Global Outlook November

Author

Gerry Fowler, Investment Director, Multi-Asset Solutions

We are approaching the end of 2020…. what a year it has been! If you’re like me, you will have experienced ‘covid-time’ where days, weeks and even months became somewhat indistinguishable from each other. The relative serenity of 2019 feels a lifetime ago and it might as well have been 1BC.

This year we have seen Governments and central banks being more active than they have been in decades, with efforts to support the economy and their citizens. However, crisis volatility brings dispersion and interventions come with unintended consequences. There has been a large divergence opening up between the winners and losers from the economic effects of Covid-19 and the policy support attempting to be offsetting. This divergence has been dubbed the K-shaped market. In this Outlook, these themes of divergence in policy interventions and divergence in financial winners and losers is pervasive.

In the first article, James McCann, Senior Global Economist and Stephanie Kelly, Senior Political Economist, both of the ASI Research Institute, sit down together one week after the election and discuss what we might expect from a Biden presidency.  In terms of the White House, it may be all over bar the shouting, but the race for the Senate rages on. What does this mean for markets and what are the implications for investors?

Next, the most recent earnings season has been reviewed by Karolina Noculak, who finds that companies are only modestly being rewarded (with higher share prices) when they beat expectations. This could be in part because Covid-19 has caused a serious reduction in visibility for companies and fewer than normal are providing outlooks for 2021. Conversely, companies that are missing expectations are seeing a much larger impact on their share price as the K-shaped market continues to provide plenty of capital to the companies that need it least, while capital becomes increasingly scarce for those that need it most.

One part of the market that is not suffering from a lack of capital allocation this year is the renewable energy sector. As the latest wave of Covid-19 cases and lockdowns spread around the northern hemisphere, we continued to see the next socio-economic wave building too. That wave is climate change. As investors, this is translating through the rapid adoption of ESG investing as a norm. Jim Gasperoni, Co-Head of Real Assets, highlights that the market has numerous small and private operators that are ripe for consolidation presenting opportunities for private capital to create efficiencies and profitable investment opportunities that are also supportive of renewable energy transition goals.

Finally, when we speak of policy intervention, countries have differed in their reliance on monetary and fiscal tools. India is an example where monetary policy has been particularly dominant. Ray Sharma-Ong, Investment Director, Multi-Asset Solutions, investigates the opportunities and finds that investment in the Indian bond market has quite a lot of appeal. India has been hit hard by Covid-19 but the RBI has continued to provide support for the economy with rate cuts and bond purchases among other tools. They are doing ‘whatever it takes’.

As we exit 2020 we face a vortex of key events for markets. Virus cases are rising again and politics are clouding the outlook for monetary and fiscal support around the world. Recent announcements suggest a vaccine is imminent and 2021 is likely to be a less turbulent year. If this crisis begins to pass, then the next wave to watch for is in ESG investing.

 

RISK WARNING

The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.
 

US election update: what does a Biden presidency mean for markets?

Economics

Authors

Stephanie Kelly, Senior Political Economist, and James McCann, Senior Global Economist

As the dust settles on a Biden victory, the race for the Senate rages on. What does this mean for markets and what are the implications for investors? Our experts regroup one week after the election to discuss what we might expect from a Biden presidency.

One week on and Georgia is front of mind

While the presidential winner looks clear, the party holding the Senate majority will be determined by two run-off elections in Georgia in January. With much still up in the air, this note provides an update on what we know, what we don’t know and what it all means for investors. We will continue to research the implications of these elections in the coming weeks. We will focus in particular on how regulatory changes might impact key sectors, most notably energy, ‘big tech’ and financials.

Third time’s a charm for Biden

Joe Biden looks set to become the 46th president of the United States, having passed the threshold of 270 Electoral College votes over the weekend, notwithstanding any substantive court challenges to the count in key states. As we had foreshadowed, Pennsylvania was crucial to his win but took a few days to materialise. We may see a further boost to Biden’s tally following a recount in Georgia, where the margin was razor-thin and automatically triggered a recount.

It took a few days for the results to come through, confirming our expectation that it would be an Election Week rather than Election Day. This reflects the huge amount of early and absentee voting and record-breaking turnout levels. In states where absentee ballots are counted early, like Florida, results started strong for Biden but ultimately turned in Trump’s favour. Conversely, in states like Pennsylvania where absentee ballots are counted afterwards, it took a few days for the ‘red mirage’ to clear and the ‘blue shift’ to show a stronger and ultimately decisive outcome for Biden.

The extent to which these trends are repeated in subsequent presidential elections will partly depend on whether absentee voting – which was accelerated due to Covid 19 – remains structurally higher in the US as a result.

Democrats struggled in House and Senate races

While Biden managed to carve out a path to victory, it wasn’t strong enough for both House and Senate candidates to ride on his coat-tails

While Biden managed to carve out a path to victory, it wasn’t strong enough for both House and Senate candidates to ride on his coat-tails. The Democrats are set to keep a majority in the House, albeit with a narrower margin after a disappointing Election Week.

The big question-mark for investors is who wins the Senate majority. The current balance is 48-48, with Republicans set to win the races in North Carolina and Alaska to take them up to 50 seats. However, we will have to wait until January 5th for two Georgia run-off elections to find out whether Democrats can get to 50. As a reminder, the Democrats only need 50 seats for a majority because the vice-president casts the deciding vote in a tie.

The Republicans are early favourites to win the run-offs in the traditionally Republican state of Georgia, given their results in the first round and the expectation that lower turnout in January will benefit Republicans. We think the Republican party has a roughly 70% chance of winning both Georgia run-offs. However, we shouldn’t rule out the Democrats completely; this election is set to be a very high-profile and expensive race given what is at stake for the Democratic administration. We will be watching closely for signs that momentum is building for the Democrat candidates through high-profile political efforts, polling and race funding.

Fiscal policy looks very different depending on whether Congress is split or united

Uncertainty over who holds the balance of power in the Senate is one of the reasons why we are sceptical that any short-term Covid support legislation can pass during the ‘lame-duck’ session. Moreover, an acrimonious handover, with President Trump refusing to concede the election, makes it harder to know if he will even support legislation. However, uncertainty is very high at present and we will need to look carefully for signs that bipartisan progress is being made, especially with Senate leader McConnell having pushed the case for a short-term deal. In particular, we will be watching negotiations over the December 11th government funding deadline for indications that stimulus measures could be packaged into this legislation.

Absent this, a Democratic sweep remains the easiest policy environment to forecast. This outcome would likely lead to a large short-term Covid relief plan early next year. We had pencilled in a $2.3 trillion (tn) package under this scenario in our work before the election. This sum could even drift higher if worsening Covid trends persist. This would deliver a structural loosening in fiscal policy amounting to over 3% of GDP next year, over and above the 10% stimulus delivered in 2020 (excluding contingent liabilities and loans). As we highlighted in our work pre-election, the size and persistence of this fiscal boost would make us notably more confident around the US growth and inflation environment over our forecast horizon. Also, it would pull forward the expected date for Federal Reserve policy tightening.

Chart: US fiscal impulse – year-on-year (y/y) change in structural deficit (% of GDP)

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ASI and the Congressional Budget Office 2020

A unified Congress would also be able to deliver at least part of Biden’s broader policy agenda for significant increases in spending, only partly financed by higher taxes. A narrow majority in the Senate would probably force compromise around some of these policies. Nevertheless, a net stimulus of around $1tn seems possible through this legislation, with this likely to be heavily front-loaded. Factoring this into our fiscal forecasts still suggests a sizeable tightening in fiscal policy in 2022 of around 9% of GDP. This should be easier to manage, given that the recovery is expected to be much further advanced by this point, helped by expected progress in the Covid vaccination program. If the economy is more vulnerable, we would expect further fiscal support to lessen this fiscal cliff.

The more likely scenario, in which President Biden faces a split Congress, is challenging to call. In our work before the election, we had predicted that partisan gridlock would stall all major legislation efforts, as House Democrats and Senate Republicans fail to agree on the size and scope of any package. This would have delivered a huge structural tightening in fiscal policy of 7.5% of GDP next year according to our calculations, putting significant stress on the recovery. However, since then, we have seen a renewed domestic Covid crisis put the focus on the need for additional support. Our contacts in the Republican party believe that there is appetite in the Senate to work with Democrats across the aisles on this particular issue, albeit within tighter spending limits.

The upshot is that we would now expect a Covid relief package costing between $500bn-1tn to be passed under a Biden split government in early 2021. However, it is important to note that stimulus of this scale would moderate - but not eliminate - the tightening in fiscal policy current taking hold, as large parts of the CARES act expire. Indeed, even if we assume that a stimulus bill lands at the top end of this range, we would still see a y/y structural tightening in fiscal policy of around 3% of GDP in 2021. Certainly this will provide an unhelpful headwind for the recovery, in an economy which is likely to continue to face disruptions from Covid through much of 2021, even with the prospect of an efficacious vaccine being rolled out through the year.

Moreover, this tightening is likely to persist into 2022 under a split government (7% of GDP). Biden’s policy program for higher taxes and spending looks impossible to pass without control of the Senate. Our Senate Republican contacts did suggest that their members might be open to an infrastructure plan, but warned that financing this through tax hikes or debt were unrealistic. Therefore, we expect no further major fiscal legislation outside of short-term Covid relief, reducing the expected responsiveness of fiscal policy to economic conditions.

Chart: US fiscal impulse – y/y change in structural deficit (% of GDP)

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ASI and the Congressional Budget Office 2020

Whatever the make-up of Congress, Biden can and will act on regulation, trade and foreign policy

Given presidential powers in regulatory matters, we expect greater regulatory pressure and scrutiny of non-renewable energy, technology and financials to be high on Biden’s agenda, although precisely which regulatory changes are likely remains to be seen. In particular, we expect that Biden will tighten regulation to tackle climate change and boost renewables. Tighter regulatory standards on emissions and empowering the Environmental Protection Agency will likely challenge traditional high-emitting industry but make winners of renewables providers and suppliers to the sector. It isn’t just a question of which regulations are changed but also how existing regulations are interpreted. This can come through presidential appointments to lead regulatory agencies.

That said, it will be almost impossible for Biden to pursue his more ambitious climate objective of putting the US on a path towards ne-zero emissions by 2050 through regulatory means within the scope of existing legislation alone. The upshot is that we should expect greater emissions mitigation than under a Trump presidency but much less than if Democrats were able to win a Senate majority.

The impact of regulatory change can be quite challenging to quantify. In the coming weeks, we will be embarking on research to better understand what the president’s regulatory powers and agenda could mean for major sectors including energy, big tech and financials.

In spite of significant executive power around regulation, there is a strong likelihood that tightening policy prompts legal challenges. This will pit Biden against the judicial system and Supreme Court. Given the new Conservative tilt on the Supreme Court, there is a chance that the legal system resists some of these efforts, creating more uncertainty about the outlook.

On trade policy, we expect Biden to strike a more strategic, multilateral approach, notably improving relations between the US and European allies. One likely consequence of a more constructive US-EU partnership is progress on the OECD digital taxation initiative. On China, Biden is unlikely to rapidly reduce trade barriers with China given the domestic political backdrop. Instead, we expect he will opt for a strategic review of the relationship, engaging more with multilateral organisations. This should nonetheless help reduce headline volatility and fears of de-globalisation.

Markets react positively

Judging the market reaction to the election result is complicated by the unresolved outcome in the Senate. However, the consensus is likely to be that Republicans will win both run-offs in Georgia and therefore retain control. If this is right, then some of the immediate market moves expected in our cross-asset work under a split Biden result have played out, while some have not materialised as anticipated.

Certainly, this has been the case in currency and rates markets. As expected, the dollar was broadly stable, falling by a modest 0.7% in trade-weighted terms by Friday. Investors seemingly balanced out the benefit of a predictable geopolitical policy from President Biden with the potential disappointment from the receding chance of domestic policy fireworks that we would have expected under a blue sweep. Similarly, rates markets rallied as predicted, with the long-dated end outperforming, before both trends reversed following yesterday’s very positive vaccine news. Inflation pricing came under particular pressure during this yield curve flattening. Again, this likely reflected a pricing-out of sustained and reflationary stimulus under the blue-wave scenario.

However, risk assets preformed slightly better than we had been anticipating at the headline level. The S&P 500 Index was up 4% by the end of the week while both investment-grade and high-yield corporate bond spreads tightened. We had expected these markets to be flat, or modestly weaker under this result, largely due to our guidance that fiscal stimulus would be much more modest in this environment. In part, this could reflect a relief rally as uncertainty over a smooth transition of power eases, despite President Trump’s legal challenges. Moreover, building expectations that a split government will be able to get something done on short-term Covid relief could be providing some support, even if this is likely to be more modest than under a Democrat sweep. Finally, the falling likelihood of tax hikes under a Biden government could be helping these assets. However, we have to remember that these receipts would have been used to finance even larger increases in government spending, which would have boosted pre-tax earnings.

Image credit: Getty Images / Joe Raedle / Staff

While Biden managed to carve out a path to victory, it wasn’t strong enough for both House and Senate candidates to ride on his coat-tails
 

Third-quarter earnings: overshadowed by uncertainty

Earnings

Author

Karolina Noculak, Investment Director, Multi-Asset Solutions

With the third-quarter reporting season well underway, we’re seeing some welcome improvements in corporate earnings. But as the Covid crisis continues, huge uncertainties persist, and that has muted investors’ response.

So far, third-quarter earnings are showing a marked improvement on a savage second quarter. Year-on-year contractions are now averaging around 13% in the US and 30% in Western Europe – compared with 30% and 50% in the second quarter.

Analysts’ expectations are being beaten too. Unusually, analysts in developed markets had upgraded their earnings expectations before reporting season began. Even so, most companies have beaten those expectations by wide margins.

It looks as though around 85% of companies will beat consensus expectations. But there’s one big caveat: outlook and guidance from companies have been uncertain or absent altogether.

That’s the main reason that the stock market hasn’t reacted positively to earnings beats and has penalised missed expectations severely. Investors haven’t been looking in the rear-view mirror but want some clarity on what lies ahead. Companies have been unable to provide that.

Take the banking sector. In the first half, the focus was on provisions for delinquent loans. But even after those massive provisions, banks still don’t know where they stand. Jamie Dimon, JP Morgan’s CEO, said that his bank could be overprovisioned by $10 billion or, in the worst-case scenario, underprovisioned by $20 billion. That colossal $30-billion swing shows just how uncertain things are.

At the macroeconomic level, the uncertainty has two distinct strands. First, there is the US election, which could change the fiscal outlook there significantly. Second, there are the questions over the path of the pandemic, the return of lockdown measures and the possibility of an effective vaccine.

Earnings announcements are raising important questions too. In the technology sector in particular, expectations of future growth appear to have overshot. Netflix missed expectations by a wide margin. The company had earlier warned that it was ‘pulling subscribers from the future’ during lockdown, but its shares still fell sharply after its announcement. Despite beating earnings expectations, Facebook was also punished after it reported a decline in the number of its US users. Twitter beat earnings expectations but disappointed in user growth. Its shares suffered a sell-off in response.

These disappointments offered a reminder that the growth such companies enjoyed in the first half of the year was boosted by accelerated take-up for their services when most people were confined to their homes. So investors shouldn’t expect that growth to be sustained at a similar rate in the quarters ahead.

Three of the largest tech companies – Apple, Amazon and Alphabet – all surpassed earnings-per-share forecasts. But in each case, investors have focused on what lies ahead. Alphabet has been rewarded for returning to sales growth, but Apple has been punished for weakness in iPhone sales. And Amazon’s eye-catching third-quarter earnings were outweighed by its lacklustre fourth-quarter forecast.

The key issue here is the sustainability of the Covid ‘winners’ – the high-growth companies that prospered as the pandemic crushed their peers. What happens when and if activity normalises?

The key issue here is the sustainability of the Covid ‘winners’ – the high-growth companies that prospered as the pandemic crushed their peers. What happens when and if activity normalises? Will ‘value’ stocks – such as industrials – play catch-up? And could that change the leadership of the market?

If an effective vaccine materialises and Joe Biden wins the US election by a substantial margin, banks and industrials could stand to benefit from both restored normality and increased fiscal stimulus. That could prompt a rotation away from tech stocks and towards cyclical areas of the market. We should be clear here that we don’t expect a sustained shift in leadership away from growth stocks (those supported by strong secular trends), but we do think that value stocks could stage a temporary snap-back under the right conditions.

And conditions for those companies appear to be improving. The results of the third-quarter reporting season point to a broadening of ‘beats’ towards cyclical parts of the market – earnings of industrials, consumer and media stocks surpassed expectations, although they remain in deeply negative territory when compared with last year.

Another intriguing trend is the improvement in earnings at manufacturers of luxury goods, such as Kering, LVMH and Hermes. These companies did badly during lockdown. Now, however, they are receiving a boost from the recovering Asian consumer. Asian countries have benefited from their ‘first in, first out’ status during the pandemic, and the effective containment of Covid-19 in China, South Korea and Taiwan has allowed a semblance of normality to return there.

As the lack of corporate guidance indicates, it may be quite some time until we have clarity on the course of the pandemic and its economic effects. In the meantime, volatility and uncertainty are likely to persist. But as we look into 2021 the prospects for earnings recovery remain very real – especially in those areas where the Covid pandemic has punched the biggest holes.

The key issue here is the sustainability of the Covid ‘winners’ – the high-growth companies that prospered as the pandemic crushed their peers. What happens when and if activity normalises?
 

Energy transition an accelerating trend

Real assets

Author

Jim Gasperoni, Co-Head of Real Assets

We might now be months into this pandemic-induced crisis, but investors are still assessing the market trends it has created and the impacts it has made. The real assets sector, an area typically known for its diversification benefits and inflation-hedging characteristics is one of the areas under scrutiny. Unfortunately, in recent years, the asset class has become almost synonymous with volatility and underwhelming returns. With commodity prices collapsing in line with reduced demand and rising inventories, the current crisis has provided no respite.

For those investors focused on the power-generation sector, the broader market remains questionable. Even with recovering economic activity, fewer people are working in offices, visiting restaurants and shops. Less overall demand for electricity is the result. The International Energy Agency expects global electricity consumption to decline by 5% in 2020 compared to 2019. This would represent the largest annual decline since the Great Depression and is eight times greater than the demand drop-off in 2009 following the global financial crisis. This has led to lower electricity prices and has made it more difficult for high-cost conventional generation methods to remain viable. Investors might assume that such issues apply to all power-generation methods – but the resilience of the renewable power sector has surprised many. What makes it different?

The answer to this question may lie in longer-term trends that were developing prior to the COVID-19 crisis – some of which have actually accelerated over the past few months and the evolving dynamics across the U.S. are reflective of the transition.

The growth of renewables before Covid-19

Even before Covid19, the world had been undergoing a shift in power generation from older conventional methods, such as coal, to alternative sources such as natural gas and renewable energy. According to the US Energy Information Administration, in 2010 coal represented 45% of the country’s electricity net generation (measured in megawatt hours) compared to natural gas at 20%. Meanwhile, renewable energy sources provided a mere 1% of the power-generation mix.

Chart: US Electricity Generation by Source

 

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Source: EIA AEO 2020, January 2020

At the end of 2019, the U.S. power generation mix had shifted. Coal had declined to 24%. And while the natural gas contribution increased meaningfully to 38%, it was the emergence of renewable energy as a significant provider at 19% of the overall share that captivated investors.

What caused this massive change in the energy landscape? The simple answer is that renewable energy has become much more cost-competitive relative to other traditional generation methods. This is largely due to advances in the underlying technology and development process. For example, costs for solar and wind projects have fallen to $20-30 per megawatt hour (MWh) compared to a decade earlier when costs were above $100. As such, these renewable methods are increasingly displacing the more expensive, although traditionally important, methods of power generation (e.g. coal-fired power plants).

Renewable energy has been buoyed for the past decade by a combination of government subsidies known as Production Tax Credits (PTCs) and Investment Tax Credits (ITCs). It is now clear, however, that these credits have incentivised early players to move into the industry and to innovate further. PTCs and ITCs were intended to reduce costs to a point where renewable power generation could eventually compete with conventional methods once the subsidies rolled off. This is the point we find ourselves at today. Further, renewable power assets, as elements of critical infrastructure, appear to have held up well during this period of volatility. Those with long-term power purchase agreements that have contracted cash flows over extended periods of time have shown particular evidence of this trend.

An industry ripe for continued disruption – a private capital opportunity

Subsidy incentives and advances in renewable technology have led to a wave of capital entering the sector to benefit from this industry shift. This is especially true at the smaller end of the market. The result is an unnatural ownership base as well as a high degree of fragmentation – not only are these owners unfamiliar with operational “best practices” in the renewable energy sector, but there are also too many of them.

The combination of this unnatural ownership base, a high degree of fragmentation and an industry in transition presents an opportunity for sophisticated players with specialised experience in this sub-sector. They may be able to consolidate these smaller assets at attractive prices. Private capital focused on the power sector is well positioned to finance the acquisition and aggregation of renewable projects in the lower middle market where large investors may not be willing to spend the resources.

Much of the real assets sector has operated in a challenging environment for the past eight years. Renewable power remains an exception

Much of the real assets sector has operated in a challenging environment for the past eight years. Renewable power remains an exception. Given the favorable trends described above – many of which were well underway prior to the current crisis – it may prove more resilient and more durable than previously thought. It is also possible that long-term, patient investors, such as those within private equity, can capitalise on specific inefficiencies that have hindered greater growth in operating performance.

Much of the real assets sector has operated in a challenging environment for the past eight years. Renewable power remains an exception
 

When the central bank builds a goldilocks cottage for India bonds…

Multi-asset

Author

Ray Sharma-Ong, Investment Director, Multi-Asset Solutions

The divergence in fiscal and monetary support for India has created a supportive environment for Indian Bonds within a multi-asset portfolio.

India’s partial economic rebound is on the way, what should we make of it?

As India transits out of lockdown in phases, the re-opening of Indian states has led to a natural rebound in the economy, driven by low base effects. We are of the view that this rebound will be a partial one as there are many factors at play that threaten the completeness of the economic recovery. Despite this, we do see investment opportunities arising from it, as the current divergence between fiscal and monetary support has led to the creation of an environment that is favorable for Indian bond investors.

In this article, we aim to explore the key drivers supporting the environment for Indian bonds by looking at: (a) the existing fiscal impulse from the Indian government, (b) the steps taken by the Reserve Bank of India (RBI) to support the Indian the financial system, and (c) the attractiveness of Indian Bonds when compared to its regional peers.

Low fiscal impulse despite India’s pre-Covid struggles

As India transits out of lockdown in phases, the Indian economy is rebounding from its Covid-driven slump. We are of the view that this recovery will be an incomplete one, owing to the following factors:

a) India entered into the Covid crisis in a much weaker state than other economies, as it was struggling to deal with numerous pre-existing challenges, namely

  • Teething effects pertaining to implementing of a Goods and Services Tax (GST)
  • Tax collection challenges and revenue shortfalls
  • The ripple effects of India’s demonetization drive

b) India has not managed to contain the spread of Covid, and continues to have one of the highest number of active Covid cases in the world. The high rate of infection prevents the effective resumption of consumption and services.

c) India’s sovereign credit rating is currently at BBB-, and with its consolidated fiscal deficit is expected to be at about -12% of GDP this year. As such, concerns about its credit rating have inhibited more substantial fiscal support for the economy.

India’s discretionary fiscal support for the economy at present is at about 2.1% of GDP. Discretionary fiscal support is important as it provides direct assistance to households and businesses affected by Covid related demand and supply shocks. In relative terms, India’s support package of 2.1% of GDP is very low compared to what both developed countries and other emerging markets. Countries such as the United States through its CARES Act has provided discretionary fiscal easing to the tune of about 12% of GDP, six times that of India’s. We are of this view, that given the low fiscal impulse, the trajectory of India’s growth rebound will not be as strong as the other economies.

India’s central bank to hold the fort

With fiscal purse strings tight in India, monetary support for the economy has been in the spotlight, with the Reserve Bank of India (RBI) being expected to do most of the heavy lifting.

The RBI has placed the revival of the Indian economy as its top priority, and since the beginning of this year, the RBI has eased policy rates by a total of -115bps (-75bps in March, -40bps in May).

At the most recent RBI policy meeting on 9 October 2020, the RBI reaffirmed its commitment and sent strong dovish signals to the market by introducing additional measures such as:

  1. Doubling its Open Market Operation (OMO) purchases to INR 200bn (from INR 100bn previously)
  2. Conducting special OMO purchases of India State Development bonds
  3. Extending held-to-maturity (HTM) limits for banks to March 2022 (from March 2021 previously).

The RBI governor also provided guidance to market participants that the central bank would do whatever it takes to support liquidity and to ensure an orderly functioning bond market.

With the RBI committing to ensure that the government and state borrowing programs function in a non-disruptive manner, by acting as a backstop to prevent any disruptive spikes in bond yields, this creates a favorable environment that is supportive for Indian bonds.

Inflation has been a concern for market participants, as high inflation may restrict the RBI’s ability to provide further monetary support. While inflation at present is above RBI’s headline inflation target range of 4% +/-2%, we are of the view that inflation pressures will ease off over the next few months. This expectation is driven by (a) the easing of supply chain bottlenecks related food and transport prices as lockdown restrictions ease, and (b) lower food prices due to higher crop yields as this period’s monsoon is generously above historical averages (7% above normal).

Given the high weights of food and transport in India’s headline inflation basket (CPI), the easing of prices from these two components will have a material impact on inflation. (Table 1)

Table 1: India CPI Breakdown (%)

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Source: Central Statistics Office India (30 September 2020)

What provides support to our view is that the RBI’s own projections are in line with our expectations, and that these projections point towards the easing of headline inflation over the next few quarters. (Table 2)

Table 2

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Source: RBI (9 October 2020)

Valuations supportive for the India Bond Market

Given the RBI’s commitment to ensuring a non-disruptive bond market, we think this increases the attractiveness of the current policy spread between India bonds and current Repo policy rates.

Given the RBI’s commitment to ensuring a non-disruptive bond market, we think this increases the attractiveness of the current policy spread between India bonds and current Repo policy rates.

The policy spread, and RBI support provide investors with higher degree of certainty over India bond demand / supply dynamics and with a sizeable carry buffer. (Chart A)

Chart A: 5 Year Policy Spread

 

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Source: Bloomberg, RBI & ASI as at 23rd October 2020

Looking outside of India, relative to other Asia regions, India bonds are higher yielding with steeper term structures. This provides attractive carry and roll characteristics for investors. (Chart B)

Chart B: 5 Year -2 Year Slope

 

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Source: B & C: Bloomberg, ASI as at 22nd October 2020

Given a low for longer monetary policy rate environment across most regions, investors searching for yield have extended duration exposures to reach for higher yields. While the bond markets in other regions face similar issues, the valuations of Indian bonds on a duration-adjusted basis are attractive. (Chart C)

Chart C: 5 Year Yield Per Unit of Duration

 

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Source: B & C: Bloomberg, ASI as at 22nd October 2020

Putting the attractiveness of Indian bonds into perspective, within the context of Multi-Asset portfolios, Indian bonds provide diversification benefits given their low correlation to developed and emerging market equities. In addition, they can provide an effective way to utilise a portfolio’s duration budget, given its high yield per unit of duration versus regional peers. Indeed, in September and October 2020, our Multi-Asset portfolios with allocations to India bonds benefited as India bond yields held in, while US bond yields climbed higher.

The road ahead…

With fiscal policy constrained in India, the RBI is expected to carry most of the burden for supporting the Indian economy. With the RBI prioritising the revival of India’s growth, and committing to ensure that the Indian government / state borrowing programs function in a non-disruptive manner, the RBI is effectively acting as a backstop against bond yield disruption. In our view, this creates a ‘goldilocks’ environment that is supportive for Indian bonds.

Looking ahead, while the current environment may be supportive for Indian bonds, all is not lost for India’s economic recovery.

In order for India’s economic recovery to be more sustained, we think there are two key critical requirements:

  1. A greater sense of political urgency and willingness will be needed to implement a more forceful fiscal support
  2. The release of the Covid vaccine

Through recent events, we have seen that if the ruling Indian BJP party seeks to address an issue with greater political urgency and willingness, then results can improve. As an example, in the past quarter, the BJP has managed to push through the liberalization of some labor laws and has introduced agriculture reforms streamlining India’s food distribution process.

While politics has often been the reason for holdbacks, at the next parliamentary upper house election in November 2020, it is possible that the BJP may take control of the upper house. This will result in the BJP controlling both the upper and lower house, potentially making it easier to push through further economic support measures.

In terms of the expected Covid vaccine, its timely arrival would, hugely benefit India, given its global leadership in the number of infected cases. This would allow for a further economic rebound lead by the service sector.

In summary, while there are some bright sparks on the horizon for Indian bonds, investors should continue to tread cautiously given the risk factors surrounding Covid and Indian policy effectiveness.

Given the RBI’s commitment to ensuring a non-disruptive bond market, we think this increases the attractiveness of the current policy spread between India bonds and current Repo policy rates
 

Tactical Asset Allocation

MULTI-ASSET

The Multi-Asset Tactical Asset Allocation (TAA) team’s view on bonds, equities, commercial property and other assets will affect asset allocation over the coming months. When making these asset-allocation decisions, we first consider the outlook for each asset class (e.g. government bonds), followed by views within that market (e.g. the US versus Europe, or European core economies against peripheral countries).

The views of individual asset class teams may differ to this multi-asset TAA view.

ASSET CLASS POSITION COMMENT
Government Bonds Negative

We have made no changes to our government bond allocation compared to a month ago and remain underweight. However, when coupled with our overweight exposure to Credit, our interest exposure (as measured by duration) is close to neutral. While we think government bonds in the developed world are expensive, the conditions for a substantial rise in yields are still not in place: central banks are expected to maintain a very loose policy stance for a long time, growth risks remain skewed to the downside, and inflation is expected to remain well contained. We still expect economic growth to reaccelerate next year and market inflation expectations to pick up: we therefore retain a US Treasury yield curve steepening strategy (the granular nature of this position cannot be reflected in the table) as the Federal Reserve will not be able to restrain longer-dated yields, and also remain overweight US breakeven inflation. As we go to press the US election has just taken place and it is too early to draw concrete conclusions, although it looks like the chances of a Democrat clean sweep are increasingly small, which means we may have to revisit both our yield curve and inflation views. Finally, in order to hedge against economic disappointment, we continue to hold Australian government bonds.

UK Gilts Neutral
US Treasuries Positive
European Core Negative
European Periphery Negative
Japan Negative
Australia Positive
UK Index Linked Neutral
US TIPS Positive
Credit Markets Positive

The attraction of credit has diminished as spreads have narrowed over the last few months, which explains why we have already removed our overweight in investment grade corporate bonds where we retain a neutral stance. However, we expect investors' hunt for yield to remain a powerful force, leading to some further spread compression in lower quality credits, namely high yield. However, during the recent equity market sell-off we have seen European high yield bonds remain relatively resilient, prompting a small reallocation from the latter into equities, marginally increasing the use of our risk budget. Portfolios retain their overweight to both Emerging Market Local Currency and USD-denominated bonds. While EM economies face considerable challenges, those which face the biggest issues have already seen material currency weakness and have lagged in the recovery that other credit sub-asset classes have experienced. An improvement in the global economic cycle over the next 12-24 months should gradually improve sentiment towards unloved EM currencies. However, the absence of a Democrat clean sweep in the US elections may reduce the previously made case of averaging in to a bigger position in the future.

UK Investment Grade Neutral
US Investment Grade Neutral
Euro Investment Grade Neutral
US High Yield Positive
Euro High Yield Positive
Emerging Market (Hard Currency) Positive
Emerging Market (Local Currency) Positive
Equities Positive

We have increased our overweight positioning in equities by initiating an overweight in Emerging Markets. The case for adding to equities can be made from two perspectives: first, prices have fallen recently as investor's attitude towards risk has been undermined by signs of a resurgence in Covid-19 infections in many large economies leading to renewed need for more social distancing: technical measures are signalling oversold markets. Second, there are some signs that investor positioning in equities has also fallen: there is little sign of greed or complacency, in contrast to some warnings in September. Our preference for Emerging Markets reflects the bloc's heavy weight (circa 80%) towards Asia: not only has this region's containment of the Covid-19 pandemic been more effective (and we expect this to remain the case), but the sectoral makeup of the bloc provides growth style attributes, which we expect to be of considerable benefit given the uncertainty surrounding the strength of the global economic recovery over the next year or so (properties that could become more attractive in the event of a Biden/Republican Senate outcome). We retain overweights in the US, Europe ex UK and Japan, while also remaining underweight Pacific ex Japan.

UK Neutral
US Positive
Europe ex. UK Positive
Japan Positive
Pacific Asia ex. Japan Negative
Emerging Market equity Positive
Property Neutral

A significant portion of the REIT investment universe has been severely disrupted by lockdown and social distancing policies and while long-term value exists in some areas, the outlook remains too uncertain to express an overweight stance. There is a huge divergence of fundamentals depending on the sector (e.g. data centres vs. retail), but at some point confidence in cash flows should improve in some of the challenged sectors. While low interest rates are supportive of REITs outperforming equities, the essential condition for this to trigger is a benign and stable growth outlook, but a catalyst for this to happen remains outside our investment time horizon.

US Neutral
Europe Neutral
Alternatives Positive

In search of alternative sources of diversification, we retain a small overweight in gold. While we do not expect gold to outperform equities, the asset class should benefit portfolios in the event that governments are forced to fund increased fiscal support through greater debt issuance.

Gold Positive
Cash Negative

With interest rates so low, cash remains the preferred funding source for risk-on positions.

CURRENCY OVERLAY POSITION COMMENT
Dollar Negative

The global compression of interest and bond yield spreads means that monetary factors are a less powerful driver of relative currency performance; nonetheless, the sharp decline in US interest rates relative to other major currencies has not been fully discounted and would support further modest US dollar depreciation - however the probability assigned to scenarios driving a more material US currency depreciation has probably diminished given initial US post-election developments. The strength of the Euro has been significant over the summer, and hence we remain underweight, while maintaining our Japanese yen overweight. A re-acceleration of global growth (beyond any short-term pause related to containing Covid-19 using localised lockdown policies) should also, at the margin, benefit pro-cyclical currencies such as in Emerging Markets. Finally we are still using the Australian dollar underweight as a potential cyclical hedge given its strong performance in recent months.

Euro Negative
Yen Positive
Australian Dollar Negative
Emerging Market currencies Positive
Sterling Neutral

The views and conclusions expressed in this communication are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security.

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Risk warning

Risk Warning

The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.