A temporary reversal for the reflation trade

  This is an excerpt from our equity outlook - a temporary reversal What are the risks? Too many incentives in the US can mean that inflation expectations are no longer anchored, forcing the US Federal Reserve to hike key interest rates sharply. However, the markets do not currently reflect such a scenario. The Fed has continued to stress that it is happy with the expected rise in inflation and is in no rush to hike rates. This explains the recent reversal in nominal US bond yields. Medium-term inflation expectations have eased slightly, possibly due to the impact of rising taxes on growth after the debt-driven stimulus. The details of the Biden Administration's broadly defined infrastructure packages will be of critical importance. The size of the expense and the degree to which it is paid through higher corporate and personal taxes or further debt issuance will determine the extent to which bond yields, that is, market rates, will rise.

The continuing potential of value stocks

Rising bond yields benefit value stocks like financials. Other factors support the value such as higher crude oil prices. Crude oil prices have returned to pre-pandemic levels. As the US and Europe further relax pandemic restrictions and reopen borders, we expect the recovery in demand to drive oil prices higher. The shift to value stocks reflects the shift in demand away from lockdown beneficiaries like tech companies to "reopening winners" like transportation companies. This shift is also reflected in analysts' earnings estimates: they are rising faster for value stocks than for growth. The higher earnings momentum for value comes with far lower earnings multiples. In other words, the premium that growth stocks have over value stocks is still high despite the rotation we've had since last November. We believe that between strong earnings momentum, attractive valuations, rising energy prices and interest rates, there is still potential to add value to outperform growth.

Small Cap Stocks - Just Taking a Break?

The expected rise in taxes is one of the factors behind the reversal of small-cap stocks (see Figure 1). Another reason could be that small caps are benefiting less than large caps from the increase in spending on infrastructure, welfare and the Green New Deal, as large companies are better able to capture this rising demand. U.S. small caps have previously suffered the same large-cap tech curse as value stocks, meaning the good returns for large-cap tech stocks dominated index returns. To the extent that large-cap technology lags the broader market in creating value, small caps could resume their outperformance. However, potential gains may be limited as small caps now trade at the long-term average premium versus large caps. We believe that from now on, small caps will require superior earnings growth to outperform large caps.

Alternatives to value and cyclical allocations

Rather than focusing on value or cyclical stocks, investors could overweight countries or regions as a proxy. Indices that track the outperformance of cyclical stocks or value stocks include the UK - due to its greater exposure to commodities and low exposure to technology - and the Eurozone. To capture cyclical outperformance, one could look to Canada and emerging markets. How about switching from US stocks to European stocks to hit the next leg of reopening trading? European stocks are more cyclical than US stocks, but the market may have already priced in the recovery. We are currently overweight in US equities, but the prospect of higher interest rates and taxes in the US if relative valuations stay in favor of Europe could make the difference. Or emerging market stocks? We expect EM ex-China to outperform developed markets over time as emerging markets are cyclical, benefiting from reduced US-China trade tensions and a weaker US dollar. Rising US interest rates could delay outperformance as higher US yields make EM investments relatively less attractive. The slower pace of vaccination in emerging markets is likely to offset the growth benefits of reopening borders. Finally, growth in China, which is a major determinant of the outlook for emerging markets, is being challenged by Beijing's efforts to deleverage the economy. Read the full publication Here All views expressed here are those of the author at the time of publication, are based on available information and are subject to change without notice. Individual portfolio management teams can have different views and make different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income from them can go down as well as up and investors may not get back their initial outlay. Past performance is no guarantee of future returns. Investments in emerging markets or specialized or restricted sectors are likely to be subject to above-average volatility due to a high degree of concentration, greater uncertainty due to less information available, less liquidity or due to a greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than most internationally developed markets. As a result, portfolio transaction, liquidation and maintenance services on behalf of funds invested in emerging markets may involve greater risk. continue Reading

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