The new nominal, accelerated

The Democrats’ newly gained majority in U.S. Congress paves the way for greater public spending but the narrow margin limits the scope for higher taxes, in our view. We expect this outcome to speed up “the new nominal”, or our expectations for stronger growth coupled with stable nominal yields, even as a more infectious virus strain threatens to make the path to a full activity restart more bumpy.

Chart of the week
Performance of U.S. mega-cap and small-cap stocks, 2020-2021

The new virus strain has sent hospitalizations spiking in the UK where it was first detected, and is spreading globally, posing serious challenges to efforts to beat back the virus. It could delay the activity restart in the near term and increase the time needed for the economy to return to its pre-virus trend. Yet ultimately we still expect the cumulative economic activity loss from the Covid shock – what matters for markets – to be just a fraction of that seen after the global financial crisis, and believe investors should look through any market volatility triggered by evolving virus dynamics. The rollout of vaccines is off to a slow start, yet we believe once vaccination becomes widespread it will allow a more forceful restart due to the pent-up demand. As part of our overall pro-risk stance, we are overweight U.S. small- and mid-cap stocks as we see them benefitting from the vaccine-led restart. The prospects for more fiscal spending under a united Democratic government could further fuel the ascent of small caps, after they have significantly outperformed mega caps since the U.S. election, as the chart shows.

We expect significant fiscal support relative to a scenario of ongoing Republican control of the Senate. This could accelerate our new nominal theme, pushing inflation higher over time but with the Federal Reserve keeping the rise in U.S. Treasury yields in check. It also reinforces our turbocharged transformations theme, including the tectonic shift toward sustainability. A Democratic majority could pave the way for major green investment. Last week’s market reaction was consistent with this view. Treasury yields breached 1% for the first time since last March, driven by increases in both inflation expectations and real yields. This suggests markets are likely to test the Fed’s resolve to lean against any excessive climb in nominal yields. We expect greater fiscal spending to be largely funded through increased deficits rather than higher taxes, given the Democrats’ slim majority in both chambers of Congress. The policy revolution has brought on greater tolerance for higher debt globally, yet just how long such attitudes could last is key. Modest increases in corporate taxes may be possible, but large-scale changes including raising taxes on high-income earners, appear unlikely, in our view. Democratic control of the Senate will likely lead to smooth confirmation of nominees to head the regulatory agencies that are crucial for policymaking.

The first half of 2021 is likely to be a choppy ride. The pandemic poses serious challenges to public health and the activity restart, while we see more policy support in the U.S. on top of the recent $900 billion fiscal package. We advocate a barbell approach to risk exposures, with selected cyclicals such as U.S. small-caps and emerging market equities on one end and quality assets including U.S. and Asia ex-Japan equities on the other. We also like tech and healthcare. These sectors benefit from structural trends turbocharged by the pandemic and their strong balance sheets and cash flows provide some resilience against volatility. Yet we recognize U.S. tech could face challenges from greater regulation and corporate taxes.

Bottom line: The new slim Democratic majority in Congress boosts our expectations for more public spending without commensurate tax increases. We also expect a strong vaccine-led restart later in the year. All this reinforces our view on growth, rates and inflation, and underpins our preference for inflation-protected securities over nominal U.S. Treasuries. We expect the Fed to lean against any further spike in nominal bond yields. We remain pro-risk overall, favoring overweights in both equities and credit, but see a potentially bumpy path for asset prices broadly, especially as markets have moved a lot since we published our 2021 global outlook in early December.

Download the full commentary

Read our past weekly commentaries here.

Assets in review
Selected asset performance in the past 12 months

Market backdrop

U.S. stock markets rallied to record highs and bond yield rose after the Democrats won two Senate runoff elections in Georgia and gained a slim majority in Congress. President-elect Joe Biden can now push through policy priorities, including regulatory appointments, fiscal stimulus and spending on green initiatives, whereas the Democrats’ narrow majority limits large-scale tax increases. Markets largely shrugged off rioting on Capitol Hill that interrupted Congress’ certification of the presidential election result. The vaccine rollout has been slow as a more infectious strain of the virus is spreading, but we don’t see it materially changing the cumulative economic impact of the virus shock.

Week ahead
Jan. 11 – China total social financing
Jan. 15 – University of Michigan Surveys of Consumers; U.S. industrial production

The pace of vaccine rollout amid a virus resurgence will stay in focus in a week of relatively few data releases. The University of Michigan Surveys of Consumers could shed light the health of consumer spending. The U.S. consumer sector, a key pillar of the economy, has shown signs of weakness in recent months. Retail sales declined for two straight months in October and November as Covid hospitalizations and restrictions grew.

Download the full commentary

Read our past weekly commentaries here.

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. It also faces structural growth challenges, even given potential for catch-up growth in a vaccine-led revival.

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 the 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 fading fiscal 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 structural challenges that have been exacerbated 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 and Asia fixed income.

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.

Download the full commentary

Read our past weekly commentaries here.