Asset Allocation 2021 outlook: The year of hope

My takeaway from Tim’s economic outlook is that 2021 will be the year of hope. The fundamental backdrop he describes should boost equity markets in particular as investors start to see a potential end to the economic and social hardship of the past year.

But this isn’t just about optimism. We are only early in the economic cycle, with a meaningful output gap that can still be closed, while recession risk is low and there are limited inflationary pressures. Risk-adjusted equity returns from this point in the cycle have historically been strong.

Valuations are not a troubling headwind either. Equities may look expensive in absolute terms, but on a relative basis the equity risk premium – the equity earnings yield minus bond yields – remains attractive, in our view.

All things considered, our base case would therefore be that equities are among the best-performing asset class in 2021; we would not be surprised to see double-digit returns.

One point to note is that we are obviously not alone in this view. Sentiment has turned bullish for the first time since the pandemic, and at some point in 2021 it is very likely that markets will price in too much optimism. For now, though, we think this is too early to be a dominant factor.

Low pressure

We continue to believe in our ‘lower for longer’ theme in fixed income, seeing limited upside potential for bond yields from their current levels. We expect inflation dynamics will become more important than growth dynamics in determining bond yields once we get past the recession phase. That has been true for the past four cycles, but should be even more important now that the Federal Reserve (Fed) has indicated it will not react pre-emptively.

That should mean positive news on the vaccine rollout is unlikely to be enough to put sustained upward pressure on bond yields. We will also need evidence that inflation is moving sustainably above 2%, which is very unlikely to happen in 2021 with unemployment still extremely high.

On the corporate side, investment-grade credit is in our view less attractive than other risky assets like equities, given the compression in spreads seen since March. Today’s tight spreads are partly a reflection of subdued corporate bond defaults thanks to fiscal support, cheap financing and the prospect of a vaccine in 2021.

Returns from credit do not typically accrue evenly; instead, and perhaps understandably, they tend to be higher when starting spreads are wider. That suggests to us there is potential value in having space in portfolios to add significantly to credit in extreme selloffs. Admittedly, that comes at a cost – namely the returns given up by patiently waiting for a better entry point – but we believe it’s the right framework for thinking dynamically about credit for the medium term.

A low yield environment provides challenges for investors both from a return and a risk mitigation perspective. Though there is no single panacea, one of the measures we believe investors can take is to look at smaller, non-traditional fixed income markets to find better risk-off hedges. Smaller rates markets with higher yields that could still fall become more interesting and important, for example.