Fund Managers’ Mid-Year Review

Feature Stories | Jun 23 2021

As sharemarkets continue to rebound, fund managers target sectors and stocks appropriate to the next stage of the economic cycle and a new post-covid normal.

-Morgan Stanley expects US tapering to begin in April, 2022
-High quality equity positioning in Australia, as a hedge against inflation
-Stocks within Healthcare favoured by some fund managers
-ASX200 companies to potentially shift from capital preservation to capital allocation
-Portfolio implications of a more Chinese approach by the US
-Caution on commodities

By Mark Woodruff

Investment managers are currently weighing-up where the domestic and global economies are placed in a highly unusual economic cycle.

In describing where equity markets sit some fourteen months from the covid-lows, Citi suggests investors face early-cycle timing, increasingly mid-cycle conditions and late-cycle valuations!

In general terms, the equity market bounce-back from covid is still reverting towards the norm and appropriate covid-recovery trades can be made. However, the question as to whether that norm has changed throws up some creative investment opportunities for both the near and longer-term.

Some fund managers are retaining leverage to mid-cycle expansion, while also embracing a degree of exposure to Quality. The latter may act as a hedge to later-cycle risks that attach to building inflation and higher bond yields.

Global outlook

Morgan Stanley is positive on the economic recovery, with a strong capital expenditure cycle expected to drive activity well above its pre-covid path. The expectation is for inflation to move sustainably above 2% in the US and policy makers should be slow to respond.

As a result, there should be a hotter, shorter cycle, and with risk assets already elevated, the investment bank reduces overall exposure to credit and equities and expects the US dollar and yields to move modestly higher.

It’s felt that policy makers should err on the side of providing more accommodative macro policies to ensure an inclusive recovery, due to an uneven impact on low-income households.

Morgan Stanley predicts the official announcement of tapering by the Federal Reserve will be at the March 2022 meeting, with tapering to begin in April, 2022. It’s expected the Fed will first raise rates in the third quarter of 2023 and pursue a gradual path of tightening thereafter.

T Rowe Price is also bullish on the global economy though cautious on stocks, as valuations are seen to be elevated in both the US and Australia. The investment management firm has recently shifted to a slight underweight position in stocks relative to bonds, due to the strong market rebound to date. Also, higher interest rates leave the risk/reward balance for equities less attractive.

Meanwhile, Citi believes the combination of stimulus, personal savings, pent-up demand and changes in consumption patterns augurs well for a rapid recovery and an expansion that could last several years.

For the rest of 2021 and into 2022, Citi continues to seek selective exposure to the cyclical recovery from the covid recession, as we are still in an adjustment process or mean reversion. There’s still time to benefit from exposure to the recovery, especially via non-US markets. Certain real estate assets and select national markets, such as Brazil and the UK, are among the possibilities.

During 2022, we should expect a new, more traditional expansion and mid-cycle conditions.

From this point, the trends that have helped to reshape the world economy during the pandemic should be pursued. These include such unstoppable trends as digitisation, healthcare and renewable energy, which can help portfolios grow even amid economic turbulence. Future market dips may be an opportunity to gain or increase these exposures.

However, the world beyond covid will be rather different with a changed perspective for digitisation, healthcare and renewable energy, explains Citi. Businesses and consumers alike have discovered new efficiencies by embracing technology during the pandemic, while the development of other treatments and medical technology has accelerated. In addition, advances in renewable energy may persist far into the future.

Australian Outlook

The domestic recovery appears to be on a strong footing, according to T Rowe Price. This is largely due to ongoing policy stimulus, multi-year highs in consumer and business confidence and signs of pent up consumer demand. Inflation is still seen as a key risk and while Value is catching up to Growth, there’s still room for Value to outperform. Despite the inflation risk, the overall view for portfolio positioning is that growth and inflation may peak in 2021.

While T Rowe sees the Reserve Bank remaining dovish, long-term interest rates may rise to reflect the strong economic momentum. However, this is a scenario that should be positive for the stock market, as a steep recovery in earnings should outweigh any potential rise in long-term rates.

In 2022 fiscal stimulus is set to turn negative (the ‘fiscal cliff’ effect), subtracting from GDP growth. With a return to slower growth and sustained low interest rates, growth stocks should return to favour.

As a result, consensus earnings growth estimates will likely be trimmed and earnings momentum (upgrades less downgrades) may turn negative. There’s believed to be limited scope for interest rates to move much higher given the historically high post-covid levels of domestic household debt. 

Australian policymakers are expected to keep economic policies accommodative, especially with the covid-19 vaccine rollout missing the mark so far. 

On the fiscal side, a federal election is expected to take place in Australia within the next 12 months. The stronger recovery from the pandemic means that government revenues are $50bn more than originally projected. Thus, we can probably expect to see some additional moderate fiscal support from the government ahead of a federal election.

Overall, T Rowe Price has tilted portfolio positioning towards more domestic exposures to reflect the stronger economic performance of the Australian economy.

Near-term economic growth should remain solid, according to Morgan Stanley, even after a return to pre-covid conditions, helped by continued supportive policy settings and a strong housing market. The RBA is expected to stay dovish near-term with tapering signalled later in the year. In addition, government spending is forecast to remain at its highest share of GDP since the early 1980s. This is important for the economy, particularly because it provides some offset to the headwind the government's international border restrictions are providing to growth.

Consumer spending is expected to strengthen further as households continue to deploy excess savings accumulated over 2020. It’s thought the capex cycle will expand beyond residential construction and see broader participation from business investment as corporate confidence and conditions improve.

Although there is a risk of the sector overheating, at this stage neither the RBA nor Australian Prudential Regulation Authority (APRA) seem likely to step in to cool the sector, since fostering the economic recovery takes precedence. Housing is central in this respect, since rising residential property turnover historically has had a positive multiplier impact on the Australian economy.

Morgan Stanley sees further scope for house price increases, before macroprudential measures are put in place next year.

Inflation should also improve, particularly given less of a headwind from the Australian dollar and rent inflation in 2022. It’s expected to only reach the bottom of the RBA's target range (2-3%) by the end of next year, lagging the US in particular.

Australian Equity Portfolios

Based on analysis by T Rowe Price, the Value rebound is only half-way through so there is still an improving outlook for domestic cyclicals though much of the easy gains have passed. For Australian equity portfolios it’s not too soon to think of taking profit on some of the Value positions that have done well and to position for a return to favour of Quality, and to a lesser extent Growth in 2022.

Later on in 2022, under the scenario of negative earnings momentum, Value is unlikely to continue to outperform Growth and T Rowe Price expects the Value rotation trade to first fade and later reverse.

As a result of the above view, the investment manager has been capitalising on the underperformance within the high-quality segments of the market. This underperformance over the past year has created opportunities for previously out-of-favour businesses such as select healthcare names.

To fund these changes T Rowe has taken profit selectively in positions where prices have run very strongly and where either valuations or earnings deceleration pose risks. Some examples of this are within the Bank sector and iron ore exposures. Regarding the latter, for the first time in the history of the investment bank’s strategy, there has been a full exit of pure play iron ore exposures.

Morgan Stanley concurs on the opportunity in the high-quality segment of the market. In short the investment manager is advocating better Value and sound Quality.

While the case for better Value remains intact, the deep value opportunity has largely passed and a more broad reflation exposure makes sense. Hence, reflation is still a persistent theme to stay exposed to though it makes sense to pivot towards the greater quality.

This in Australia can continue to be played through select Materials exposure with laggard opportunity in Energy. Fiscal beneficiaries also are supported while Banks and Diversified Financials also retain Value credentials.

Risks to the global and domestic outlook 

As mentioned previously, inflation is seen by T Rowe Price as the key risk. Beyond that, mutations in the covid-19 virus could side-track vaccination efforts, geopolitical concerns relating to China could worsen and cyberattacks are becoming an increasing problem.

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