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SystematicEdge Monthly Market Overview February 2021

Market Context: The rise in long-term interest rates is marking the start of a new economic cycle

Global Macro: 

As the world is recovering from the pandemic amid the deployment of vaccines, long-term interest rates have been rising around the globe. Governments’ massive money printing has increased the global supply of long-term government debt, which sold off in February. On the other hand, we expect governments’ stimulus packages to underpin a reflationary recovery in 2021 and 2022, which will be supportive to the Equity market. As a result, investors are requiring a higher risk premium to hold bonds from the oversupplied government bond market. The 10-year yield exceeded 1.50% in the US and Australia during the month of February while remaining close to 0% in Europe. However, these levels are not compelling enough to make investors switch from Equity and Credit to government bonds. Central banks have firmly anchored short-term rates at ultra-low levels around the world, with the US Fed fund rate at 0.07%, the ECB deposit rate at -0.50%, and the BoJ policy rate at -0.10%. In addition, governments with ballooning debt cannot afford to see their long-term borrowing costs soar. Central banks thus reiterated in February that they will continue to resort to “yield curve control” to keep a lid on their borrowing costs by maintaining their bond purchasing programs. As such, we expect long-term government rates to be capped at 2.5% in the US and 1.5% in the Eurozone in the coming years, while consumers’ continued quest for lower prices – underpinned by the rapid development of companies like Amazon and Uber – and the growing awareness of energy consumption efficiency maintain downward pressure on inflation.

Financial Markets:

 Equity markets declined at the end of the month as rising bond yields raised concerns about growth stock valuations. The 10-year US Treasury yield jumped by as much as 37bps in February to end the month at 1.46%, representing an increase of 54bps year to date. Although the performance of regional equity indices was flattish in February, the sectorial rotation continued as stocks with high P/E (price-to-earnings) ratios, such as Tech stocks, sold off given the sensitivity of their valuation to interest rates while low P/E stocks, such as financials, rallied thanks to their resilience to rising interest rates. As the progressive exit from the pandemic points to a reflationary economic recovery, commodities rose sharply in February with oil prices surging close to 20%. We believe the rise in long-term interest rates and commodity prices, combined with the sectorial rotation of the equity markets, is marking the start of a new economic cycle, characterized by a strong post-pandemic economic rebound in 2021 and 2022.

Equity: Month to date the S&P 500 gained 3.0%, Euro Stoxx 50 +4.5%, Hang Seng +2.5% despite a clear sell-off at the end of the month triggered by rising long-term interest rates. Fixed Income: The 10-year US yield rose 37bps in February to 1.46%. As a result, Emerging Market government bonds declined 3.8% in USD and 3.3% in local currencies. High-yield corporate bonds edged up 0.5% in EUR and remained unchanged in USD. Currencies: The USD appreciated with respect to most major currencies, underpinned by the rise in long-term interest rates: EUR -0.4%, CNY -0.7%, AUD +0.8%; safe haven JPY -1.8%, CHF -2.0%. Commodities: Oil prices continued to rise in February while gold prices further contracted: WTI Oil +18.3%, Gold -6.3%.

Risks:

In this new market regime and early phase of a new economic cycle, we have identified the following major risks:

  • Covid-19: New restrictions around the world would have a negative impact on the economic growth outlook.
  • Bankruptcy wave: The number of bankruptcies has been rising amid the economic recession and could worsen in the coming months.
  • Tech bubble: Tech stocks remain under pressure, given the highest valuations since the dot-com era and high market concentration, while the Biden administration is expected to take a much stronger stance on the tax and anti-trust treatment of Tech companies.
  • Long-term interest rate hikes: At some point, central banks will reduce cash injections and taper their bond purchasing programs, which will result in higher interest rates and downward pressure on equity valuations. Meanwhile, investors are requiring higher yields to compensate for the risk of governments’ ballooning debt.
  • US-China tensions: US-China trade frictions remain strong, with increasing tension around Taiwan and the South China Sea. Although President Biden might be more inclined to adopt a multilateral approach with China than his predecessor, he has already sent signals that the US will remain tough on China on such issues as trade and technology.

Opportunities:

  • China H-shares: Although H-shares sold off at the end of the month following the increase in stock stamp duty in Hong Kong from 0.10% to 0.13%, we believe H-shares’ upside potential remains intact. The unique combination of China’s strong growth dynamic and the moderate growth of Hong Kong-listed Chinese stock valuations – still below the peak of 2018 – makes H-shares particularly attractive for investors. The composition of the Hang Seng Index will change in March with an increase in the number of components. Moreover, the proportion of sectors participating in the digital transformation will rise and cyclical stocks, such as financials and property stocks, will remain a substantial part of the index. We expect the Hang Seng Index to benefit from the long-term trend of digital transformation, the cyclical sector rotation, and the reflationary recovery of 2021 and 2022.
  • Financials: Following the US election ‘blue wave’, investors are positioning themselves for higher long-term rates in the US and more generally the end of rate cuts. This is positive for the banking and insurance sectors where valuations continue to look attractive. We expect stocks of well-capitalized quality banks in the US, Europe, Hong Kong, and Japan to pay an above-market dividend yield following their central bank’s green light.
  • Oil & Gas: The sector partly recovered in 2020, yet still trades at half the book value of the market, its lowest level since 1928, and is lagging the oil recovery. We are seeing more interest from investors towards major energy players that are implementing green energy programs to transition from fossil fuels to clean, sustainable energy production, thus making them major decarbonization contributors.
  • Chinese Yuan: The RMB reflects the forward growth of the Chinese economy (IMF forecasts over 8% growth in 2021) and the increase in global trade and investments in the Chinese currency. The Yuan is also becoming an important reserve currency for central banks and financial institutions, underpinned by China’s strong economic fundamentals: a large positive commercial balance, growing domestic consumption, and interest rate at 3% vs close to 0% in Western economies. Moreover, the UN announced that China became the number one country in the world for Foreign Direct Investments in 2020, with growing inflows from investors buying Chinese stocks, bonds, and hard assets contributing to the strengthening of the renminbi and consolidating its role as a major trade currency.