It’s the question on everyone’s mind: what happens next? As the global economy continues to recover from the COVID-19 pandemic, what opportunities and risks will characterize the second half of the year, and beyond?
In its recently published 2021 Mid-Year Market Outlook, T. Rowe Price predicts four main themes will dominate the rest of the year, including: the efforts to build a sustainable global recovery; greater focus on earnings growth; the need for investors to remain creative amid rising yields; and exciting alpha opportunities in a rapidly-transforming China.
Recently, Lara Crigger, the Managing Editor at ETF Trends, sat down with Chris Dillon, investment specialist in T. Rowe Price’s Multi-Asset division, to drill deeper into the firm’s predictions—and how advisors can position their clients accordingly.
Crigger: In the Midyear Market Outlook, T. Rowe predicts we’ll see a “sequenced,” versus a “synchronized” recovery. Could you elaborate on what that entails?
Dillon: For us, 2020 was all about the pandemic, while 2021 is all about the vaccines.
The great vaccine news came in early November 2020; then the momentum that the U.S. gathered by disseminating the vaccine in 2021, to us, that’s the key to this “sequenced” global recovery. We’re fortunate here in the U.S. that we’ve had the resources to organize initiatives to get America vaccinated. Sports venues are opening up, and so on. The U.S. has momentum. A classic reopening is happening in the U.S., and it’s happening in certain parts of Europe, too.
But if you look abroad in emerging markets, segments there are much less fortunate from that perspective. Look at the infrastructure of India, in being able to get the vaccines, but then also to get them out to their people. In Brazil, it’s a similar story. With the inconsistencies of vaccine resources, those countries will lag now, but the hope is that they follow later with their recovery as vaccines get more widely disseminated.
So, for now, it’s really the U.S. and China, which effectively confronted Covid-19 last year, leading the global economy, which is due to positive vaccine developments and the resilience of their economies. The additional good news is that these two economies are large enough to drive the global economy.
Crigger: How do you see the U.S.-China relationship evolving as we move forward? Will it continue to be as contentious as it was pre-pandemic?
Dillon: In the outlook, we discussed a different trajectory for U.S.-China relations moving forward. Rob Sharps, President and one of the firm’s CIOs, made the point that when China was brought into the World Trade Organization in 2001, the hope was that the country would become less authoritarian, and as quasi-capitalist/communist state, would prospectively lean toward capitalism. But here we are, twenty years later, and that hasn’t happened. It’s actually gone the other way.
From a democratic society perspective, it is natural to be concerned with regard to strong, central communist leadership and its a command economy which is quite contrary to what we’re doing here in the U.S. and Europe. But in a command economy, if the government is telling you to go get vaccinated, and not to go anywhere, and to put on a mask, then you do it. In China, it’s not an option. In the U.S. you have a choice to get a vaccine; the government isn’t going to seek you out. Given this structure, as well as the level of their operational sophistication, we’re not surprised that China was able to get a handle on COVID-19 as quickly as they did.
From an historical perspective, what China has able to accomplish in a matter of decades is remarkable. But while they came into the World Trade Organization, it’s their not playing by the rules of Western open democracy that has held them back in terms of broader inclusion into capital markets.
Think about the structure of the United States, the role of the U.S. dollar, and America’s open capital account, as part of a fluid, functioning global financial system. Is China the parallel of the U.S. from that open structure standpoint? The answer is no. The Chinese currency is more fixed and pegged to the dollar when it works for China; and when it doesn’t, there’s some flexibility around it. Theirs is not an open and fluid system.
Let’s also not forget geopolitics and concerns around intellectual property theft. One of China’s telecom champions, Huawei, for example, is alleged to be involved in technological espionage at the highest levels.
Ultimately, T. Rowe Price is hopeful that the U.S. and China find a way to prospectively work together, but it will be within a more guarded framework than has existed in the past twenty years.
Crigger: Is that why you argue, in the market outlook, that China is underrepresented in stock market indices?
Dillon: Here’s China with this massive economy—a lot of innovation, a lot of technology, and just a 5% weighting in the MSCI world index, which seems really low relative to where they are, and where they’re going.
The next phase of China’s evolution is the rise of a consumption-based economy, competing with the U.S. on the world stage. So not only is there going to be technological innovation, but there’s also going to be service, healthcare, and financial services economies there. These are examples of areas where there’s going to be a progressive opening up of liquidity, as the MSCI index family brings China more into its fold.
To us, the story of Tencent and Alibaba is already very well-telegraphed. While these great companies still represent an opportunity, we are even more excited about China’s next 100 companies and beyond, which are largely off the radar right now.
From several perspectives, the U.S. and China need each other. Global initiatives around green energy or combatting corruption as it relates to the proliferation of cryptocurrencies are just two areas where China and the U.S. can work together. T. Rowe Price is betting on this to happen as we opened an investment office in Shanghai this year. We are excited about the long-term opportunity that looks to exist there which will require “boots on the ground” to best see.
Crigger: T. Rowe Price is predicting that we’ll see a surge of reflation. Which sectors do you see opportunities in for the rest of 2021?
Dillon: Markets are always trading ahead. This time last year, we were getting information from our health sciences team that vaccines were going to be coming. And we were thinking about this great news relative to the valuation chasm that existed between growth and value as well as in the small- to mid-cap space. As a result, just about this time last year, T. Rowe Price Multi-Asset tilted toward value, both in the U.S. and internationally as well.
The U.S. economy was stuck on a 2% economic growth trend pre-pandemic. Now we’re looking at 6% to 8% this year. Who benefits the most from that? The cyclical parts of the market: energy, financial services, banks, industrials.
This time last year, second quarter earnings were dropping on a year-over-year basis in the S&P 500 in the range of about -32%, and the sectors hit hardest were financials, energy, and industrials. Those earnings are now coming back strongly.
Last year global policy makers threw approximately $28 trillion in aggregate stimulus at the pandemic. The good news is that this stimulus helped drive the market up over 90% since March 23, 2020 while also helping facilitate what is shaping up as a rapid economic recovery. But the other side of massive stimulus is the question of what happens over the next 12 months. That mass of money that was pushed into the system is actually starting to roll over. In looking at the S&P 500 since early May, it’s been seemingly stuck in a range around 4230 points. Part of the reason for this is what we are calling “stimulus fade.”
So we think the policy fade is part of today’s investment story. We’re moving from a stimulus-driven, multiple expansion-driven market to an earnings-driven market. Right now, you’ve got a powerful earnings recovery that’s happening. Earnings are accelerating powerfully. The biggest beneficiary of that acceleration is cyclicality: industrials, financials, the value side of the equation, small caps, mid caps, all of that. As we have already mentioned, T. Rowe Price Multi-Asset positioned for this shift in the market just about a year ago.
We also believe that the “pulse” of this earnings recovery story could carry into the end of this year and into the first half of 2022.
Crigger: A lot of advisors have shifted away from fixed income, as they seek out alternative sources of yield beyond traditional Treasuries and so on. Inflation too is top of many advisors’ minds. But T. Rowe Price has argued that there’s still a role for fixed income in a portfolio—you just need to rethink how to get exposure. Where do you see opportunities in the bond market going forward?
Dillon: Let’s not forget where we are right now from a valuation standpoint in fixed income. The Fed has its policy rate pinned at 0%. As we’re speaking today, the 10 Year Treasury yield is hovering in range around 1.50%—and it was as low as 90 bps late last year.
Last year you had the vaccine news announced, you saw momentum in the U.S. with reopening, you saw the surprise results in the runoff Georgia election, which paved the way for additional fiscal policy to be added to what was already a really accommodative environment. We were looking at a 90 bps 10-Year Treasury yield last year and were concerned with the asymmetry of it.
Now we’re hovering in the range of 1.50% on a Ten Year U.S. Treasury, but we are also talking about U.S. GDP at 6-8%, and potentially at 4-5% next year. Meanwhile, the global economy is running around 6% this year and 4-5% next year. Throw in that headline CPI right now is 5%, and when we add all of this up, current U.S. rate levels do not seem like enough compensation to be aggressively invested in conventional fixed income right now. While we still own “core fixed income,” we are really focused on plus sectors with an emphasis on Bank Loans, which are all really well supported from what is a strong economic backdrop right now.
While we think current elevated inflation levels are “transitory,” we still think inflation is going to be higher trend-wise, once we get through the extremes of the current environment. Take five-year breakeven Treasury yields, which is the difference between what you get with inflation-protected Treasuries vs. nominal Treasuries. Pre-pandemic, the five-year average for five-year Treasury break-even yields was roughly 1.6%. Now, the expectation is 2.45%. For us, going forward we expect inflation to trend beyond pre-pandemic levels, but calling that level precisely is difficult in an environment that is right now characterized by extremes.
Crigger: So how does one prepare a portfolio for that?
Dillon: You do need to be creative with your fixed income. Own some core fixed income in the range of 40% to 50% of your fixed income allocation, but complement that exposure with plus sectors such as Bank Loans. While this space is made up of below investment grade companies, these companies are well-supported in what is a strong economic environment, and they have a coupon that resets every ninety days, based on risk free rates.
The U.S. consumer has got $2 trillion of savings. That’s 25 years worth of savings. The U.S. consumer is on solid footing, and corporate America is in good shape. With such favorable fundamentals, below investment grade credit can comprise 15-20% of your fixed income allocation. This part of the credit markets tends to have a lower duration profile as well, which is an attractive counterbalance to interest rate risk that exists at such low rate levels.
We’re also leaning into emerging market fixed income. We’re searching for rate exposure in Asian markets. The 10-Year sovereign in China is yielding in the range of 3% and is an A rated credit. If you’re in Asian credit, you’re getting a spread on top of that 3%, which is an attractive complement to the Bank Loan asset class we just discussed.
Liquid alternatives are also interesting. Within Multi-Asset at T. Rowe, we are making active use of our Global Dynamic Bond strategy, which is absolute return fixed income that’s also designed to have a unique and low correlation relative to equities.
It’s important to remember right now with rates as low as they are that fixed income is intended to protect you when equities don’t do well. To accomplish that task today, your fixed income needs to be a lot less traditional and more global. Ten years ago, the 10-Year Treasury was 4% and enjoyed an attractive correlation relative to the equity market. Balanced investing was easier. Owning just the S&P 500 and the 10-Year Treasury and/or the Bloomberg Barclays Aggregate Bond Index was enough to generate an attractive risk adjusted return. Those days are long gone.
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