A common meme among financial analysts making their year ahead forecasts is to project which year in history the upcoming one will most take after. While we can’t say with certainty which year from the past 2021 will most resemble, we can say with some conviction that it will be very different from 2020. 
True, we’ll start the new year with the same easy monetary policy that helped us through 2020, and Covid-19 will dictate our social and working interactions for the first quarter or two. But we approach 2021 with a new cycle broadening out. Fiscal stimulus, which plugged gaps in 2020, will likely recede as the private sector rebounds. And a global vaccine rollout is already beginning to push coronavirus from a present threat to a historic event. All of these issues have a bearing on asset markets. But for investors the transition from a market fuelled largely by emergency liquidity and stimulus to one driven increasingly by a global economic recovery may present the biggest challenge.
We will begin 2021 with a renewed conviction that the economic recovery is robust. As the year progresses we expect growth to broaden out and “left behind” sectors like travel and leisure to show new signs of life – particularly as vaccine rollouts extend to the wider population. Certainly, the distortions to the labour market and to Main Street will take some time to heal, but in our view the extent of permanent scarring is surprisingly contained, leaving the supply side of the economy mostly intact.
The debate around inflation risk
Nevertheless, we expect monetary policy to remain extremely accommodative. The Federal Reserve (Fed) will likely prefer a little more inflation risk to the risk of scuppering the recovery through premature withdrawal of policy support. For investors the debate around inflation risk is central both to return expectations and the outlook for market volatility over 2021. Market participants who believe that inflation risks are likely to elicit a policy reaction are generally more cautious. We see only limited upside for inflation in the near term, and fully expect the Fed to look through it were it to arise. But we also note that inflation is not well discounted in asset markets. As we turn to our asset allocation views it is a factor we need to consider, if only at the margin.
Our positive outlook on the economy in 2021 calls for a pro-risk tilt in our multi-asset portfolios. As a result we stay overweight both equity and credit, with our exposure balanced across the two asset classes. While we see some path to yields drifting higher as growth broadens out, we believe that monetary policy will control the pace at which yields can rise. With 10-year US Treasury yields closing in on 1 per cent, but few signs that central banks intend to wind down their quantitative easing any time soon, we move from underweight to neutral on duration. At the same time, the risk that inflation expectations pick up implies that real yields along the curve are likely to remain profoundly negative; hence we move cash to underweight.
Across the equity complex we take a cyclical tilt, but equally prefer to remain well-diversified. The economic rebound is global, we believe, and regional leadership is thus more nuanced. In particular, we are overweight US small-cap and emerging market equities, which are well exposed to the broadening recovery. We also have a mild overweight to Japanese equities, and to European stocks which, though cyclically geared, face some near-term risks from recent lockdowns and Brexit. We upgrade UK equities from underweight to neutral, and are also more neutral on US large-cap stocks in our portfolios given the headwind from elevated valuations.
In credit we trim US investment grade to neutral and keep high yield at overweight but with a reduced conviction. Spreads across the credit complex tightened sharply in Q4 2020, but we still believe credit as a whole is well geared to the wider recovery. We also diversify our credit exposure by moving emerging market debt to overweight. In sovereign bonds, we once again prefer US Treasuries to core European bonds. But in general we will be looking to play any upward repricing of US inflation through a short on the US dollar rather than an underweight to duration.
Overall our portfolio aligns to expectations of above-trend global growth and easy policy. We acknowledge the risk of rising inflation expectations, but believe that should such a repricing spur volatility, the Fed would respond swiftly. As the principal driver of asset returns pivots from policy to growth, we expect cyclical equities to benefit. But with global policy remaining easy, bonds may be among the last, rather than the first, of the major assets to react to the broadening recovery.
John Bilton is head of global multi-asset strategy at JP Morgan Asset Management. The views expressed above are his own and should not be taken as investment advice.