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Federated Hermes forecasts what lies ahead for the rest of 2021

This year's market environment has already been challenging to navigate. A number of themes have captured the attention of our investment floor and our managers below have taken stock of how these are likely to evolve going forward.

  • Eoin Murray, Head of Investment

As we ‘build forwards better’, rather than ‘back’, the world is facing a period of fundamental change.  All of the net zero pledges and commitments, alongside moves to green the economy, are great to see, but we likely still face a mean temperature rise of at least c.+2.4oC. 

Combatting pandemics, reducing inequality, and eradicating global poverty and climate change require systems thinking and global solutions. We need to go further, faster and push forward with a sustainable revolution.

The first industrial revolution was all about the application of steam to industrial processes and transport; the second industrial revolution was all about electricity replacing steam; this sustainable revolution that we are just at the beginning of is focused on changing the source of that electricity from fossils to renewables.

Wind and solar energy account for around 10% of global energy generation today, which will need to grow to around 40% by 2030 and to as much as 75% by 2050 if we are to achieve net zero. For investors, this is transformational. Firms unable to transition will suffer, with knock on impacts for human capital. But for those that get it right, the opportunity is enormous. 

 

  • Silvia Dall’Angelo, Senior Economist

Since our last forecast at the end of 2020, the economic outlook has brightened significantly. The recovery from the sharpest recession in decades has made considerable progress, underpinned by advances in vaccine roll-outs and ample monetary and fiscal accommodation. While the strength of the recovery should support sentiment in financial markets in the short-term, risks have not disappeared.

In the short-term, persistent divergencies – most notably the one between developed and emerging economies – are an element of fragility. Somewhat related to this, the evolution of the virus is still a source of uncertainty. Finally, from the perspective of financial markets, fears about a possible return of elevated inflation and consequent removal of monetary policy accommodation could cause volatility and, in the worst-case scenario, a tightening of financial conditions for the real economy.

Risks and opportunities are even more pronounced in the medium-term. Despite the hype about ‘building back better’, it is not clear that forceful policies are in place to favour a green and inclusive recovery. There is therefore a risk of going back to a pre-Covid macroeconomic scenario, dominated by sluggish productivity growth, rising inequalities and a looming climate crisis.

 

  • Louise Dudley, Global Equities Portfolio Manager

Risk appetite has continued to be volatile, but, despite the pull back in mid-May, investors remain positioned to lean towards risk-on assets. This is reflected by a preference for Value at the expense of Growth. Inflation remains the key concern with investors undecided as to whether it is transitory or something more persistent. For the time-being the Fed appears to be in the transitory camp, stating that there will be no rate rises until 2023. But, with wage inflation on the rise and supply constrained in certain areas, pressure seems to be building. However a move from the Fed is likely to take wind out of the inflationary sail, keeping the Value rally going but with a quality tilt.    

Looking further ahead, we expect focus to turn back towards environmental issues as we emerge from the pandemic. The EU Taxonomy should broaden awareness of environmental opportunities, while the International Energy Agency’s net zero by 2050 roadmap highlighted the immediate imperative to deploy clean energy solutions. Plus, with COP26 due to take place later this year, the focus on greener areas of the market will likely grow. Green spending will increase and spill into the broader market.

We also remain focused on the outlook for good governance standards. The pandemic has clouded some companies’ risk priorities, allowing for potential areas of weakness around product governance in particular. This is a risk that a large swathe of the market has exposure to through financial impacts to brands, reputation, trust and license to operate. As companies grow through seeking new capital, M&A or internal innovation, assessing metrics on product governance are crucial to identify the sustainable winners of tomorrow.

 

  • Andrew Jackson, Head of Fixed Income

The recovery is starting to gather pace and we are seeing strong earnings coming through from corporates, which will support credit metrics. Ratings agencies are taking note and upgrades are picking up, reversing some of the heavy downgrade activity we saw last year. Year to date, cash bonds have outperformed synthetic and this has created opportunities for us to switch from bonds into CDS, also helping reduce our exposure to interest rates.

In terms of risks, rising inflation and a disorderly sell off in rates remains a key tail risk concern for us, we see energy and metals companies as best placed if inflation continues to rise. As companies reach balance sheet objectives there is also potential for a further increase in non-credit friendly behaviour and we note an increase in M&A volume and Cov-lite issuance this year. Implied volatility however has fallen significantly over the last year, making the cost of hedging through options very attractive, even if you do not perceive a significant market shock in the near term.

Despite current valuations, we see plenty of opportunities beneath the surface and feel a flexible approach, unconstrained by security type or geography, gives the best chance of continuing to deliver alpha in this market. Ability to access to all parts of fixed income, such as Structured credit, Direct Lending and Real Estate Debt can also help investors to access diversified sources of return and income. Finally, as the world continues to wake up to large challenges such as climate change, we see ESG integration within the investment process as vital for investors going forward.  

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