valuations across many asset classes via rising discount rates. Yet the policy revolution means any rise in inflation from today’s levels will likely be better for risk assets than in past episodes.

Central banks have signaled they will be more willing to let economies run hot with above-target inflation by changing their policy frameworks to make up for prior inflation undershoots. At the same time, the fiscal-monetary policy revolution – a necessary response to the Covid-19 shock – risks greater political constraints on central banks’ ability to lean against inflation. We see central banks likely curbing nominal yield rises to prevent an unwanted tightening of financial conditions.

We see other reasons for higher inflation, as detailed in  Preparing for a higher inflation regime. Production costs are set to rise on the rewiring of global supply chains, while we see scope for corporates to exert their pricing power to protect profit margins. Corporate cost cutting may mitigate inflationary pressures in the near term. But even the moderately higher inflation in our base case – around 2.5-3% annually – would surprise markets after a decade of undershoots. See the Under-appreciated inflation risks chart.

Developed market government bonds in portfolios are challenged; with yields near effective lower bounds and central banks limiting yield rises even as growth picks up, we believe they will be less effective as portfolio diversifiers. Real yields look to be headed lower – one reason why we favor inflation-linked securities on a strategic basis.

Importantly, we believe this new nominal of constrained nominal bond yields will support risk assets. As a result, we are tactically more pro-risk and maintain a higher strategic allocation to equities than if higher inflation were to have its typical impact on nominal yields.