The flare-up of the Delta variant has heightened concerns about successive waves of Covid, with new evidence indicating that even vaccinated people may become infected, with so called breakthrough cases. These cases are increasingly likely the longer it has been since vaccination, compounded with the same vulnerabilities (age, weight, compromised immune systems). That’s in addition to the large portions of the world that remain unvaccinated and even more susceptible. In the US, the recent call by the Centers for Disease Control and Prevention for vaccinated people to resume wearing masks in indoor public places is aimed at high-risk areas of the country. The reality of this second pandemic year has turned out to be far less triumphant or colorful than last year’s Kodachrome dream of a vaccinated world. For investors, the challenge is determining how policymakers and others will react to what may turn out to be an endemic condition for many years to come, with potential lockdowns in material portions of global GDP posing the risk of market drawdowns.
As worrisome as the flare-ups are, the mood in most developed nations has shifted since the earliest days of the pandemic, where fear of the unknown drove lockdowns. Outside of Asia, whether because of lessons learned, fatigue, or a combination of both, there is little appetite among Western policymakers to again shutter economies. In an increasing number of emerging countries without access to efficacious vaccines, the reaction is becoming a shrug, acceptance of natural immunity, and keeping their economies open.
To date, the Delta variant has looked like a Roman candle, ripping through India at record speed, cresting just 40 days later, with cases subsequently crashing. This pattern is now repeating in the UK, with cases skyrocketing for 40 days, then crashing in this past week. Cases peaked simultaneously at the same number of days for both the well vaccinated UK and the poorly vaccinated Indonesia, where Indonesia experienced record fatalities while UK fatalities rose a bit, yet remained substantially below prior Covid waves, and occurring almost exclusively from the unvaccinated. While breakthrough cases themselves are fear-inducing, symptoms tend to be very mild with the incidence of hospitalization and fatalities dramatically lower.
The vaccination wall is holding, and in spite of all of this, slogging through seems to be the most likely policy course of action for most countries. Fortunately, we’re all now better prepared to do just that. Businesses, individuals, governments, and non-profit organizations including hospitals have all learned how to adjust and cope with this pandemic. For governments, all efforts short of lockdowns are likely to be emphasized, including social distancing and more mask requirements, as well as an even greater push to encourage vaccination.
Each wave is generating less economic and market disruption, with risk and safety both continuing to rise during this recent Delta variant wave. Nonetheless within markets, rotation toward safety has been pronounced since April given the fear of lockdowns, which are unlikely to manifest. Such fear may itself soon crest and fall, like a Roman candle.
Conviction Score (CS) and Investment Views
The Conviction Scores shown below reflect the investment team’s views on how portfolios should be positioned for the next six to nine months. 1=bullish, 5=bearish, and the change from the prior month is indicated in parentheses.
Markus Schomer, CFA
Global Economic Strategy
CS 2.50 (unchanged)
Stance: We still believe global GDP growth will remain well above average over the next 12 months, but see reasons for a possible downgrade of our score in the fall.
Outlook: Despite rising Covid infections in the US and Europe, hospitalizations and fatalities remain far below previous levels, suggesting a low risk of re-closings. The US inflation surge continued in June, but inflation is very much a US problem that doesn’t seem to be spreading globally. The risk of a steeper fiscal cliff in the US remains elevated, but another spending package soon may be coming. Finally, Fed chair Powell reassured Congress and markets that he is not in the early tapering camp, while the European Central Bank (ECB), with its new tweaked inflation target, is not likely to reduce its stimulus.
Risks: Financial market instability is the currently biggest risk to the recovery. While fundamentals and policy don’t appear to be threatening the rebound, rallying bond markets and volatile stocks suggest investors may be nervous about the Delta variant or US fiscal or monetary policy. A sharp equity market correction or a sharp bond market sell-off could affect business and consumer confidence and thus growth prospects over the summer or fall.
Gunter Seeger, CFA
Portfolio Manager, Developed
Markets Investment Grade
CS 4.00 (unchanged)
The spread of the Covid Delta variant has caused a flight to safety in developed markets globally, with a rally in Treasuries. At the same time, with the US Consumer Price Index (CPI) posting its third straight massive surprise to the upside, the Federal Reserve has reacted swiftly by raising rates earlier in the dot plots, suggesting a taper program is coming sooner than later. The ECB, by contrast, may purchase more bonds in the second half, which should have currency implications. The US bond market has seen a proliferation of volatile days, with the 10-year experiencing several 10-basis-point moves in less than 24 hours. The driver appears to be a lack of liquidity, which will be exacerbated this summer as market participants take their first vacations in two years.
Steven Oh, CFA
Global Head of Credit and Fixed Income
CS 2.75 (-0.50)
Credit spreads widened in July – from +260 to over +300 in high yield (HY) and from near +70 to near +90 in investment grade (IG) – on fading optimism over growth, more modest inflation expectations, and a rise in Covid infections from the Delta variant. While the tail risks have increased, we do not expect a repeat of full or material shutdowns, even if cases continue to increase. Therefore, we expect very strong, early-cycle fundamentals to remain intact. While valuations have improved, prices for most fixed-rate credits held steady as the drop in benchmark yields offset wider spreads. From an excess return standpoint, we are more positive on credit spread valuations, hence the improvement in the conviction score back to a marginal pro-risk bias from a slightly defensive posture last month.
Senior Associate Sovereign
Analyst, Global Markets
CS 2.75 (unchanged)
The euro/US dollar relationship continues to take its cue from the two-year rate differential between US Treasuries and German Bunds, rather than the 10-year differential, implying the market is still optimistic on the timing of the Fed’s taper. With the Delta variant putting the market on edge, the US dollar and Japanese yen have benefited from their safe-haven status, the flattening yield curve, and overweight euro positioning. In emerging markets (EM), improving fiscal finances amid a sharp spike in nominal GDP growth, rising GDP deflators, and a sharp increase in tax inflows have been widely underestimated and underreported. In combination with rising current account surpluses and record high foreign exchange (FX) reserves, many EM economies look very robust, and several EM currencies offer compelling value, including the Colombian peso, Chilean peso, Mexican peso, and the Brazilian real, with the latter two benefiting from central bank tightening.
Managing Director, Co-Head of
Emerging Markets Fixed Income
USD EM (Sovereign and Corp.)
CS 2.50 (unchanged)
Local Markets (Sovereign)
CS 2.25 (unchanged)
EM will continue to lead developed markets (DM) in overall growth and productivity gains, despite the challenges of an aging and more slowly expanding population. This ongoing view, extending well into 2022, supports our current bullish stance, with our “Bright Future” scenario is at 35%, “Fly High” at 5%, and our central “Cruise Along” scenario at 60%. We see sovereign balance sheets improving and corporate leverage expected to return to its lowest level since the 2008-2009 crisis. The positive fundamental outlook and the speed of rebound post-Covid is leading to greater institutional inflows as the asset class firmly showed its robustness in 2020. We expect more strategic allocations to follow.
Managing Director, Portfolio
Manager, Global Multi-Asset
CS 2.75 (-0.25)
We are a bit less bullish. Fading growth impulses and less-generous monetary support over the next nine to 18 months, together with asset prices that offer less reward for taking risk, all dampen our enthusiasm. Global fundamental data continues to improve overall; yet, we are beyond the rapid recovery phase and regional divergence is becoming more pronounced, driven by China’s deceleration and the sequencing of vaccine availability. Vaccinations continue to gain traction in Europe. Japan is next, while most emerging markets fall further behind. After maintaining a decidedly bullish stance for the past 12 months, we are dialing our Conviction Score down from 2.5 to 2.75, edging closer to neutral.
Principal, Real Estate
The focus on ESG has dramatically intensified over the past six to 12 months and the industry is grappling with how to measure social and governance factors, which had been largely neglected, and incorporate them into management and investment decisions alongside environmental considerations. On the operational side, changing use patterns are exacerbating dramatic undersupply issues in logistics and the institutional rented residential sector, including senior living, and these sectors are consequently attracting the majority of investment capital. Risks include a resumption of increases in construction material costs and inflation-related interest rate increases, which could lead to notable value erosion should they materialize.
Rob Hinchliffe, CFA
Portfolio Manager, Head of
Sector Cluster Research –
CS 3.00 (unchanged)
A balanced, bottom-up portfolio has been key to delivering alpha in this market, with various issues – the Delta variant, inflation, monetary and fiscal policy, supply chains, etc. – causing volatility. We look for the commentary accompanying second-quarter results to offer insights into the effects of these issues and into whether earnings revisions will remain positive. Despite valuation and volatility challenges, we have been able to uncover opportunities across financials, tech, and consumer staples with sufficient upside for the medium- to long-term.
CS 2.50 (unchanged)
We are keeping our score at 2.50, supported by positive earnings revisions. In China, consumer retailers saw strong growth in the first half on robust demand, but staples are under margin pressure due to rising raw material costs and limited opportunities to raise prices. In India, early second-quarter results paint an encouraging picture, with IT firms showing good topline growth due to revival of global demand and banks reporting better-than-expected collections. Higher commodity prices have boosted demand in Latin America and in EMEA, which also has been helped by EU stimulus. While EM companies have moved up the value chain, they do not benefit equally, making stock selection critical.
Quantitative Fixed Income
Our US Market Cycle Indicator (MCI) continued to fall from its March peak, mainly due to a yield curve that was 24 basis points (bps) flatter. Option-adjusted spreads on BBB credits tightened six bps to 107 bps in June. The short ends of spreads in IG and HY looked rich. In industry selection, we liked cyclical sectors including energy, basic industry, and banking over the defensive utility and communications sectors. Our global rates model forecasted slightly lower yield on slowing M2 growth and the favorable equity dividend over Treasury yields. It continued to forecast a flatter curve. The rates view expressed in our G10 model portfolio was overweight global duration. It was about neutral in North America, but overweight Europe and underweight in Japan. Along the curve, we still see flattening and are overweight the long end.