2021 mid-year outlook
Summary
The economic outlook is positive at the mid-year point, thanks in large part to the significant economic stimulus packages over the past year, but all this growth may come at a price.
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How inflation can be an opportunity for active fixed-income investors
Summary
Rising prices for goods and services are one of the biggest risks for investors in conventional government bonds. But there are ways for active managers to generate positive returns from rising – and falling – inflation.
Key takeaways
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What’s ahead for the rest of 2021?
Overall, economic growth has returned forcefully after last year’s severe pandemic-related slowdown, bringing a boost to capital markets – though growth will likely remain below the pre-pandemic growth trend for years (see chart). While the Covid-19 crisis isn’t over, vaccines are helping some parts of the world turn the corner and the hope is that pandemic risks will decrease as the year progresses. This boom in the economy and markets comes at a potential price – not least a rise in inflation. Investors will also need to navigate uneven levels of economic growth across countries and sectors. And with diverging amounts of fiscal and monetary stimulus around the world, policymakers are responding in a way that investors will want to factor into their strategies.
Investment implications
- A spike in inflation this year – and potentially beyond – makes it important to preserve purchasing power with additional sources of return.
- The recent jump in inflation was a major factor behind the US Federal Reserve’s decision to implement small rate hikes in 2023. The market has also been expecting the Fed to start “tapering” its bond-buying, probably in 2022. Both these moves could trigger some volatility depending on how they are managed by the Fed.
- We still have a bias for risk assets – albeit with some caution. As such, we don’t think investors should “de-risk” their portfolios, but rather consider a more neutral position along the risk/return spectrum – at least for the short term.
GDP forecast (2020-2021)
Source: Bloomberg, Allianz Global Investors. Data as at May 2021.
Key takeaways for investors
In this “lower for even longer” environment, keep an eye on inflation
Governments and central bankers dug deep in their pockets to address the Covid-19 crisis, and economic stimulus will continue to be a major factor for financial markets in the second half of 2021. It will likely be lower than the record-setting levels implemented last year, and some emerging markets are expected to raise interest rates. Still, stimulus will likely keep flowing in developed markets – particularly in the US. This is raising concerns about “nanny capitalism”, with central banks effectively beholden to their governments by funding this spending. Major central bank balance sheets are at all-time highs and rising (see chart).
One consequence of this stimulus has been a notable spike in inflation that started in the second quarter. The Fed has already reacted by announcing small rate hikes in 2023, and other central banks could follow. But we continue to believe that over the long term, real interest rates (which are adjusted for inflation) will stay low compared with their long-term averages. That’s because economic growth is also likely to stay low, and economic growth and interest rates historically track each other relatively closely.
Investment implications
- Fixed income. We have a bias for keeping durations short. Many bonds are expensive, including sovereign, investment-grade and high-yield debt. If bond markets get nervous about inflation and central bank action, yields may rise (and prices fall). Investors will want to manage their positions actively in this environment, but lower prices may also present an attractive opportunity. Income replacement will continue to be a challenge in today’s low-yield environment.
- Equities. Central bank liquidity and a general “risk-on” attitude have pushed up the prices of equities. US stocks are expensive – perhaps they’re even in bubble territory – but could move higher in the near term. European and Asian equities are cheaper. We favour the value style of investing over growth but, in the long run, tech stocks have an important role to play. Focusing on companies that emphasise sustainable business practices – including environmental, social and governance (ESG) issues – can help investors navigate a possibly bumpy road ahead.
- Risk management. Consider agile risk management strategies. In a low-yield environment, many investors acknowledge that they will need to take more risk to achieve their objectives. The key is to take this risk in a managed way.
Central banks have ramped up already massive asset purchases
Monetary base (bank reserves + money in circulation) as a % of GDP
Source: Bloomberg, Allianz Global Investors. Data as at May 2021.
Setbacks in Chinese equities are opportunities to re-establish a longer-term position
After China’s authorities successfully managed the country out of the Covid-19 crisis last year, and reported stellar year-over-year GDP numbers in early 2021, equity markets sold off dramatically in February and March. China’s internet-sector clampdown earlier this year played a notable role, as did profit-taking among previous stockmarket winners. Since then, equities have moved mostly sideways. Through it all, corporate China has been doing well, with most companies meeting or exceeding expectations, and many reporting strong underlying demand. But the internet sector remains under a cloud, and valuations are set to remain under pressure.
China’s economic policies during the pandemic have been arguably the most orthodox of any major central bank around the world, and China has been the only major economy to tighten fiscal and monetary policy. But while the natural inclination of China’s policy makers is to take proactive steps to prevent the build-up of inflationary pressures and asset bubbles, the extent of any policy tightening for the rest of the year will likely be constrained.
Investment implications
Over the longer term, we continue to see compelling reasons to invest into China. It is a relatively volatile asset class, so it’s important for investors to have a long-term perspective and consider their comfort level with drawdowns.
- Equities. In the short term, we would not be surprised to see more consolidation in China’s equity markets, but the recent pullback was a healthy development that helps set a more solid foundation for the future. Still, the extreme profit taking has subsided, as seen in the performance of growth stocks in the China A-shares markets (stocks traded in Shanghai and Shenzhen), which have made up lost ground on value stocks (see chart). It remains extremely important to be selective, and ESG factors can be a good lens through which to identify companies that will continue to thrive in this environment.
- Fixed income. “Onshore RMB” bonds (those traded in mainland China and denominated in CNY) offer an attractive opportunity to international investors. This is primarily thanks to their higher yields, compared with bonds from other major economies, and the diversification potential provided by their low correlations with other asset classes.
China A-share growth stocks have made up lost ground
MSCI China A Onshore Index – growth vs value (2021 year to date; in USD; indexed)
Source: Refinitiv Datastream, Allianz Global Investors. Data as at 21 April 2021.
The MSCI China A Onshore Index is an unmanaged index that captures large- and mid-cap companies listed on the Shanghai and Shenzhen exchanges. Investors cannot invest directly in an index.
Sustainable investing is the new standard
Global ESG assets under management reached USD 1.7 trillion last year, according to Morningstar, and over a third of global AuM now applies ESG criteria (see chart). This growth is set to continue, accelerated by the Covid-19 pandemic. Investors are increasingly convinced of the essential role that sustainable approaches play in driving investment performance and helping to manage risk. In particular, independent data shows the outperformance of actively managed ESG funds over their passive counterparts during the start of the pandemic, underscoring the value of an active approach to sustainable investing.1
In the post-pandemic recovery, ESG factors will be critical for assessing a new array of risks and identifying previously unknown opportunities. This should make investors more comfortable taking a “risk-on” stance, but we also urge caution. Economic growth paths – and monetary policies – are diverging, but real economic growth overall will likely be lower. Assessing companies across the spectrum of ESG factors – and actively engaging with them to influence change – will be critical to test their resilience against this backdrop. The key is to identify those factors that are most influential for each individual company – such as greenhouse gas emissions, workers’ rights and executive pay – and encourage them to increase transparency.
Investment implications
- Look for ways to invest in green infrastructure, which will be a post-pandemic focus for governments that have pledged to “build back better”. An array of projects will require funding, and we at Allianz Global Investors are committed to helping position our clients for these long-term investment opportunities.
- Incorporate ESG factors into everyday decision-making to test companies’ resilience in a challenging investment environment, and to drive change on urgent issues.
- Consider investments aligned with the United Nations sustainable development goals (SDGs). This may include investments that improve access to clean water and food security.
- Explore growing opportunities in green debt. The pandemic and green infrastructure spending likely provide scope for new issuance.
- Many institutional investors are using impact investing in the private-markets space, in areas such as renewable infrastructure and development finance. It’s a highly effective way to promote inclusive and sustainable growth in emerging and frontier markets.
Over a third of global AuM now applies ESG criteria
ESG-compliant AuM of UN PRI signatories vs global AuM
Source: UN PRI (United Nations Principles for Responsible Investment). Data as at 2020.
Our 2021 mid-year regional outlooks
Multiple factors have boosted the economy and corporate earnings – including the successful vaccine rollout, a decline in Covid-19 cases, low interest rates and ongoing fiscal stimulus. But rising inflationary pressures and potential tax increases could turn into headwinds in the second half of the year.
Although financial markets have done well in 2021, we expect bouts of volatility throughout the year. The markets could have an ongoing bias towards value and cyclical sectors. Financials could benefit from a higher yield/steeper yield-curve environment, while energy and commodities should continue to perform as the global economy reopens. Parts of infrastructure, clean energy and 5G are all supported by President Joe Biden’s policy agenda.
Given strong growth and rising inflation, yields may continue to grind higher. This may put more downward pressure on long-duration assets/sectors, including investment-grade corporate bonds and sectors such as growth and technology.
After a weak start to the year, economic activity has moved up a gear. A strong and broad-based rebound is possible once virus-containment measures are eased more markedly and private consumption picks up. Inflation looks set to peak in 2021 before moderating in 2022. Any economic recovery will continue to depend on economic policy support, and the European Central Bank’s monetary policy remains accommodative overall.
Amid continued pandemic-inspired uncertainty, accelerating growth should help corporate earnings – which will likely be the main driver of equity returns in 2021. Although we expect longer-term government bond yields to rise moderately, led by the US, rising inflation may be temporary and the overall low-yield environment should remain intact.
We expect the economy to continue to rebound thanks to a swift vaccine rollout and the broader reopening. This will enable a catch-up in consumer spending – unleashing the high levels of household savings accumulated during the pandemic. Fiscal policy should remain supportive even as post-pandemic stimulus fades towards the end of the year. Inflation is expected to rise during the second half, but underlying cost pressures are mounting only gradually.
Post-Brexit trade frictions (particularly non-tariff barriers) continue to weigh on exports, despite the EU trade deal agreed at the end of 2020. There is little definitive evidence yet that the slump in trade with the EU will be offset by stronger trade with the rest of the world.
Thanks to effective containment of Covid-19, China’s economy has largely returned to its trend growth rate. Fiscal and monetary policy support have begun to normalise, which could be less helpful for risky assets, but China’s authorities will remain vigilant to prevent any issues from arising. Strained relations with the US may yet have an impact on the outlook for China’s trade and finances.
The recent pullback in China’s equity markets should be viewed as a healthy development, bringing valuations to more attractive levels. China’s fixed-income markets also offer investors the kind of yields that are hard to find in other major economies, where rates could remain lower for even longer. Still, China’s markets are volatile, so investors should keep a long-term perspective.
Despite a recent rise in new Covid-19 cases, Japan has begun its vaccination programme and the delayed Olympic games are scheduled to take place in Tokyo this summer. Against this backdrop, we expect domestic demand to recover gradually during the second half. Meanwhile, Japan’s external demand (the sum of exports minus imports) looks set to remain firm thanks to a continued recovery in global capital expenditures.
Price pressures remain muted despite an improved growth outlook, so the Bank of Japan has sought to make its monetary policy framework more sustainable.
The global economic recovery and modestly weaker US dollar are helpful conditions for most emerging markets. Some EM central banks have already begun to tighten – including in Turkey, Brazil and Russia -- and the expected increase in inflation may lead even more to do the same.
The threat of a renewed pickup in Covid-19 infections is particularly acute in emerging markets. While their progress in tackling the pandemic continues to lag developed markets, they are set to make more progress on this score towards the end of 2021. We continue to expect the recovery in emerging markets to be both fragile and unevenly spread. Generally, those countries that have been most successful in containing the pandemic – such as South Korea and Singapore – look to be best positioned.
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12022: The growth opportunity of the century, PwC