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Please see below for Legal & General’s latest Asset Allocation Team Key Beliefs Article, received by us yesterday afternoon 19/07/2021:

Bearish sentiments

This week, we look at investor sentiment, Peru, and China – can you guess the obvious link between them?

Bulls and bears

The latest AAII Bull/Bear spread, which is based on a survey of investors’ outlooks, has started to drift lower again. The number of bullish investors has now declined to a year-to-date low.

Overall, there are still more bulls out there than bears, but the dampening of excessively positive sentiment can be seen in other indicators too. For us, this is a positive, as it reduces the risk that frothy sentiment quickly unwinds, prompting investors to pull positions and cause a market slump of their own creation.

Yet the overall bullish tone does still remain. Yields are low, policy conditions are generally supportive, and inflation – although high – is not seen as problematic. The vaccine story is also generally good, although we are aware of the risks.

In our own scenario analysis, the conclusions look similar – and that in itself acts as a red flag. Both our most likely scenario of a healthy recovery and the weighted average scenario in our analysis suggest above-trend growth and modestly above-target inflation ahead.

Given the positive sentiment, we think that is pretty well priced by markets too, so return expectations shouldn’t be too lavish from here if that scenario plays out. The upside is a ‘Roaring 20s’ type recovery; the downside is a COVID-19 variant or vaccine failure inducing a deflationary slump or rapid cycle compression, although neither attracts a particularly high probability in our view.

It’s fine to be in the crowd for a while – indeed, some of us may look forward to being in actual crowds again – but as investors we don’t want to stay there for too long. Consensus thinking can be dangerous.

Change at Paddington’s home

There is a new Paddington Bear movie in the pipeline, a Paddington exhibition at the British Library has opened, and Gareth Southgate’s management style has been juxtaposed against Paddington Bear.

Our reason for bringing him up, though, is his origins in “deepest darkest Peru”. Our economist Erik has had his spectacles on to look at Peru and other Latin American economies recently.

Peru now has a decidedly leftist government, but we believe it is a country with enviable fundamentals and China-like growth rates. In the run up to the recent elections, the currency sold off in anticipation of a hard-left candidate winning the vote.

Pedro Castillo did indeed win the presidency, and has vowed to overhaul the country’s economic model. But while his party is socialist, Castillo has drawn up more neutral policies since his victory, including central-bank independence and not nationalising the mining sector.

While we are wary of Castillo and will continue to monitor his policies and cabinet appointments closely, our view is that he may not be as negative for the country as the media are making out. With strong economic fundamentals, the risk event of the election behind us, and attractive valuations after the recent selloff, we have moved in on the currency, looking for negative sentiment to moderate.

Panda pop

This month has brought news that giant pandas are no longer endangered in the wild, according to China. The species is native to South Central China and, thanks to conservation areas, its outlook has been improving. Our view is that the Chinese economy is on a good footing too.

Much of the economic data looks solid and second-quarter growth came in stronger than expected. This made us a little surprised to see a cut in the reserve requirement ratio (RRR), one of the tools used to manage the economy, last week.

GDP is broadly back to its pre-pandemic trend, so if anything is responsible for the RRR cut it could be that growth remains a little unbalanced, with retail sales remaining depressed.

We added Chinese bonds to a number of portfolios in the early parts of the year as we believe the highly rated securities still offer an attractive yield and can play a role as an interesting diversifier in our portfolios. We still think that holds. The downside risk of a vaccine failure causing an economic slump in the country also makes us think these bonds could help should a bear market prevail.

Please continue to utilise these blogs and expert insights to keep your own holistic view of the market up to date.

Keep safe and well

Paul Green DipFA

20/07/2021