Risk assets have notched strong and even spectacular returns from their pandemic lows, prompting the question: how much upside remains? While a lot of good news has certainly been priced in, we expect markets to grind higher – albeit with quite a bit of volatility along the way.
We believe most investors, like us, are positioned to buy meaningful market dips. We struggle to see how the short-term narrative would make investors become sellers, bar a geopolitical incident or a new black swan like the pandemic.
In our view, further market upside faces a headwind of bullish investor sentiment and positioning, which is already long. But with record amounts of stimulus still gushing through global markets, and the economic cycle at a relatively early stage, we see a significant tailwind as well.
Follow the money
The short-term outlook is one of economies opening up and normalising. Policymakers, meanwhile, will likely continue to be very supportive in the absence of pressure from rising inflation expectations. And even if this cycle plays out more quickly than the last, we believe it would be premature to expect equities to price end-of-cycle dynamics now. Such a scenario is too distant and too uncertain, in our view, with recession risk low.
At the same time, there has been a surge in US broad money supply, the magnitude of which has not been seen since the Second World War. Half of the increase has flowed into household accounts, while cash as a share of financial assets for non-financial corporates is at its highest level since 1969.
Markets are still figuring out what all the monetary and fiscal stimulus means for the world economy. We believe that a significant amount of this cash will be spent, boosting growth and possibly inflation. Of equal importance is our expectation that a significant amount of the cash on consumers’ balance sheets will be invested in financial markets.
Equity markets may look expensive in absolute terms. However, we believe the equity risk premium – especially outside the US – remains acceptable on a relative basis.
We also see meagre long-run return potential in bonds, which makes long-term expected equity returns, albeit lower than normal, still quite attractive, in our view. In addition, we expect corporate profitability to improve, thanks to operational leverage and short-term increases in productivity.
Real yield moves
Investors are understandably growing concerned about the rise in yields and recent choppiness of equities. Yet we believe equity markets would be able to digest a move higher in yields, if it reflected the anticipation of faster inflation and stronger growth (a possible catalyst for which could be the weakening of the US Senate’s filibuster).
There is also little empirical evidence that rising real yields are particularly bad news for equities, especially at their still very low levels; rising real yields have mostly been associated with higher stock markets.
In the event policymakers become fearful about the impact of all the stimulus they have unleashed, not least with regard to inflation, we would be ready to shift our positive stance. For now, though, we favour exposure to equities to play the current phase over investment-grade credit, where we believe tight spreads pose an asymmetric risk to investors.