- We have revised growth for the US and China up compared to our November forecasts.
- The current economic euphoria is driving U.S. bond yields higher, causing nervousness in the market.
- On a 12-month horizon, we do not see any sustainable upward trend in real yields, which means that risk assets still have potential.
...buy the rumor, sell the fact.
Investors' dilemma can currently be summarized as follows: On the one hand, the economy is at the beginning of an upswing that could this year produce one of the highest growth rates for the global economy in many decades. Hence we are seeing signs of early-cycle euphoria. On the other hand, the capital markets are displaying characteristics that one would expect in the late stages of a cycle: high valuations, a large number of IPOs, a boom in exotic forms of investment, and a certain degree of complacency on the part of investors. This means many investors don’t want to get off the dance floor – just so long as the music keeps playing.
The unusual mix of early and late cycle and investors' consequent dilemmas reflect the pandemic, which is also upsetting other patterns. For example, a large part of the momentum in financial markets is based solely on catch-up effects in an economy that previously suffered quarters of partial paralysis. You might say the dancers have only just been able to get back on the dance floor. There is therefore great uncertainty among economists about the sustainability of the current momentum. Gross-domestic-product (GDP) growth forecasts for the U.S. in 2022 range from just 1.8% to 6.1%, an unusually wide margin.
Another pattern that could be broken is the common market logic of "buy the rumor, sell the fact." That adage would suggest that if the pandemic is largely brought under control later this year, markets may have peaked. After all, the economy should be able to stand almost completely on its own feet again and there should be no more need for aid packages that are music to investors' ears. But in our view, the two largest stimulus packages, the U.S. and the European, will not begin to have an impact until later in the year. This, in turn, brings up another source of doubt, reinforcing the concerns of some market participants that some economies could overheat sooner or later. Especially since the central banks have so far countered any impression that they want to dampen the party just when it is getting swinging. That government bond yields are being pulled up in this environment is unsurprising; the speed at which they are doing so is.
We believe speed is also apparent in another area: sustainability. And here, too, central banks are playing a key role. DWS is also moving forward in leaps and bounds on this topic. This year, for example, we will review government and corporate bonds in terms of the ESG profile of their respective home country. In addition, we are planning to make ESG an integral part of the investment process across all asset classes this year. Besides meeting regulatory requirements and customer demands in this area, we believe a consistent focus on ESG has the potential to be positive for returns and, above all, the risk profile of individual investments.
Global economy likely to grow at record pace – yields are taking notice
The basis of our macroeconomic forecasts is the assumption that the pandemic will be largely brought under control in the course of the year and that no lockdowns on a similar scale to the winter now ending will be necessary next winter. We have upgraded somewhat our forecasts for global growth since our November 2020 outlook. We now expect 5.3% growth in 2021, instead of 5.2%, and 5.5% in 2022, instead of 5.2%. In particular, we have increased the 2021 forecasts for China (to 8.7% from 8.2%) and the United States (to 5.0% from 4.0%). We believe the two largest economies should therefore act as still more of a locomotive for the global economy and, in view of the latest figures on the economy and the pandemic, it cannot be ruled out that there may be a need for further upward adjustments. All the more so now that the stimulus package worth the full 1.9 trillion U.S. dollars has been passed in Washington. Because of its design – a large part is accounted for by direct checks to households and an increase in unemployment assistance – the U.S. package will in our view have a much faster impact than the European one. Of the 750 billion euros from the EU bailout fund, a maximum of one-third is likely to be disbursed to member countries this year. And further months are likely to pass before it is spent, so that the stimulus may approach 0.5% of GDP in the best case, compared with over 5% in the U.S., again in the best case
Global growth forecasts
We expect the U.S. and Asia to show a stronger recovery than Europe, Japan and Latin America
Sources: Bloomberg Finance L.P., DWS Investment GmbH as of 2/18/21; F refers to DWS Investment GmbH forecasts
The consequently increased transatlantic growth differential is certainly the most important change from our forecasts published in November, especially because of the impact on financial markets. Much has favored the U.S. so far this year. The Georgia by-elections provided political clarity and increased the government's ability to act. The fact that the Democrats were also able to secure a working majority in the Senate helped them to pass the stimulus package quickly. It continued with a relatively good reporting season for listed companies and the vaccination campaign, which is making rapid progress. In Europe, meanwhile, vaccinations are lagging. Only the United Kingdom is doing well, but it has otherwise been noticeably affected by Brexit and, like continental Europe, by extended lockdowns.
Inflation has come back into focus sooner than expected as a result of the combination of the growth upswing, stimulus packages and expansive central banks – and most recently also, sharply rising oil prices. In our view the inflation rate could reach or even exceed three percent in the U.S. in the second quarter and also in Germany towards the end of the year. However, we see this as only a temporary phenomenon, as many of the drivers of the inflationary uptick are pandemic-related one-off effects. The massive underutilization of productive capacity and labor in 2020 depressed prices last year. And normalization of commodity prices alone is providing a significant base effect. Together with pent-up demand for many goods, especially in services, this is likely to increase inflationary pressure this year, before it then subsides.
We do not expect larger, sustainable interest-rate increases
Central banks have repeatedly declared their willingness to look through the 2021 inflation spikes just described and leave both their key interest rates and bond purchases untouched. The market, however, is not buying the U.S. Federal Reserve's (the Fed's) story and has priced in one rate hike for early 2023 and two more by the end of 2023. Although the Fed has given itself a very flexible decision framework, we expect it will, at the least, face major communication challenges in the current year. Questions will mount about when it is going to respond to the likely rise in inflation, 10-year Treasury bond yields, mortgage rates and the dollar. Or, alternatively, whether it would take a sharp correction in the stock market or corporate bonds to prompt it to intervene. The Fed will have to strike a balance, finding reasons to remain expansionary without transmitting a pessimistic economic outlook.
Boredom is therefore unlikely in the U.S. bond market this year. In the case of 10-year Treasury yields, the two-percent mark could well still be breached, which could cause corresponding nervousness in risk assets. However, over a 12-month perspective, our strategic planning horizon, we expect the bond market to calm down again and see 10-year yields remaining close to 1.5%. In Europe, the European Central Bank (ECB) appears to have a much more relaxed year ahead. It seems likely to be able to operate largely on autopilot, at least as long as there is no surprise slump in the economy or markets. We see Bund yields at around current levels in twelve months' time, following the upward movement in U.S. Treasury yields only to a small extent. Over the next one to two years, and this is the key assumption in our forecasts, we expect the low-interest-rate environment to continue. This also means that we expect negative real yields in the ten-year range in both the U.S. and Germany over the next two years.
Our focus in these regions therefore remains on corporate bonds. Although they are not immune to the current rise in yields, we expect fewer non-performing loans in 2021 than originally thought and less issuance activity, which should take the pressure off prices. We also remain positive on emerging markets from a strategic perspective. In Asia, in particular, countries have mastered the pandemic relatively well without unduly straining their public finances. As an export-oriented region, Asia is also benefiting from the global economic recovery. In the short term, the strengthening dollar and higher U.S. yields are creating some headwinds. We do not see the dollar's upward trend that started at the beginning of the year coming to an end yet; against the euro, we expect a rate of 1.15 dollars per euro. A stronger dollar and a tendency towards slightly rising real interest rates do not favor gold, in which we see little upside potential over the next 12 months.
Yield development for major bonds
While U.S. and Euro corporate spreads are trading below their pre-crisis levels, Asian credit is not there yet.
*Average of U.S. and Euro option-adjusted spreads (OAS); U.S. investment grade (IG): Barclays U.S. Aggregate Bond Index; Euro IG: iBoxx Euro Corporate Index; U.S. high yield (HY): Bloomberg USD High-Yield Corporate Bond Index; EUR HY: Bloomberg EUR High-Yield Corporate Bond Index.
** J.P. Morgan Asia Credit Index (JACI)
Sources: Bloomberg Finance LP., DWS Investment GmbH; as of 3/10/21
We believe equity markets will be driven by structural winners and cyclical beneficiaries
Our view is that equities still have upside potential, thanks to likely higher earnings. We favor Asia and European small caps. Our optimism is based on the global vaccination campaign, which could transform an uncontrolled acute disease into a controllable chronic one. As a result, consumers should be able to emerge from the dark Covid tunnel in the coming months. The reallocation of consumers' excess savings and pent-up demand, and additional government stimulus, should provide further upside for cyclical stocks in particular. We are raising our 12-month targets due to the prospect of higher earnings across the board. The new targets for the S&P 500 and the Dax are 4,100 and 14,800, respectively, leaving moderate upside potential at index level. Broad investor confidence makes us somewhat cautious, as do the valuations already attained. But for 2021, we expect the music to keep playing, with the rotation into cyclical stocks continuing.
The equity rally that has been underway since May was vindicated at the turn of the year, with earnings being revised upwards for the first time (see chart). Higher commodity prices and lower bank provisions were also major drivers. Tech companies were doing well anyway, which helped U.S. stock markets in particular. This trend will continue, in our view, and it justifies a whopping price-to-earnings (P/E) ratio of 22 on estimated 2022 earnings for now, assuming that real yields remain negative. The flip side, however, is that the current yield increases are hitting growth stocks the hardest, and among them, again, those that are not yet profitable. However, due to the S&P 500's strong focus on global technology and other growth stocks, the index is not representative of the U.S. economy. As a result, we expect little positive impact on S&P earnings from the U.S. stimulus program, which is more likely to support smaller companies and households.
In this environment, a twofold (also called "barbell") strategy should prove particularly robust: one pillar consisting of structural winners from the technology sector and the other consisting of cyclical companies that should benefit from the economic upturn. European small and midcaps could be a suitable vehicle for the latter. Cyclical commodity and energy stocks, which are currently valued relatively favorably, are also benefiting from the current environment. But those who are serious about their ESG orientation might want to choose very carefully here.
Other examples of attractive sectors with high cyclical sensitivity include automotive and (Asian) semiconductors. A more constructive view on financials has long been hindered by low interest rates. But since November they have outperformed the market thanks to rising yields. Industrials have already discounted the upswing, in our view. In previous cycles, German stocks would have been an obvious consideration, due to their cyclical bias. But this time, Japanese stocks appear to be a better option due to the more diversified composition of their index and higher share of exports to emerging Asia. It is indeed emerging Asia that remains our favored region due to the combination of earnings growth of 30% already in the current year, reasonable valuations, proximity to China and increased buying by domestic investors.
Real estate remains an attractive alternative
We also believe that suitable investments can be found in alternative asset classes both for the medium-term continuation of the low-interest-rate environment that we expect and for a temporary rise in inflation. For example, a large number of privately run infrastructure projects contain inflation-compensating price mechanisms that should also benefit from a renewed increase in mobility.
As an alternative to low-interest government bonds, some investors have been relying on real estate for a long time, which has had a corresponding impact on prices. Due to the pandemic, some fundamental drivers in this otherwise rather sluggish market have changed almost overnight, so that many new opportunities but also risks have arisen. We differentiate between coronavirus effects that are likely to last and those that are only temporary. For example, we would consider the challenges that the leisure and gastronomy sectors continue to face as only temporary. The lower demand for office space meanwhile should be longer lasting, since we don't expect that working from home will be scaled back to pre-crisis levels any time soon. We also think that the extent of business travel and overnight stays will remain below its pre-crisis level for a long time to come. On the other hand, we believe the share of online consumer spending is likely to remain at a higher level in the long term, even if people will initially pour into pedestrian zones at the end of lockdowns. Residential accommodation, on the other hand, has gained in importance again due to Covid.
These considerations also shape our sector preferences. For the most part, we are still avoiding classic office and retail properties. Our focus is on residential and logistics properties, especially in structurally attractive cities such as London, Amsterdam, Paris, Warsaw, Berlin and Helsinki. In apartments, we consider suburban areas to be interesting, while for logistics locations, inner-city areas continue to be among the most sought-after. Even though real-estate prices appear quite high in some places, we do not see them necessarily as bubbly. In Europe, where construction activity is too low, excess demand for property, especially in the major cities, favors high prices. So does the low-interest-rate environment.
Yield expectations for various European real-estate sectors
Logistics and residential have been the major beneficiaries of the pandemic. For office space we expect longer-lasting lower yields.
Source: DWS Investment GmbH as of 12/2020