Volatility ahead, asset and style allocations are key

With vaccinations gradually rolling out globally and the approval of the US$1.9 trillion fiscal stimulus package by the US administration, both growth and inflation expectations continue to build up, triggering some volatility in both the equity and the fixed income markets in the first quarter. We believe that volatility is likely to stay in the near term given the tug-of-war between concerns over liquidity tightening from rising inflation, and the improvement in corporate earnings growth as a result of a normalising economy.

Inflation is likely to pick up further in the second quarter, as the base effect from the COVID-19 outbreak last year shows up in the statistics together with rising commodity prices and fiscal stimulus. The upward pressure on bond yields from inflation will therefore be negative for fixed income as an asset class. Low bond yields have been supporting equity valuation in 2020, and therefore rising bond yields inevitably means that equity valuation will need to be adjusted lower as a result. The impact is likely to be bigger on areas of the market where valuation is high, such as technology and beneficiaries of the pandemic.

Economic growth is also expected to shift from “virtual” to “physical” economy, lending support to earnings expectation for cyclical sectors like materials and financials. The internal rotation within equities from “new economy” to “old economy” sectors provide opportunities for active allocation, but this would also limit the return potentials for equities as an asset class.

In our investment strategies, the overweight position in equities and corporate credit in 2020 was proven to be effective. As volatility is expected to stay in the near term, we have turned more defensive and became neutral on equities. However, we have been taking advantage of the rotation in equities by adding to cyclical markets and sectors, such as Japan and financials, while trimming the exposures to technology and the US, which delivered favourable performance last year.

We have also kept an underweight position in our duration exposure to cushion the impact from rising bond yields on our portfolios. US dollar should remain as a ‘perceived safe-haven’ and provide diversification against any unexpected changes in overall market liquidity.

The second half of 2020 allowed us to capture some “low-hanging fruits”. Looking ahead, markets will certainly be more volatile in the rest of 2021. Active and nimble asset and style allocation with appropriate diversification will become more important to delivering performance in the future.

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