Asset Allocation Views: Early Cycle Investing
2020 was an extraordinary year for financial markets. The pandemic was a black swan event that caused the biggest quarterly drop in global GDP and increase in unemployment since the Great Depression, and the drawdown in equity and credit markets was one of the fastest on record.
Yet, if the market meltdown was unprecedented, so was the recovery that followed. We believe the global economic recovery is poised to continue in 2021 and will gain strength once vaccines are broadly deployed and the world starts to return to normal social distancing.
As our latest Asset Allocation Outlook discusses in detail, we expect profit growth will accelerate, and the improvement in fundamentals should bode well for risk markets and cyclical assets in particular. We remain overweight equities in our multi-asset portfolios and select areas of the credit markets and have added exposure to more cyclically oriented sectors and regions.
To be sure, PIMCO expects the economic recovery will be a “long climb” with hiccups along the way (as we discussed in a June 2020 blog post), and it could take up to two years to reach pre-COVID-19 levels of global output. The two key swing factors – virus containment and fiscal policy support – will greatly influence the recovery process.
As a result, we continue to focus on portfolio diversification and resiliency.
Equity versus credit
Increased earnings growth is positive for both equities and credit, but it provides a more significant tailwind for equity markets. This is why, historically, equity markets have generated higher risk-adjusted returns during the early stages of a business cycle.
The Fed’s commitment to overshoot its inflation target is also supportive for equities, which look attractive given what is likely to be an extended period of negative or low real yields.
In addition, with monetary policy constrained by near-zero interest rates in most of the developed world, fiscal policy will need to do the heavy lifting. The size and the scope of fiscal response is bound to have critical implications for both the economic recovery and asset prices.
The recovery in activity and improvement in corporate profits should support cyclically sensitive assets, which have meaningfully lagged market leaders like big tech since the market bottom in March. The global manufacturing recovery should bolster sectors such as industrials, materials, and semiconductors. Focused fiscal stimulus and healing in the labor market should aid personal savings and consumption, benefiting the housing and consumer durables sectors. However, we remain cautious on transportation and hospitality, which could face earnings challenges for several years. From a regional perspective, we expect cyclically oriented equities – such as in Japan and select emerging markets – to benefit from the recovery.
We also continue to seek opportunities in sectors that may benefit from longer-term disruption. These include technology companies, which are supported by strong fundamentals and stand to benefit further from secular trends accelerated by COVID. The U.S. and China remain dominant players in the global technology sector, but we are also looking to take advantage of themes playing out in other regions, such as green energy in Europe and automation in Japan.
Credit spreads have tightened meaningfully since March and April, and while we believe credit is less attractive than equities on a relative basis, we see pockets of opportunity.
Within corporate credit, sectors are recovering at different paces depending on how the pandemic affected them. We are cautious on high yield credit, especially in areas that might face funding needs in the second COVID wave, but we see value in higher-quality investment grade issuers and sectors. We continue to favor housing-related credits (mainly in the U.S.) given strong fundamentals. In emerging market credit, we see attractive opportunities but prefer to take exposure in more liquid instruments.
Key risks, and diversifiers
The major near-term risk is that virus containment efforts hinder the economic recovery.
We believe high quality duration (government bonds) will continue to be a reliable source of diversification against a growth shock despite yields at historically low levels. U.S. Treasuries have more room to rally than most developed market government bonds and are likely to remain the flight-to-quality asset of choice. We also favor select emerging market government bonds, including Peru and China, which offer yield advantage and have tended to perform well during risk-off events.
Another potential risk is an inflation surprise. We expect that inflation globally will remain subdued in the near term as the effects of the pandemic keep the price of goods in check. However, large fiscal injections, climbing government debt, and accommodative central banks could lead to higher inflation in a post-COVID world.
We are focused on assets that can serve as both an inflation hedge and a diversifier in a scenario of weakening economic conditions. This includes inflation-linked bonds and gold, which we believe provides a good store of value over the long term with a low correlation to traditional risk assets. (We discuss gold valuations in this recent blog post.) We are avoiding more growth-sensitive real assets – such as energy commodities – given our expectations for a gradual economic recovery with meaningful downside risks and low or negative real yields for years to come.