At the start of the year, our base case was for a very supportive macro backdrop. It has been even better than expected – the economic rebound is accelerating while monetary and fiscal support remains exceedingly strong (at least in the US).
Valuations are not cheap, and assets sensitive to duration moves have underperformed, but most things have done well this year thanks to such a terrific backdrop. So, when LGIM’s investment team gathered at our recent strategy week to discuss the market outlook, we sought to answer the question: why wouldn’t we simply roll this broadly positive view forward?
To help answer this, we debated six topics that could upset the trajectory.
1. When will the Fed allow financial conditions to tighten?
We’re in line with the consensus view that the current spike in inflation will prove temporary, but we could see a more persistent rise at the start of 2022 – at which point the US Federal Reserve (Fed) might be happy to tighten credit conditions. However, we’re fairly confident this is not a risk in the next three months. If and when accelerating inflation becomes problematic, investment styles will likely have to adapt.
2. Where will we see market pressure first?
While we can identify areas of over-exuberance and stretched valuations (e.g. bitcoin, SPACs), there doesn’t appear to be an immediate trigger to cause a significant market reversal. Equity markets do appear more volatile than is indicated by the subdued VIX index, but this is probably a function of aggressive sector rotation. If yields and the US dollar rally significantly in the next few weeks, thanks to accelerating growth and inflation, emerging markets are often the place where pressure builds first.
3. What are the chances of an EM crisis?
We think emerging markets (EMs) are better placed today to weather a dollar liquidity crunch than in previous cycles. That said, there are a few vulnerable countries like Turkey and Brazil that we will keep an eye on.
4. What’s the probability of a major credit issue in China?
China is clearly the most important emerging market, and it is actively tightening credit conditions. The latest pressure point is the asset manager Huarong*. This is a bigger issue than just the $20 billion of outstanding bonds: there is a direct read across for other large Chinese issuers, which could become a systemic issue if Huarong suffers a messy default. Our current view is that authorities will probably not let this happen.
5. What would it take for the S&P 500 to fall 10% due to geopolitics?
A bit like questions about bubbles, it’s easy to pinpoint potential geopolitical flashpoints from Russia to Taiwan. But are we more concerned today than normal? Perhaps in the context of very strong equity markets and tight credit spreads – i.e. there’s not much risk premium. But we are not sufficiently worried to believe the threat of a geopolitical crisis undermines the overall positive macro backdrop.
6. Will investors worry about US tax hikes?
The current proposals would clearly be negative for US corporate earnings. For now, though, the market consensus is that tax hikes will either be watered down in the legislative process or that the fiscal support side of the equation will dominate. So it’s probably another case of something to worry about later in the year, rather than right now.
Overall, therefore, we still think the macro backdrop remains positive for risk assets even given stretched valuations.
We prefer the more obvious upside associated with equity markets to taking investment-grade credit risk, which could also be impacted by rising yields; we could also see significant debt issuance if companies get involved in more M&A deals. Still, as the year progresses, we will be increasingly mindful of the accelerating economic cycle.
*For illustrative purposes only. Reference to a particular security is on a historical basis and does not mean that the security is currently held or will be held within an LGIM portfolio. The above information does not constitute a recommendation to buy or sell any security.