Divergence in economic growth at the start of the year was influenced by Covid-related lockdowns and the degree to which governments provided additional stimulus. Europe struggled due to renewed lockdowns, while, in the US additional stimulus packages boosted activity. US GDP appears likely to recover to its pre-COVID level in the second quarter, and could return to the prior trend before year-end.
Intermediate and long-term bond yields spiked in Q1. This was mostly driven by an increase in inflation expectations, most of which occurred on the short end. Longer term expectations are consistent with the Fed meeting its inflation target. This suggests the market expects a cyclical uptick in inflation rather than secular. Our base case is that inflation remains contained around central bank targets, but the risk of a secular increase in inflation is a rising tail risk.
We remain optimistic on equities and other risky assets over the short- to medium-term. The early/mid stages of economic recoveries tend to be positive for equities. While equity markets have already priced a lot of good news, the strength of the economic recovery is likely to lead to a substantial increase in earnings and more optimism.
Within US equities, we favor value over growth, as a re-opening economy is likely to favor more cyclically-oriented value companies over mega-cap tech stocks. We also maintain a preference for small-caps over large. Small-caps tend to perform well in the early and middle stages of the economic cycle. Valuations also appear more attractive for small-caps and value stocks.
We maintain a favorable view on emerging market stocks and suggest overweighting them relative to developed equities. Valuations are reasonable and Asia should experience a robust recovery. While EM stocks could face headwinds from policy tightening and DM firms could benefit from a re-opening tailwind, we think EM markets are well positioned to outperform over the intermediate-term.
High yield valuations have become less attractive as spreads have narrowed. We currently prefer the risk-to-reward of local currency emerging market debt within growth fixed income portfolios due to a supportive environment for EM assets, relatively high yields and undervalued currencies.