Taking the pulse for Q2: Rotation rolls on

Karim Chedid, Head of Investment Strategy at BlackRock

The restart is real

We see the path out of the Covid-19 shock as a ‘restart’, not a typical business cycle ‘recovery’, and expect stronger growth and negative real yields ahead as the vaccine-led restart accelerates and central banks limit the rise of nominal yields –even as inflation expectations climb. This should mean a more supportive backdrop for risk assets than in previous inflationary episodes, and we prefer to take risk in equities over credit amid low rates and tight spreads.

Nominal bond yields have picked up since the start of the year in light of rising growth and inflation expectations, triggering volatility in some risk assets. Yet despite recent moves, nominal yields are still proving less sensitive to higher inflation expectations than in the past. Along with recent developments such as the global vaccine rollout and the approval of a further $1.9T in US fiscal stimulus, this has given us cause for increased optimism as we head into Q2.

Our recent client polling suggests that investors have been reassessing their overall level of bullishness heading into the second quarter, with recent volatility and liquidity events in mind: 32% stated that they have turned less bullish since the start of the year, compared to 27% who have turned more bullish. Yet overall, the picture remains positive. The 41% who are unchanged in their view can be considered in the context of our client poll in December, which showed a clear risk-on mood, with an overwhelming preference for equities (71% of the vote), and more than a third of respondents listing emerging market (EM) equities as the biggest area of opportunity for 2021.

The cycle of life

The vast majority (83%) of respondents stated that they see the cyclical rotation continuing in Q2 –perhaps unsurprising, as the vaccine rollout and activity restart continue to gain pace, and policy support remains strong. We also see the cyclical rotation continuing, and favour exposure to cyclically tilted equities within a barbell approach that also includes allocations to quality-tilted stocks. In particular, the financial sector looks attractive against a backdrop of steeper yield curves and is further bolstered by the potential for dividend resumptions –which we see playing out as the year progresses. From a factor perspective, value strategies have historically benefited during periods of higher economic growth, such as the one we may be entering. Fiscal stimulus, dovish monetary policy, and a robust underlying economy provide fundamental support for value equities, and valuations remain attractive, in our view, despite recent strong sentiment towards the factor. Commodities are also poised to benefit from the accelerating restart and infrastructure spending.

Embracing EM

Among the investors we polled, the view on EM assets remains positive: 37% of respondents are currently overweight EM vs. just 18% underweight. This comes after EM equities ranked as the area with the best opportunities for 2021 in our poll in December, with more than a third of the vote.

The global policy revolution spurred on by the pandemic has helped to support emerging markets, and we see this continuing in the months ahead. We continue to be overweight EM equities, which could benefit from more predictable US trade policy and a stable-to-weaker USD. We remain neutral hard and local currency emerging market debt (EMD). While recent USD strength and yield moves in the US have weighed on local EMD, we see catch up potential, given that the asset class has lagged the broad risk recovery. A benign USD going forward and easier global monetary policy should also be supportive. Hard currency exposures may benefit from more predictable US trade policies and the global restart. We favour above-benchmark strategic allocations to Chinese assets, as the engine of global growth continues to shift eastwards. Blending China and EM ex-China exposures could allow for a more tailored approach to EM equities in particular.