Emerging from the winter of discontent

As we move through the second quarter of 2021, the global economic recovery continues apace, although market volatility and ‘mini tantrums’ are testing central bank credibility. Against this evolving market and macroeconomic backdrop, our Global Macro and Strategic Asset Allocation team explain why they are still pro-risk for now and outline their highly selective approach to asset allocation

Over a year since ‘the great lockdowns’ began across regions, the global economic recovery continues, though signs of increased divergences are strengthening. The economic damage has been less severe than expected following the winter surge in virus cases in many regions given generally lower stringency measures, better adaptation among populations and continued policy support. Effective vaccine roll-outs will be critical in the next phase of the pandemic, but the Covid-19 story is far from over yet, as variants start to become increasingly problematic.

Fiscal policy taking centre stage

The role of central banks and monetary policy remains important, but fiscal policy has taken centre-stage, and will dominate the macroeconomic and market outlook over the coming years.

We have seen an unprecedented flood of governmental relief payments during the lockdowns, amounting to $5.6trn or 26% of US 2019 GDP. Including the $3trn of infrastructure, green investment and social spending that President Biden has proposed in the Build America Back plans, total discretionary fiscal spending in the US over a several-year period could amount to a staggering $8.6trn, or 40% of 2019 GDP.

The logical outcome, and we believe the most lasting legacy of the Covid crisis, is the burgeoning public debt issued to fund this fiscal spending worldwide. This much higher debt burden, not seen in the US and other developed markets since WWII, will require major central banks (including the US Federal Reserve) to implicitly target negative real interest rates for the foreseeable future in order to maintain debt sustainability.

The conflict between pressure to keep rates low and a growing need to confront increasing inflation expectations on the back of unprecedented fiscal stimulus poses a serious challenge for the Fed and other central banks, which will define the post-pandemic landscape.

The reflation theme and style rotation are now starting to embed in markets

The unique nature of the Covid recession has meant the recovery has been speedy, already moving through the mid phases of the business cycle in some cases.

Through 2020 H2, we saw the hallmarks of an early cycle recovery with asset classes pricing it in accordingly: equities and credit rallying, yield curves steepening, and cyclicals and commodities performing strongly. Markets have been leaning into early-cycle reflation trades which have already rallied significantly leading to mid to late cycle type concerns arising. Also, with volatility picking up, there are signs we are passing through mid-cycle in terms of pricing. However, based on our analysis, we still believe the reflation trade has more to go.

Coming into Q2, we remain positive on equities given strong earnings and the prospects for strengthening global growth, and more negative on duration and cash. Within fixed income, high yield assets look more attractive than investment grade counterparts due to falling high yield default projections and tightening credit spreads. Meanwhile, we prefer equity regions more geared to the cyclical upswing such as Japan and emerging markets. UK equities will also be a beneficiary given their highly cyclical sector composition and the better than anticipated vaccine roll-out.

The ‘new abnormal’

Given the high and rising debt burdens, the global economic system is highly exposed to a steep rise in interest rates. Keeping real rates in negative territory, in our view, has become a monetary policy goal.

With economic re-opening drawing nearer and massive fiscal easing in the US putting upward pressure on cyclical inflation, having a strong anchor on the relationship between breakevens and real rates (based on lessons from 2013 and 2018) will be critical in shaping our views on risk assets.

From a strategic asset allocation standpoint, we believe it is imperative to re-think the current core asset mix and in many cases accept that a traditional 60/40 approach may no longer meet the needs of investors over the coming years, especially when looking at European and Japanese government bonds.

As investors, we must therefore also be open to designing portfolios using a different framework and developing new toolkits to build robust portfolios against this evolving backdrop. When it comes to designing strategic asset allocation, we must acknowledge the profound changes in the evolving macroeconomic landscape and move towards a more flexible approach to mapping the investment implications of the ‘new abnormal’.

This article is an excerpt from a longer paper from Fidelity's Global Macro Team. You can access the full version by clicking here.

About the authors

Salman Ahmed, Global Head of Macro and Strategic Asset Allocation, Fidelity International

Salman Ahmed joined Fidelity in August 2020. Previously, he was co-chair of Global Investment Committee and Chief Investment Strategist at Lombard Odier IM (LOIM). Before spending nearly 8 years with LOIM, Salman was head of Global Macro at Edf trading between 2009 and 2012. He also spent nearly 5 years with Goldman Sachs International as a global economist within the global macro team. He began his career in finance with Watson Wyatt (now Towers Willis Watson) in 2001. Salman holds a PhD and MPhil in Economics & Finance from University of Cambridge. He obtained his undergraduate degree from Lahore University of Management Sciences, Pakistan, in 1999.

Anna Stupnytska, global Macro Economist, Fidelity International

Anna Stupnytska leads the production of input to investment teams on globally relevant macroeconomic variables, probability weighted economic outlooks and producing macro and policy views across major developed and developing economies. Anna has been at Fidelity for over six years, starting as Global Economist and team leader of Markets Research and, more recently, as Head of Macro and Investment Strategy. Prior to joining Fidelity, Anna was Macroeconomist at Goldman Sachs and a leading member of the team famed for coining the concept of BRICs. Anna holds a First class MA (Hons) degree in Economics from the University of Cambridge and a Masters of Philosophy in Economics (with Distinction) from the University of Oxford.

Wen-Wen Lindroth, Lead Cross-Asset Strategist, Fidelity International

Wen-Wen Lindroth formulates cross-asset and top-down investment strategies and organizing macro forums for the firm. Wen-Wen joined Fidelity in 2014 as a global power and utilities analyst and has over 20 years of experience as an investor in equities, fixed income and derivatives in the US, Europe and Emerging Markets. She was previously a Senior Vice President at PIMCO in Newport Beach, CA. Wen-Wen holds advanced degrees in Philosophy, English and Foreign Affairs from Stanford and Georgetown and earned a bachelor of science degree from MIT in 1992.

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