Armchair strategists: H2 is set to move us from early to late cycle allocation

• Cross-market pricing generally seems fair. This shifts focus to marginal stories.

• Europe is set to underwhelm investor’ hopes, while US rates climb further.

• We are likely to move into a ‘late cycle’- like environment during H2.

Over the last few months, we have been moving towards a global narrative of recovery. Looking ahead, macro seems easy to forecast as we head into H2 and everyone knows there will be re-opening, higher inflation and consumer spending on services. However, it seems to me like markets are well into pricing this. As we look ahead, I think the optimal allocation will increasingly be ‘late cycle’-like. Thus, overweight DM equities over EM equities and credit, and underweight duration. Being long European equities should be kept tactical and viewed as a levered bet on declining EUR. We recommend to hedge dollar assets below benchmark and lean into the new cyclicality of the dollar. A stalling recovery in US jobs is the key risk, which may keep us in early cycle and make dollar weaken further.

US interest real 10-year rates have risen roughly 40bp in 2021, the dollar has strengthened and companies within industry, autos and airlines have faired well. Meanwhile, the 2020 winners have faded gains across e-commerce and Asia as spending is set to shift towards services, amid Chinese tightening. No asset classes appear distressed or mispriced, though we are pricing the right scenario. Focus will therefore turn to the marginal issues.

I think European macro will underwhelm and that Fed will start to tighten liquidity conditions in H2.

The June FOMC meeting will be key to the next step in re-pricing US yields as well as taking another step in holistically upgrading the US. The return of inflation after markets have repriced rates some and the recent scaling back of dollar shorts leave the dollar vulnerable in H2. The Fed’s response during the summer will thus be key for where the broad dollar is headed next, though we suspect talks of tapering will support USD.

The base case for many seems to be that US data is simply leading Europe by a few months. I do not think so. Rather, the Chinese credit cycle is rolling over well and this will spill into European macro over the summer. That will happen amid rising US yields, which also spill into European yields at a smaller beta but at a point in time where ECB simultaneously contemplate fading support. As we look into H2, there is a cyclical European recovery story but surely not a new structural narrative: There might be a pent-up demand story but it will last 3 months and there is a risk of an ECB policy mistake by withdrawing policy support too early. I think investors will be disappointed and I would treat longs in European equities as a high-beta expression of being short EUR/USD. The key problem is there is not a premium for distressed European assets to be unwound. EUR/USD is quite high at 1.19 and analysts’ expectations to earnings in Northern Europe and autos are well above their pre-COVID levels. I have a hard time seeing much of a potential turnaround story.

As with the market after COVID, the market cycles/themes run at an extremely compressed pace. So we will probably move from early-to-mid cycle, into a late cycle-like allocation quite easily during H2.

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