Foresight November 2021: macro themes and market outlook

The Fed’s plans for tapering and hints that rate rises could take place earlier than expected at the beginning of the summer have been digested. From here, we maintain that interest rates should continue to move modestly higher as the global economy returns to a more stable state and central banks continue to normalize. In our view, the recent move up in yields following the Fed’s shift in tone has created a more even balance of risks, with a rally in bonds being a possibility should the Fed walk back some of its projected views in response to a deterioration in the growth/unemployment picture or a moderation in inflation. Overall, given the asset class’s weak return profile and the fact that the balance of risks is slightly to the upside (for yields), we maintain a modest underweight in this space. In the longer run, we believe that yields will continue to move modestly higher as the Fed continues to tighten monetary policy, warranting an underweight in the asset class.

The BoC’s policy stance has shifted markedly over the last six months: While tapering had already begun in the spring, the central bank’s expectation for Canada’s output gap to close in mid-2022 strongly implies that initial policy rate increases are likely to occur at about that time. We believe the BoC faces a more delicate balancing act than the Fed: High levels of public and private sector debt in Canada would suggest a slower pace of tightening. In our view, if the Canadian dollar (CAD) were to strengthen against the U.S. dollar (USD), as expected over the longer term, Canadian debt would be slightly more attractive than U.S. debt—if only marginally. Canadian corporate credit could offer marginally higher total returns relative to U.S. corporate credit for similar reasons.

We expect European and Japanese interest rates to continue to lag relative to the United States, largely a function of longer central bank normalization timelines and a more muted growth/inflation profile. We believe that normalization will inevitably push European and Japanese rates higher, particularly at the longer end, which will likely translate into headwinds in their respective bond markets. Crucially, on a currency-adjusted basis, we find Japanese fixed income slightly more attractive than European fixed income. Separately, we expect monetary policy movements in the United Kingdom to follow a timeline that resembles developments in North America as opposed to their European peers. 

Being overweight in emerging-market (EM) debt remains one of our high-conviction views. We think the asset class could provide some of the most attractive expected total returns over both the short and long term, thanks to the relatively high level of expected income returns the asset class offers, coupled with additional support from a weaker USD. Although we’re forecasting a rising interest-rate environment in the coming years, we believe any change will be modest and that rates should remain near historical lows. This is likely to create an environment that should drive more flows into EM debt as the search for yield becomes more pronounced and the concept of carry becomes more important to investors. Over the shorter term, any cyclical recovery derived from an inventory rebuild and subsequent normalization should also support an overweight stance on EM debt. Regions such as Latin America are poised to benefit from global growth and rising demand for commodities. Finally, given our expectation for the USD to weaken over time, we have a slight preference for local currency debt over USD-denominated EM debt.

We maintain our favorable view of U.S. high-yield debt, largely due to the carry, which the asset class can offer in the current low interest-rate environment. While spreads relative to U.S. Treasuries are tight, we believe that the current economic environment should continue to support yields at or close to these levels, thereby enhancing the risk/return profile of the asset class. 

In our view, positive carry from the asset class will likely outweigh any headwinds arising from higher interest rates, especially relative to government bonds. While we think that high-yield debt has a more attractive return profile than investment-grade credit, it’s worth noting that the latter asset class can be used as a tool for investors to add duration to their portfolios. Within this space, we have a preference for lower-rated credits, but we also believe it’s important to keep an eye on cross-country opportunities.

On a short-term basis, we believe that U.S. equities should continue to perform well through year end as consumer consumption remains healthy and manufacturing activities seem well placed to support the asset class. That said, high valuations remain a concern. As such, a moderate overweight stance is likely appropriate from a risk management perspective. On a structural basis, the United States has the healthiest long-term economic profile in the developed world; however, stock valuations and an expected depreciation in the greenback, particularly against other key developed-market currencies, remain headwinds to the asset class.

Higher oil prices and an improving outlook for Canadian financial services can provide attractive sources of upside for a significant portion of the equity market, making it an appealing asset class on a shorter-term basis. Despite a more modest long-term growth profile relative to the United States, we continue to find Canadian equities attractive because of the supportive dividend profile and reasonable valuations. They could also enjoy some upside from an expected appreciation in the CAD.

European equities should benefit from any inventory rebuild that occurs as supply chains begin to normalize. Valuations also remain intriguing relative to U.S. equities. Continued fiscal and monetary policy support should underpin the region’s growth prospects, while the European manufacturing segment—autos, in particular—should perform well as supply chains improve. Although the asset class might appeal from a dividends perspective, an expected appreciation of the euro could translate into additional modest tailwinds; it also must be noted that the region’s weak structural growth profile could dampen investor enthusiasm toward European equities.

This asset class is levered to manufacturing and the global trade impulse, which remains constrained by supply chain disruptions. Meanwhile, ongoing economic uncertainty in China, which represents a large part of the EM equities universe, is also a concern, as are political issues in Brazil. All things considered, we believe a near-term neutral stance is warranted; however, any evidence of improved supply chain dynamics, an inventory-fueled acceleration in production, a resolution of semiconductor chip shortages, or improved political stability could materially improve the outlook for EM equities, especially in view of compelling valuations. We continue to believe that EM equities remain appealing from a strategic perspective. Valuations remain inexpensive, and the asset class’s growth and dividend profiles are attractive over our five-year forecast period. A structurally weaker USD would also provide a modest tailwind to this asset class.

Japanese equities should, in theory, provide an intriguing opportunity to investors. Any procyclical move as a result of a global inventory rebuild, a weak yen, and continued massive monetary and fiscal support could provide support here; in practice, however, the asset class has proven disappointing in recent months. That said, we believe investors should nonetheless keep an eye on Japanese equities should any of the aforementioned factors begin to drive performance. Structural factors in favor of Japanese equities include inexpensive valuation, a possible appreciation in the yen, continued improvement in corporate governance, and generous share buyback programs; however, these factors are offset by Japan’s anemic growth profile. From a three- to five-year perspective, we continue to have a neutral view of the asset class, albeit with a slightly positive bias.

Chinese equities underperformed in recent months as a result of uncertainty around growth and perceived heightened geopolitical risks. In our view, any sign of stabilization of shifts in sentiment could lead to a period of outperformance here. We’ve long maintained that Chinese growth will need to decelerate in order to rebalance from its industrial growth model to a more consumer-centric one. We also expect the renminbi to depreciate modestly over the next three to five years. As such, we remain neutral on the asset class. 

While we’ve upgraded our views on U.S. real estate investment trusts (REITs) since the depths of the pandemic, we’ve retained a cautious view. The great reopening—which, along with an improving macro backdrop, was seen as constructive here—has slowed. There continues to be notable dispersion across subsectors within the asset class, and the prospect of higher interest rates could also dampen investor appetite. That said, we believe REITs continue to deserve a place in a broader portfolio given their ability to offer higher yields—relative to fixed-income assets—and lower correlations to other asset classes. 

Equity valuation within the global natural resources space has mainly been driven by the energy component. Oil and gas prices continue to climb higher, and recent inflation concerns have provided a catalyst for a resurgence in the price of gold, which we believe could continue for the next 12 to 18 months. Overall, we believe global natural resource equities are an example of a cyclical play and should outperform global equities at this point in the economic cycle.