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The global economic recovery remains intact

 

12 August 2021

House view

 

 

 

 

Despite the Delta variant of COVID-19 gripping countries across the globe, and some indicators signalling the end of the economic recovery, our Chief Investment Office believes there is still the potential for further equity gains. Find out why.

Our view

The emergence of the Delta variant of COVID-19 has once again cast a shadow over the economic recovery and left some investors questioning whether it is in fact broken.

It has been quite an about-turn. Only a month ago investors were fretting about significantly higher economic activity, inflationary pressures and the prospect of the Federal Reserve (the Fed) tapering too quickly to bring the economy under control, with some even questioning the Flexible Average Inflation Targeting Framework (FAIT) introduced by the Fed only a year earlier.

With US 10-year treasury yields falling close to 40 basis points in a few weeks and cyclical value stocks slumping at the same time, it appears some investors believe the entire economic recovery - rather than just inflationary pressures - could be transitory. Indeed, with US 10-year real yields at -1%, breakeven inflation (a market-based measure of inflation expectations) at over 2% and a curve that is pretty flat, levels would imply a rather abrupt end to the current post-corona economic recovery - making it one of the shortest economic upswings in documented history.

To be clear, valuations remain as unappealing as ever, geopolitical tensions continue to simmer and the recovery appears more uncertain than a few months ago. However, similar to early 2020 we encourage investors to look through the noise and focus on their long-term investment strategy.

Despite issues with the Delta strain, data prints are still okay and we remain confident that the economic recovery is intact. In the US, earnings have been upgraded for 14 consecutive months and while inflation continues to be a concern, wage growth remains tepid (for now) leaving us confident of earnings prospects. We believe that the S&P can sustain these high multiples as long as real yields remain negative.

Regarding the FAIT, it appears there is confusion in the market as to what the Fed actually wants to achieve. The flatter curve appears to point to a focus on a 2 to 3-year horizon for inflation, however, if the Fed does actually look at longer term inflation (as we suspect it does) then the Economic Symposium at Jackson Hole, appears a good place to provide clarification on the framework. With the possibility of some taper talk mixed in, real yields could become higher and steeper quickly, providing an environment for the value trade to reemerge.

To summarise, it is our belief that the recovery is still intact, which coupled with the expectation of strong earnings revisions and the potential for higher yields, frames our view that there is scope for equities to grind higher from here. 

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Negative real yields allow for high multiples


Graph showing negative real yields allow for high multiples

Sources: FactSet Research Systems Inc., Bloomberg Finance L.P., DWS Investment GmbH as of July 2021.

What this means for our diversified portfolios

Market participants appear to be searching for the next anchor on which to set their course. As investor expectations move from one extreme to the other we see a more volatile path ahead for investment markets.

With the prospect of higher yields, we have elected to reduce duration in our portfolios by trimming our exposure to Australian bonds. This should provide some further cyclicality to the portfolio without increasing equity risk at a time when volatility could pick-up. Given this backdrop we don’t want to make significant change to the portfolio at one time. Rather, we maintain a mild overweight to developed markets equities, and if yields do pick-up as we anticipate there may be an opportunity to build our equity exposure further - via cyclical/value stocks - later in the month. Proceeds from the sale of the Australian bonds have been placed into cash.

ANZ investment strategy positions - August

Investment position
Asset class Reasoning
Growth Assets

 

Developed market equities

Our portfolios remain mildly overweight developed markets (DM) equities which continue to be our preferred exposure within growth assets.

Regarding our relative equity preferences, they currently hinge somewhat on our interest rate view and with the possibility of higher real yields and steeper curves, we believe the ‘value rally’ could resume. 

Considering investment styles within global developed markets we believe ‘quality’ and ‘cyclical’ stocks are likely to outperform ‘momentum’ in the near-term. In terms of sectors our favourite defensive quality segments remain healthcare and communications, and the favoured value and cyclical segments are financials and materials. The sectors expose some value qualities, offer likely beta to rising interest rates and are beneficiaries of higher economic growth.

Australian equities

The possibility of higher yields provides the potential for further upside for the domestic share market. Should this shift in yields materialise, cyclical stocks should benefit and with approximately 50% of the ASX 300 comprised of materials and financials (cyclical) stocks, Australian shares could outperform.  However, with volatility likely to pick-up in the near-term, and portfolios already holding a high strategic allocation to the domestic share market, we have elected not to increase our exposure to the asset class at this time.

We remain at benchmark and wait for further signals to consider building the position on any reasonable pullback.

Emerging-market equities

Last month we reduced our exposure to EM equities from a mild overweight to benchmark, citing a preference for more quality exposure and the lower probability of outperformance from the asset class in the near-term. Despite a more cautious stance on the asset class relative to its developed market peers, we retain our benchmark position this month on the basis of the potential for longer-term performance.

A stronger US dollar continues to represent a potential headwind for the asset class.

Listed real assets

We currently hold a benchmark position to Global REITs (GREITs) and a mild underweight position to listed infrastructure. Overall, this positioning results in a mild underweight to listed real assets.

While recent outperformance makes GREITs less attractive on a relative basis, it is too early to clip exposure, as it continues to offer an attractive dividend yield, diversifying effect for multi asset portfolios and a hedge against inflation.

We retain our mild underweight positioning towards listed infrastructure. Despite underperformance versus global equities having stabilised recently, within growth assets, we continue to see better relative opportunities in developed markets equities and GREITs.

Foreign Exchange Hedge Ratio*

Within our diversified portfolios we are at benchmark to the AUD. We prefer more developed market foreign currency exposure (in particular the USD) which should act as a form of protection in the event of any market pull-back.

 
Defensive Assets

 

International fixed income

We remain at benchmark to global fixed income and having trimmed our exposure to domestic bonds this month, will closely watch yield movements from here with consideration given to decreasing our current positioning should yields start to trend higher.

We continue to prefer credit versus sovereign bonds given monetary policy support, the hunt for yield and broader economic prospects.

Australian fixed income

Following our last investment committee meeting we decided to reduce duration in our portfolios, with a belief that real yields are likely to shift higher from here. This has been implemented via a reduction of Australian bonds, taking positioning in the asset class from neutral to underweight.

The Australian bond market is a higher beta market than many of its global counterparts and is therefore expected to underperform in the event of a broad based sell-off.  Additionally, global fixed income markets generally have a higher credit exposure which we currently favour over sovereign bonds. By reducing Australian bonds, we are increasing cyclicality in portfolios (we expect the value/cyclical trade could re-emerge) without increasing equity risk at the same time. The proceeds have been placed into cash where we are now at benchmark.

Cash

We have again increased cash in portfolios this month with proceeds from the sale of Australian bonds. We are now benchmark to cash which remains a defensive anchor and important source of liquidity for portfolios.

 

Notes:

*Percentage of developed market and emerging market equities hedged from foreign currency into Australian dollars.

Tactical Asset Allocation is current as at 1 August 2021.

 

 

To discuss what this insight could mean for you, talk to your ANZ Private Banker directly, or contact us below

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