In the first half of 2021, reflation was the pre-eminent theme shaping the capital markets. Economic reopenings bolstered by successful vaccine roll-outs and massive fiscal stimulus led to enhanced growth and accelerating inflation.
This fuelled a sharp rise in government bond yields that unsettled financial markets as investors weighed the tail risk that central banks were behind the curve in controlling the risks of an excessive inflation overshoot, which could force an unanticipated withdrawal of monetary policy support.
Moving into the second half of 2021, investors will need to navigate an environment where the global economy continues to expand, but at a slower pace, and we expect policymakers to start staging their gradual exit from record levels of stimulus.
This calls for a much more selective investment approach compared to the earlier stage of the post-pandemic recovery, when the powerful thrust of coordinated monetary easing by central banks worldwide drove a broad market rally.
We recommend staying invested in risk assets despite greater scope for market volatility as we continue to see new opportunities emerging from long-term structural shifts accelerated by the pandemic and ongoing efforts to rewire the global economy to set it on a more sustainable, climate-resilient path.
Inflation: transitory vs. transition
The reopening of the US economy has raised inflation to its highest levels in three decades as supply struggles to keep up with demand over the summer. Excluding food and energy prices, the Federal Reserve’s target measure of inflation – changes in core personal consumption expenditure (PCE) prices – hit 3.4% YoY in May, well above the central bank’s 2% goal.
But the Fed views this year’s inflation jump being only transitory until supply catches up with demand. Surging goods prices are likely to ease as near-term bottlenecks diminish. For example, used-car prices have been increasing by an unsustainable 10% MoM as semiconductor shortages curb the output of new vehicles.
Similarly, reopening demand for services has led to air fares jumping by 10% MoM. But as the economy returns to pre-pandemic levels of activity, demand will plateau rather than continuing to surge.
Wage pressures should also ease over the next few months as pandemic jobless benefit top-ups expire, vaccinations become more widespread and schools reopen allowing parents to return to the labour force. At the same time, the long-term forces of automation and ageing continue to exert downward pressure on inflation.
Thus, the Fed is unlikely to induce another taper tantrum this year by prematurely tightening monetary policy as inflation appears set to fall back towards the central bank’s 2% target over the rest of 2021 and 2022.
That said, inflation is unlikely to be as subdued as it was in the decade after the 2008 financial crisis. Instead, the transition to a post-pandemic world of faster growth, higher government spending and less-dispersed supply chains makes it more likely that inflation will stay elevated in future at or above central banks’ 2% targets. This will support reflation trades but also make risk assets potentially more volatile.
During the first half of 2021, interest rates rose as investors became more optimistic about long-term growth prospects. In the first six months of the year, the 10-year US Treasury yield rose by 60 basis points to around 1.5%. However, even during the most significant interest rate increase in years, Emerging Market High Yield proved fairly resilient, posting a respectable 2.3% return.
Looking ahead, we expect modest increases in rates in an environment of still-robust economic growth and manageable inflation.
Under this scenario, we see a positive outlook for global equity returns over the next 12 months, albeit lower versus the last 12 months and with a greater scope for near-term volatility. We expect the 10-year US Treasury yield to end 2021 at 1.75% before rising to 1.9% in mid-2022.
In the fixed income space, the higher carry or credit spreads of Emerging Market High Yield relative to other credit segments should provide a buffer against the adverse impact of rising rates. Even without any credit spread tightening, Emerging Market High Yield is positioned to provide investors with positive returns during a period of what we expect will be rising interest rates.
In addition, inflation will remain a key theme for commodities given that commodities are one of the few reliable inflation hedges available to investors. While concerns over the sustainability of the commodity rally have increased, fundamentals generally remain strong.
We favour oil over base metals as inflation hedges given China’s slowing growth and the country’s crackdown on commodity speculation, especially with respect to metals. Fundamentals are likely to support further oil price gains in 2H 2021. As the world emerges from lockdown, material consumption makes way for experiential demand. Pent-up demand for domestic travel in the summer holiday season in Western countries should lift oil demand.
China’s shift to a less aggressive and more sustainable growth path after its striking V-shaped recovery from the pandemic is one of the most powerful forces reshaping the world economy and geopolitics today.
China’s targeted efforts to calibrate credit expansion alongside strong momentum in its domestic economy clearly signal its intention to prioritise long term stability over short term growth.
Following its 2.3% expansion in GDP in 2020, China’s economy is likely to rebound by as much as 8.7% in 2021. But the People’s Bank of China has already begun engineering a slowdown in credit growth to stabilise China’s ‘leverage ratio’ – the scale of the economy’s debt relative to GDP.
Last year China’s leverage ratio jumped from 263% to 290% as policymakers supported the economy during the pandemic by increasing local government borrowing to finance new infrastructure spending. But this year officials have reined in government borrowing, enabling broad credit growth to slow to around 11% YoY, matching the likely growth of the economy in 2021 when including inflation. Thus, China’s ratio of debt-to-GDP has stopped increasing.
By reducing the risks of over-leveraging in future and ensuring debt and economic growth rise at slower, more sustainable levels, the authorities can focus on the strategic priorities in China’s latest Five-Year Plan.
These include boosting domestic consumption by providing stronger social safety nets to make economic growth more resilient and less reliant on exports and foreign demand, as well as focusing investment on ‘new infrastructure’ including 5G applications, artificial intelligence, internet networks and large data centres, and enabling infrastructure such as high-speed railways, airport clusters and renewable energy.
By investing in technology, infrastructure and renewable energy, policymakers aim to secure China’s long-term economic future while reducing exposure to potential external threats including trade sanctions and supply chain restrictions.
Digitalisation and disruption
In the last few centuries, technological advancements have propelled economic development and influenced almost every aspect of daily life. The ongoing digitalisation of many industries accelerated by the Covid-19 pandemic is likely to be irreversible and will have pronounced impact across a wide range of businesses. Disruptions in consumption patterns will persist long after the pandemic recedes, requiring companies to rethink their operating models to adapt to the quickening pace of change now needed to survive.
While the reopening of economies is likely to lead to a resumption of traditional face-to-face interactions, the benefits of digitalisation to businesses, such as better economies of scale and ability to serve new markets, will be increasingly difficult to ignore.
For instance, apart from leveraging large e-commerce platforms, Covid-19 has led to merchants in China becoming increasingly willing to explore decentralised commerce based on social networking platforms, enabling them to establish self-operated storefronts and market directly to targeted customers.
Looking further into the future, we believe that increases in computational power will help to accelerate the commercialisation of nascent technologies, while improvements in artificial intelligence and utilisation of big data will lead to increased adoption of automation, transforming entire industries for years to come.
These factors should serve as tailwinds for the semiconductor industry over the medium-term, as Internet-of-Things (IoT) semiconductor opportunities expand beyond consumer-focused to cutting-edge industrials and automotive end markets, driven by rapid growth in connectivity.
The narrow path to net zero
Recent developments signal that the world is moving inexorably towards embedding the environmental and social costs of greenhouse gas emissions into business and investment decisions to align economic activity with climate goals before it is too late.
Today, there are over 60 carbon pricing initiatives worldwide, covering some 21.5% of global greenhouse gas emissions, according to World Bank data.
Prices range from less than USD0.10/tonne in Poland to as high as USD137/tonne in Sweden, although these are difficult to compare across countries due to differences in economic sectors covered, specific exemptions, and other policy adjustments.
The scope of such initiatives has expanded rapidly in recent years amid a growing sense of urgency by policymakers worldwide to tackle the existential threat of climate change.
China’s much-anticipated nationwide emissions trading system (ETS) to be implemented this year will be the most significant new initiative since the introduction of the European Union’s ETS in 2005. Once implemented, China’s ETS will be the world’s largest, covering some 40% of China’s emissions.
Latest developments also suggest that countries that are slow to introduce carbon-pricing schemes will increasingly face difficulties or higher costs in accessing major export markets.
The European Union is preparing to introduce a carbon tax on certain imports that do not embed carbon costs similar to those produced within the EU, or a “carbon border adjustment mechanism”.
This is consistent with our long-held view that strong policy support for decarbonisation in the EU will have significant influence well beyond Europe. Similarly, we expect the influence of China’s decarbonisation efforts to extend far beyond its own borders in the coming years, introducing new risks as well as opportunities for businesses globally.
Our view remains that global efforts to pursue sustainable, climate-resilient development paths and mitigate the threat of climate change will drive wide-ranging, significant changes to the global economy for years to come. Businesses that anticipate and adapt successfully to these changes stand to benefit from the reshaped economic landscape as policymakers worldwide strengthen their response to the threat of climate change.
As the transition to a low-carbon economy accelerates, new opportunities are emerging for businesses and investors, including opportunities in decarbonisation technologies such as carbon capture and storage, as well as renewable energy.
Other segments that also offer excellent opportunities for long term secular growth are companies with indirect exposure to the ongoing decarbonisation of manufacturing, transport, construction and urban design.
These include suppliers of specialised chemicals, chips or other critical components used in clean-air systems to reduce emissions from vehicles and industrial plants and to produce batteries for electric vehicles, as well as sophisticated automation systems to reduce wastage and improve energy efficiency in buildings or manufacturing facilities.
We see even more opportunities emerging as the transition to a low-carbon economy accelerates in the coming years, encompassing all sectors of the global economy.
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Version: July 2020