With inflation worries unlikely to dissipate in a hurry, growth set to remain strong and central banks gradually becoming more restrictive, 10-year yields currently look too low at 1.3% in the US and 0.7% in the UK. A rise in yields in turn means conventional government bonds are likely to deliver negative returns over the coming year.
Corporate bonds should fare a little better, but even so prospective returns look set to be no more than 1-1.5% or so. The yield pick-up over government bonds has fallen to 1-1.25%, close to historic lows, and has no room to compress any further.
Positioning
We maintain a constructive pro-equity stance. Our allocation to risky assets, and equities more specifically, is a little higher than we would expect over the long term. This seems appropriate that equities should outperform bonds appreciably, even if the upside is no longer so substantial.
UK equities are one of our favoured areas. The key attraction here is their cheapness, with their P/E ratio now as much as 30% lower than the rest of the world. The UK has recently given back some of its outperformance since November as the rotation into value has gone into reverse. But it is well placed to benefit if, as we expect, value comes back into favour. UK equities have as yet regained only a small part of the underperformance seen over the last few years.
Within our UK exposure, we retain a tilt to small and mid-cap companies. They have outperformed substantially over the past year but their cyclical bias means they have some scope to outperform further on the back of the economic rebound.
We remain cautious on US equities, which have recently recaptured the underperformance of late last year. Valuations are the main concern, with the US P/E now some 40% higher than elsewhere. This gap is considerably higher than seen in the past, other than briefly last year. The US would also suffer from a resumption of the move towards value, just as it has benefited recently from the rotation back towards growth stocks and the technology sector.
Finally, the regulatory and taxation environment is becoming less favourable. President Biden has plans to raise the tax rate both on corporations and on dividends and capital gains. The OECD has also agreed a new minimum global corporate tax rate from 2023. If this is enacted, it would hit the US tech giants relatively hard due to the size of their overseas revenues.
We have become less averse to Europe now the vaccine roll-out has picked up speed, allowing the economic recovery to get underway. That said, equity valuations are not especially cheap and other markets should
benefit more from a further rotation towards value. Longer term, the underlying structural defects of the eurozone also remain a concern.
We continue to favour Asia and emerging markets due to their long-term strong growth prospects and relatively cheap valuations. China’s vast domestic equity market, is a fertile hunting ground for active stock
pickers, is also a major attraction.
China, however, has underperformed this year, reversing last year’s outperformance. This has been caused by a rotation away from last year’s winners, relatively tight monetary policy and an intensification of the regulatory crackdown on sectors such as technology and education. Still, the authorities will not want to seriously undermine either the stock market or economic growth and their actions should now be largely complete and priced in. The longer-term attractions of China remain intact.
