Published by UBS
Vaccinations overall are helping the re-opening process, even if there are slight regional setbacks. At the same time, central banks remain supportive and fiscal policy measures are still kicking in. Combined, all of this is leading to higher growth and inflation rates, as the economy is in the “reflation” phase.. In this phase, we think select areas like financials, energy, and materials should benefit, as should select re-opening winners across regions and commodities including oil.
With stocks well above their pre-pandemic highs, many investors are skeptical that there is much upside left. Yet there’s a number of factors in the market that support our view that there’s still an upside story to be told. First, strong earnings growth – with S&P 500 earnings for 1Q beating expectations remarkably, and Eurozone, Asia ex-Japan, and emerging markets earnings all rebounding sharply too this year. Second, low yields. The Fed looks set to maintain easy policy and defer any discussion around tapering until later in the year, especially after the surprising April payrolls report. Global central bank policy, including in Japan and the Eurozone should remain accommodative too. This should all limit how high US 10-year Treasury yields can go, and we maintain a year-end forecast of 2%. Third, appealing valuations. The equity risk premium in the US is around its 20-year average, while globally it’s well above its long-term average.
We see a number of beneficiaries from a reflationary environment.
Overall, companies that can easily pass on higher costs should benefit, because pricing power is crucial both over the short and medium term. Companies with pricing power should preserve or even improve margins and profits, even if their costs are rising.
Financials should benefit from the rotation to economically sensitive sectors, and are one of the biggest beneficiaries of higher bond yields. Meanwhile, energy stocks globally should also continue to outperform given they have not fully priced in the increase in Brent to USD 75/bbl by year-end as we expect.
In the US, we like large cap value stocks, given higher yields of around 2% as we expect and a strong economic recovery should favor the style over their growth counterparts. We also see potential for continued outperformance for US small-caps and mid-caps over large caps, given their more cyclical nature. Beyond their embedded cyclicality, small and mid-caps have superior earnings growth prospects versus large-caps and remain very cheap on a price-to-earnings basis relative to large-caps. Separately, ESG engagement equities tend to have a small- and mid-cap tilt, given those companies are likely more receptive to proactive investor involvement, so investors can both position for reflation and go sustainable.
We also like Japanese stocks, which have recently underperformed other cyclical peers due to slow vaccination progress. But the rollout is now picking up, earnings are recovering, and the Japanese market is also more resilient to real rate increases than other stock markets.
We see further potential for a catch-up trade among select stocks exposed to economic re-opening, across Europe, Asia, and the US, with the potential for relatively high earnings growth versus our global earnings growth forecast of around 30%.
We also think an environment of strong global economic growth, continued liquidity, and a weakening dollar should be beneficial for emerging markets, and Asia in particular.
Although there have been regional setbacks, as Asia’s economies reopen more fully, we expect a number of reopening winners, from six industries—capital goods, construction materials, consumer services, transportation, banks, and metals & mining—that should benefit from both reopening and reflation. In addition we have identified reflation beneficiaries in the twin-cities (Hong Kong and Singapore). In the US, vaccine distribution is running quickly, and the scale of pent-up consumer demand looks quite large, and so we have identified more cyclical stocks and leveraged to reopening trends. In Europe we have taken a similar approach, as consumers look forward to a “summer of fun.”
Commodities and oil
We also think this is a good time for investors to consider the role of commodities in portfolios, both as beneficiaries of faster growth and as a hedge against the risk that inflation proves persistent. We expect broadly diversified commodity indices to deliver 10% to 15% returns over the next 6–12 months. Within commodities, we also expect oil demand recovery to continue during the second quarter. We expect higher oil prices and forecast WTI and Brent crude to trade at USD 72/bbl and USD 75/bbl by end-2021.
We also expect rising commodity prices to support the currencies of commodity producers, including the Australian dollar, Norwegian krone, Canadian dollar, and Russian ruble.
Key investment takeaways:
- Growth and inflation are picking up backed by the vaccine rollout and accommodative policy measures. This phase of the recovery is known as “reflation.”
- Beneficiaries of reflation include financials and energy, and in a rising yield environment we expect US value to outperform growth. Japanese stocks can also be more resilient to rate increases.
- We see potential for re-opening winners across the globe, as the vaccine rollout accelerates and pent-up demand is unleashed.