Don't get derailed by the spike train

In neuroscience, the brain makes sense of the outside world through a series of “spikes” in neural activity, known as a “spike train.” In the months ahead, investors will have their own “spike train” to follow. The challenge will be to focus on the bigger picture and not get “derailed.”

• Spike 1: Hospitalizations. Over the past year, both policymakers and financial markets have faced sudden spikes in coronavirus cases and hospitalization rates. But now that vaccination programs are rolling out, spikes in hospitalizations may be a thing of the past. Economic normalization could arrive sooner than we think.
• Spike 2: Stimulus. On top of resurgent consumer and business demand as lockdowns are lifted, we are likely to experience a further spike in economic stimulus as the US moves closer to another record-breaking fiscal package. Further pro-cyclical stimulus presents upside risk to economic growth and corporate earnings estimates.
• Spike 3: Inflation. As pent-up demand meets constrained supply, inflation may, at least in the short term, spike higher. Shipping, food, and semiconductor prices suggest this is already happening in parts of the economy. While it may be brief, this period of elevated inflation will require investors and policymakers to hold their nerve. 
• Spike 4: Volatility. Changes in all of these key variables will lead to periodic spikes in volatility. Last month’s moves among heavily shorted stocks are just one example of how volatility can increase suddenly. We see elevated volatility as an opportunity to generate yield, take on asymmetric exposure, benefit from market dispersion, or build up longer-term positions.

Overall, we retain a favorable view of markets over our tactical investment horizon. While the “spike train” may lead to volatility, we don’t think it will derail the bull market. However, the uncertainties around key market factors may cause some investors to abandon or defer their strategic plans. Investors looking to protect and grow their real wealth will need to have a plan to put their excess cash to work, and stick to it, particularly if this lowrate, rising-inflation, high-stimulus environment persists. We recommend the following strategies. 

Go cyclical for the recovery 

In terms of equity market positioning, to benefit from the likely upturn in global economic activity, we prefer emerging markets, and like small-caps over large-caps. Since 2000, every time the US ISM index has reached a trough, emerging markets have outperformed the MSCI All Country World index by 25–30% within two years. We are now 10 months from the last ISM trough, and emerging market stocks have outperformed by only around 8%, suggesting further upside potential. On a price-to-book basis, world small caps have historically traded on an 18% discount to large-caps. They are now trading at a 30% discount to large-caps. We also continue to monitor for opportunities to take advantage of elevated volatility, particularly in US equities, as dislocations emerge. Read more here.

Hunt for yield 

With interest rates set to stay on hold while inflation rises in the months ahead, we expect positive returns in riskier credit segments over the next six months. However, the balance of risks is shifting. The scope for further spread compression in emerging market sovereign bonds is now more concentrated in the weaker quality credits (rated CCC or below), so idiosyncratic risks are more elevated, and we move the asset class to neutral from most preferred. We remain neutral on US high yield, but note that the average credit quality of US high yield bonds has improved thanks to new issuance and the entry of “fallen angels.” We continue to like Asian high yield bonds, which have a yield-to-worst of 7% p.a., and we expect total returns of 8–10% by the end of 2021. Click here for more on the hunt for yield.

Position for a weaker dollar 

We continue to expect a weaker dollar over the medium term. The US dollar remains overvalued, with both purchasing power parity and interest rate parity models suggesting a fair value for EURUSD of 1.30. Longterm institutional investors remain overexposed to the US currency: USDdenominated financial assets as a proportion of total global equity and bond market capitalization now stand at their highest level in the last 20 years. This points to the potential for sales of dollar assets as investors seek to stay diversified or hedge dollar exposures. Once vaccine rollouts allow European countries to lift activity restrictions, the current growth gap between Europe and the US will narrow substantially. A sustainable global recovery should be expected to benefit more pro-cyclical currencies like the euro alongside a corresponding decline in demand for safe havens. Read more on our dollar view here.

Mark Haefele

UBS AG