Pre-inauguration jitters likely a near-term distraction for markets
Following the harrowing insurrection at the US Capitol on 6 January, investors are understandably nervous that President Trump’s supporters could derail a peaceful transfer of power as President-elect Biden’s Inauguration day on 20 January draws near.
If a major disruption does take place, it would hurt market sentiment and likely trigger a short-term risk-off move, particularly given that the relative strength index (RSI) of global equity markets (MSCI AC World Index) is now on the high side at ~60, which suggests that the near-term momentum of global equity markets is starting to look stretched.
In addition, the volatility index of the S&P500 remains slightly above average at about 24, which signals that investors remain relatively cautious.
Even in the event of a risk-off correction, we ultimately believe that US institutions are strong and the rule of law is firmly established, and that any disruptions will likely be a near-term distraction in the rear-view mirror as we head deeper into 1Q 2021.
Focus on the bigger picture: global growth prospects have improved with unified US government; China’s growth trajectory remains solid
We believe that the outlook for markets is positive and that, despite some ebb and flow, improved global growth prospects, supportive monetary policy, and the global reflation theme remain key market drivers.
We have earlier discussed our view that a unified government will catalyze a more aggressive path for US fiscal stimulus in 2021, which will solidify the US recovery and set off reflationary forces.
Moreover, high frequency economic indicators show that China’s growth trajectory remains solid, with exports in December growing 18.1% year-on-year and its trade surplus hitting a new record of USD78 billion.
Our economics team believes that China is now in a firm position given that its economy is strong enough to make new records but not too hot that the People’s Bank of China will need to raise interest rates.
As a result, our macro team has upgraded our GDP forecasts for the US, developed markets and the world by 1.0%, 0.2% and 0.1%, respectively.
As the global economy reflates, we see equities and EM HY bonds performing well
The combination of an economic recovery and rising inflation from relatively low levels forms a sweet spot for markets. A study of the historical performance of the S&P 500 shows that its 12-month forward returns have been highest when inflation levels are at below average levels and rising.
Importantly, in this phase of the business cycle, there is sufficient leeway for the Federal Reserve to maintain a loose monetary policy stance.
During periods when core inflation is below 2% and rising, we tend to see positive performances in equities, commodities, and cyclical sectors such as financials, energy and materials.
EM currencies also tend to outperform against the US dollar.
We keep an overweight position in US and Asia ex. Japan equities and EM High Yield bonds, and an underweight position in DM IG bonds.
A surge in inflation in 2021 is a tail risk, and not our base case scenario
A key question for investors, however, is how long the market will remain in this sweet spot given the risk that a surge in US inflation could drive the Federal Reserve to turn hawkish and taper its quantitative easing.
We see an inflation surge as a tail-risk and not a base case scenario in 2021. Although the core PCE inflation reading (which is the Fed’s preferred inflation indicator) is likely to rise above 2% in mid-2021 due to base effects, we do not see it staying above 2% for a sustained period.
Given the Fed’s new strategy of aiming for 2% inflation on average over the business cycle, we expect the Fed to wait until 2022 to begin tapering its quantitative easing.
History suggests that it is difficult to kickstart inflation after a recession due to the amount of slack in the economy (i.e., insufficient demand relative to potential economic output).
In addition, due to long-term secular forces such as globalization and technological disruption, inflation has mostly surprised to the downside since the late 1990s.
In particular, the US Philips Curve (which is the relationship between the unemployment and inflation) has flattened significantly after the 2009 Great Financial Crisis.
The Fed have not had much success in driving inflation above its long-term 2% target despite the unemployment rate falling to as low at 3.6% in 2019 – a 50-year low – and significant monetary policy easing over the post-GFC cycle which saw the Fed balance sheet increase almost 4-fold from 2008 to 2017.
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