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Key Takeaways & Insights

The Q1 global recovery has been notable, but uneven. While vaccination rates continue to increase, Covid19-driven divergences between countries are driving differences in the timing and magnitude of the economic recoveries. That said, the global economy is likely on the verge of a complete recovery by the end of the year, and as policymakers remain hesitant to tighten, this should remain a favorable environment for risky assets.

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  • Corporate earnings have taken over from interest rate driven multiple expansion as the primary driver of US equity returns.
  • Intermediate and long-term US Treasury rates rose at the end of April, but the continued influence of the Fed should prevent further meaningful increases. High yield bonds continue to experience tailwinds of low default rates and investor thirst for yield.
  • Monetary policymakers around the globe should maintain their expansionary biases until they see signs of a more broad-based recovery in growth and jobs.

Key Market Drivers

A Notable, but Uneven Global Recovery

Steadily increasing vaccination rates and the receipt of two fiscal stimulus checks are driving an explosion in US consumer spending which has caused an involuntary depletion in inventories.  The rebuild of these inventories and the continued release of pent-up demand as mobility constraints are steadily reduced should lead to another quarter of strong economic growth, perhaps even better than the 6.4% recorded in Q1. With the US economy performing better than most others around the world, the trade deficit should grow and serve as the only real near-term headwind to economic expansion.

At the same time, a somewhat disorganized vaccine rollout and heavy reliance on services industries have prevented continental European countries from more fully emerging from lockdowns and mobility restrictions.  This has caused a so-called double dip recession in the Eurozone although they will likely emerge from this state on the back of improved vaccine distribution and the impact of growing global economic strength on their export industries.  Having been the first country to fully emerge from pandemic driven restrictions, China has fully recovered lost output and the government now is attempting to control economic growth to prevent budding price inflation and asset price bubbles. The outlook for Japan with their strong export sector is tied rather closely to economic growth in China and the US.  While this should be supportive of the economic recovery, their well-known demographic challenges and restrained consumption growth will slow the rate of economic improvement.

The continued inability of some countries to acquire and effectively distribute vaccines is notably constraining the recoveries in some emerging market economies.  India and Brazil are being particularly hard hit by the second virus wave with hospital capacity being severely challenged.  Lockdowns and mobility restrictions are being reimposed and these economies should again contract.  Based upon the experiences of most other countries, the hope is this only delays expected recoveries into the second half of the year.

Our Perspective

Equity Markets

 

  • The year-to-date interest rate increase and yield curve steepening have stopped the valuation multiple expansion dynamic which had driven US equity markets higher in 2020.
  • Corporate earnings growth in a recovering/expanding economy has effectively taken the mantle in fueling equity prices to achievement of further records so far in 2021. Year over year earnings comparisons will become more difficult in the second half of the year, but they should remain comfortably positive, with earnings continuing to be the most important tailwind for equity prices.
  • European equity markets are forecasting a more robust economic future as opposed to dwelling on the weak current situation. The market structure in Europe, which generally has higher weightings in the more cyclical sectors, should be favorable for market appreciation in an environment where rates should remain extremely low, and in some cases negative.
  • Japanese equities are also more laden with cyclical companies compared to the US, which should allow the market there to benefit from the global economic rebound.
  • Having been one of the stronger performing markets in 2020 as they were the first to emerge from the Covid19 recession, Chinese equities may be fully priced as some monetary policy tightening appears on the horizon.
Bond Markets

  • After a brief lull during the middle of the month, intermediate and longer-term US treasury rates resumed their upward move at the end of April. While current economic growth and inflation rates would normally be reflected in the 10-year treasury trading at least at 2.50%, these are not normal times, with the Fed as an unnatural (but perhaps more permanent) participant in the bond markets. The market may challenge the Fed’s resolve, but the continued influence of the central bank should prevent rates from meaningfully increasing even with the higher inflation numbers expected to be reported in May and June.
  • Interest rate spreads of high yield bonds compared to same maturity government bonds have gotten historically low. This may be warranted by the low default rates expected in this expansionary economic environment. But it is also a function of investors’ continued thirst for yield which should prevent this sector of the bond market from losing value through the summer.
  • Emerging market debt prices may be restrained by the slower economic recovery in many of these countries and the subsequent pressure that continued low policy rates can have on local currencies.

Monetary Policies/Currencies

  • Monetary policymakers around the globe should maintain their expansionary biases until they see more encouraging signs of a broad based, sustainable recovery in growth and jobs. The US Fed is pointing to continued high unemployment and under-employment rates to justify the maintenance of zero percent interest rates and aggressive bond buying through at least the end of 2021.
  • Inflation is being viewed as “transitory” and due primarily to year over year base effects and temporary supply chain disruptions as the economy emerges from an unprecedented recession.
  • Central banks in Europe will also be reluctant to tighten policy in any way until next year at the earliest. The Bank of Japan has taken policy ease up a notch with their purchases of equity securities and it is unknown how they will extricate themselves from this balance sheet build. With no serious inflation threat on the horizon, the BOJ will not need to face that challenge in the immediate future.
  • The People’s Bank of China is the only major central bank that should begin to tighten policy somewhat by letting some of their rates drift upward as inflation increases. However, they will be careful not to let rates rise too much as it may cause the renminbi to increase to the point that it begins to hurt their still important export industries.

What This Means for Investors

The global economy is likely on the verge of complete recovery by the end of the year. Monetary policymakers will remain hesitant to tighten until they are confident the various recoveries are more sustainable and broader based. This should continue to be a favorable environment for equities and other risky assets such as high yield bonds. The ominous impact of corporate and individual tax increases should not become a serious issue for investors until we are closer to the end of the year.

For more market insights, contact a Cerity Partners advisor or visit the thought leadership section of ceritypartners.com.


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