Overview
From the economic fallout of Covid-19 to the enormous fiscal and monetary response, markets have ridden an extraordinary 2020 that will inevitably shape the outlook for 2021. As highlighted by Fidelity International’s global macro team, we are likely to be past the ‘easy part’ of the global economic recovery.
Three main factors will now influence the investment backdrop for 2021.
▪ Fiscal policy steps into the spotlight: Both monetary and fiscal policy have been extremely supportive in 2020, and central banks appear willing to keep rates on hold for some time. The focus for 2021 will be the extent to which fiscal policy can complement exceptionally accommodative monetary policy. In this regard, we will monitor the evolving US political backdrop closely.
▪ Inflation remains a key question: The jury is still out as to whether and by how much inflation will rise in 2021, given the economic backdrop. An important development is the Fed’s average inflation targeting framework that allows for moderately above target inflation until US employment figures improve.
▪ A new US presidential term: After such a polarised election, the economic implications of the US electoral outcome will extend well into 2021 and beyond. Given the importance of fiscal policy to the medium-term economic outlook, the potential for a reduced stimulus poses a significant risk and, if the US Congress remains divided, the path of the recovery (across asset classes) could be more volatile.
Sustainability is critical
Sustainability factors are becoming ever more critical elements of investment risk. Unlike previous financial crises, the Covid-19 pandemic has disrupted far more than just asset markets: it has raised fundamental questions about the sustainability of industries, the responsibility of stakeholders, and the long-term prospects for capitalism as we know it.
This has accelerated the shift towards using sustainability criteria in investment decision-making. With regard to strategic asset allocation, we are beginning to incorporate various temperature pathways into our models to help us understand the impact of different climate change scenarios on capital market assumptions, asset returns and risk profiles.
Cautious optimism across global equities, with regional preferences
Turning to asset markets, the team continues to balance caution with the need to take selective opportunities in equities and credit.
Overall, we remain cautious about taking on investment risk against a backdrop of somewhat optimistic valuations, given current economic conditions. Looking into 2021, we generally prefer credit over equity risk and assets higher up in the capital structure but vaccine news warrants greater optimism than before.
Equity markets as a whole may be bracing for slower economic growth, but the picture is nuanced across regions and sectors. So 2021 is likely to be more about capturing relative opportunities as investors price in economic and virus-related developments.
From a regional perspective, the team is most positive about the prospects for emerging markets, specifically on emerging Asia (e.g. China, Korea and India), given attractive asset valuations, earnings revisions and technical market factors relating to broad investor positioning.
Europe continues to face risks in terms of political developments (such as Brexit), headwinds from Covid-19 measures and the impact of these on economic data. That said, attractive valuations and further European Central Bank monetary policy easing are important factors to consider in the near term.
Overall, we have a neutral outlook for US equities, given concentration risk at a market level and reverberations from the election.
The hunt for yield could intensify
Many of our team’s strategies are designed to deliver consistent income across market cycles, so the combination of fixed income sub asset classes remains critical as 2021 rolls on. If monetary policy remains highly accommodative and fiscal support is relatively modest, the hunt for yield could intensify through 2021.
With yields still at historic lows across the board, investors must strike a balance between tapping attractive income opportunities while avoiding any race up the risk spectrum. From a risk-reward perspective, we expect decent compensation for exposure to high yield bonds and emerging market debt if the credit default cycle evolves in a moderately positive direction over the coming year.
Within high yield bonds, we prefer Asian securities, given stronger underlying credit fundamentals and regional growth.
Finding defensiveness in a world of changing correlations
Perhaps one of the most pressing questions for investors as we enter 2021 is about how best to diversify investments for the long term. In the March 2020 crash, many of the traditional safe haven asset classes failed to provide the level of protection that investors expected. US Treasuries and investment grade bonds, for example, provided less effective risk diversification in portfolios compared to previous crises. With yields at historic lows, investors will need to search more widely for sources of defensiveness.
In practice, this means looking beyond developed market government bonds and towards assets like Chinese government bonds, which offer compelling relative yields, or using pair trades with asymmetrical risk characteristics (where the upside potential is greater than the downside risk).
From a tactical allocation perspective, an example of a pair trade that fits with our views for 2021 is a currency pair, with a long position in Japanese yen versus a short position in the US dollar. At a time when reasonably priced defensive assets are becoming scarce, the yen is relatively cheap and offers risk-off characteristics. At the same time, the team’s view on the US dollar remains negative.
Alternatives such as ‘long volatility’ strategies could prove their worth
Alternatives offer another means of diversification. We continue to find opportunities in areas such as asset leasing, infrastructure and renewables.
We tend to look for combinations of alternatives that have low correlations with traditional equity and bond markets. Specifically, ‘long volatility’ strategies are explicitly designed to generate positive performance during periods of heightened market volatility.
These types of strategies have cost investors in previous years as broad markets benefited from prolonged periods of growth, but performed well in 2020. We believe they have an important long-term role to play in diversified portfolios, and 2021 is likely to throw up plenty of opportunities for them to prove their worth.
