The global economic recovery continued, although the picture was more mixed in some regions as a surge in COVID-19 cases around the world has led to renewed lockdowns. The recovery should accelerate in 2021 as vaccines become widely disseminated and monetary and fiscal stimulus remain supportive.
Economic slack will likely prevent an inflation overshoot over the short-term. However, there is a larger risk of inflation over the intermediate- to long-term. Policy makers might not have the discipline to curtail fiscal and monetary stimulus if the economy reaches capacity and begins to overheat.
Strong market performance pushed equity valuations higher, to levels only reached during the tech bubble in the late-90s. Valuations are particularly high in the US. Nevertheless, valuations are attractive versus bonds. We remain optimistic on equities, as the early- to mid-stages of economic recoveries tend to be supportive.
The longer-term challenge for investors is that high equity valuations and low interest rates portend low returns on diversified portfolios. This will make it difficult to meet typical return objectives. We suggest institutions consider reviewing their strategic asset allocation to test the viability of their objectives against their risk tolerance.
Within US equities, we favor value over growth, as vaccine distribution should lead to strong economic growth later in the year which should favor more cyclically-oriented value companies over mega-cap tech stocks. We also maintain a preference for small-caps over large. Small-caps tend to perform well in the early and middle stages of the economic cycle. Valuations also appear more attractive for small-caps versus large-caps.
We retain a positive view on emerging markets and suggest overweighting them. The US election has reduced trade risks, and EM countries should benefit from the global recovery and potential dollar weakness.
With spreads approaching 2019 levels, the upside for credit is modest. However, defaults are likely to remain low over the near-term as the economy recovers, suggesting narrow spreads are appropriate.