Financial markets have been rumbled by a surge in real yields together with a fall in inflation expectations. This has posed a significant challenge to equities.
Did yields rise because of expectations of more economic growth, and higher corporate profits, or are markets anticipating some monetary tightening by the US Federal Reserve to forestall inflation? We think growth rather than inflation-busting is behind the higher yields, which should be positive for equities. We expect the drop in inflation expectations to not last given the prospect of more stimulus spending and of a post-COVID surge in demand meeting limited capacity.
The other main market driver is vaccination. In the US and UK, the rollouts are making steady progress, but the eurozone is lagging behind.
In terms of our asset allocation views, this environment in combination with the market dynamics suggests medium-term upside for risky assets. Admittedly, bullish technical signals are starting to appear in some equity markets, but our indicators are still advocating caution, with sideways moves expected during early 2021.
- We are slightly long on equities overall.
- We are long emerging market equities given our view that China/Asia growth will remain strong.
- Equity risk premiums are still high relative to real bond yields in the US, so equities are an attractive option even if valuations appear high. We are long EMU small caps versus large caps.
- In government bonds, we are short EMU bonds, expecting term yields to see upside pressure as the economic outlook improves on the back of vaccination campaigns.
- Being long EUR inflation-linked debt gives our portfolios upside in reflationary environments.
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