Max Gokhman: Overall, we believe that this will be a positive year for risk assets, by which I mean equities and spreads products like high yield and emerging markets debt. The reason is that we are emerging from a global recession that was as short as it was sharp.
According to our quantitative business cycle model, the recession ended last October. A US double dip appears unlikely due to additional vaccine approvals and a Blue Wave in Washington that should bring abundant fiscal stimulus to American shores. All that provides significant tailwinds for risk assets.
“According to our quantitative business cycle model,
the recession ended last October.”
So even though there are pockets of froth in areas where supply has been really constrained and demand has remained high, we think that it is healthy to satiate your risk appetite this year.
Max: We believe the US is where you want to be because of its bigger bandwidth for fiscal stimulus and infrastructure for faster vaccine rollouts than any other major market.
Once we get past the initial hiccups, we will be looking at a sustained above-trend recovery, especially as inoculated consumers start spending the savings they accumulated last year in an unprecedented release of pent-up demand.
Outside of the US, emerging markets and especially emerging Asia is the second favourite region for us.
There are several reasons for this. Firstly, Asian nations generally have generally handled the pandemic the best, avoiding the second and third waves seen across most other regions. As a result, their economies are further along the path to sustainable reopening.
“Outside of the US, emerging markets and especially emerging
Asia is the second favourite region for us.”
Secondly, as the rest of the world recovers, there is going to be more demand for Asian exports. For instance, semiconductors have seen a resurgence in sales and we think that is going to continue, especially with secular trends like automation and the Internet of Things.
Thirdly, commodity exporters should do well once infrastructure projects, which are often part of fiscal stimulus measures, come online. This should have the commodity cycle stabilising and continuing to improve after a pretty rough drawdown in 2020.
The other regions we consider are Europe and the UK, which we do separate out now. Here, we believe that even though there was an eleventh-hour Brexit deal, there are going to be negative consequences, as the nearly inevitable logistic nightmares heighten the potential for a double dip recession both in the EU and the UK.
If the EU can pass their unified stimulus, that's going to be a bit of a backstop, but I'm not sure if even that's going to be sufficient to prevent dipping down into recessionary territory again.
Max: Within equities, our favourites are small cyclical names. The Russell 2000 value would be probably the cleanest way to express that. These names are the most tied to the economy, which means they should see the greatest positive effects from US stimulus.
A lot of small cap firms are also the issuers of high yield debt. Thus, the Fed’s accommodative stance that Chair Powell indicated will remain in place indefinitely is especially helpful for those that are highly leveraged.
We saw small caps’ high leverage as a major early in 2020, which is why we were overweight large growth companies with their stronger balance sheets, which did obviously really great through the downturn.
But we've since completely reversed that position because small caps are looking to be the biggest beneficiaries of all the monetary and fiscal stimulus.
And then when we look at valuations, there are few investors who would disagree that large growth names, especially consumer facing mega cap tech, are stretched.
“Within equities, our favourites are small cyclical names.”
With value and especially small value, the valuations are much more attractive even after the run up from the fourth quarter through the start of this year especially considering their robust sales growth forecasts.
Even if you look at it from just a simple Econ 101 perspective, when the economy is entering a recovery phase – that will bring above trend growth and that's when smaller names and value names tend to do well.
Now, the reason why we haven't seen value or small cap outperformance over the prior decade is because the recovery that we had after the 2008 financial crisis was actually quite shallow.
The key theme of that recovery was very long-term, but very low-rate GDP growth. And that's not an environment where lower earnings growth stocks tend to do well.
We're in a very different environment, coming out of the coronavirus recession in 2021.
“We no longer like large growth because of those
stretched valuations.”
Conversely, we no longer like large growth because of those stretched valuations as well as greater government scrutiny in terms of regulation and fines, not just in the US but also in the EU. We see reigning in “Big Tech” like Facebook, Twitter, Alphabet and Amazon as one of the few bipartisan issues.
Aside from regulatory headwinds vaccinated consumers moving away from screens and shifting their spend to in-person services rather than goods will put a dent into online advertising revenue that drives profits for most of these firms.
The final pillar of this is there's a lot more infighting. For instance, Apple is planning an update to its operating system that's will allow users to prevent companies like Facebook from tracking them outside of their app. That's going to really make it difficult for those companies to do targeted advertising.
Moving from equity to fixed income, we like credit and specifically high yield and emerging market debt. We think with high yield, it's really a function of not fighting the Fed.
“The other asset class we like within fixed income is local
currency emerging market debt.”
To keep it quite simple, we think defaults have been largely staved off and now companies can roll their debt over into a lower rate and effectively kick the can down the road..
At the same time, investors are, as they have been for some time, starved for yield. They see few options but to venture into the riskier sections of the fixed income market. And that's momentum that we can get behind. At least until there’s a whiff of tapering, which we don't think will happen this year, and potentially not even until late next year.
The other asset class we like within fixed income is local currency emerging market debt. Sovereign emerging issuers have generally done a decent job of lowering leverage to the point where it’s lower than similarly-rated US corporate issuers. Plus, their central banks that have been relatively pragmatic.
For example, Argentina restructuring their debt makes us a bit more comfortable given the macro picture and the commodity cycle coming back, that emerging markets can do quite well, at least over the coming year.
