The 5 Big Forces in 2021
These five big forces are likely to determine the shape of the recovery and portfolio returns in 2021.
1. Will a vaccine be the “silver bullet” that many hope?
A vaccine will be a game-changer, eventually. It probably won’t be a “silver bullet” in 2021. The good news is that we believe a vaccine may not be a prerequisite for economic output to surpass pre-pandemic levels in certain sectors and regions (including the United States).
COVID-19 is still an important risk, but we believe its influence on your portfolio will likely diminish throughout 2021.
We do expect a vaccine, and relatively soon. It should be available to certain high-risk populations in the developed world by the first quarter of 2021 and broadly thereafter. So why won't a vaccine be a complete solution? A few reasons. We do not know how effective a vaccine will be even though preliminary results have been quite encouraging. Also critical: a material portion of the global population likely will not be vaccinated in 2021 - due to personal choice, logistics or economic constraints.
It seems likely that the world will have to continue to rely on other ways to control the spread through 2021: rapid testing, contact tracing, mask compliance and restrictions on high-risk activities. Improved treatments and procedures should deliver continued progress on treating those infected.
Even without a vaccine, there's been a rebound both in consumption and production activity globally. Consumer spending has simply shifted from sectors such as leisure and hospitality to housing and e-commerce.
U.S. retail sales are already above pre-pandemic levels. With inventories depleted, restocking has sparked a recovery in production and trade. Chinese production and exports have surged. Consumption was similarly rebounding at a rapid pace in Europe, though now it remains to be seen what kind of damage new restrictions will cause.
A vaccine may have more of an impact on markets in 2021 than on the real economy because asset prices can reflect future benefits before they actually happen. Another implication: The spread of the virus itself may not exert the same kind of downward pressure on asset prices.
Overall, we are focusing on investments that can work with or without an effective vaccine. These include companies linked to digital transformation, healthcare innovation and household consumption. Sovereign yields will probably rise and yield curves steepen as global activity and risk sentiment improve along with medical progress. This could create tactical opportunities in equities sensitive to interest rates (such as banks). However, we believe the gravity of easy central bank policy will keep rates near secular lows
2. Which governments and central banks will provide enough support?
The United States and some Asian countries. The global policy stance is supportive for risk assets, but the differences in policy support will drive relative outcomes. Investors are likely to find opportunity by investing in: U.S. and Asian equities, high yield bonds, companies exposed to physical and digital infrastructure investment, energy transitions and the next generation of transportation.
In Asia, we see varying levels of need for additional stimulus. China was able to contain the virus relatively quickly and effectively. It was therefore less dependent on monetary and fiscal policy to help bridge the economic gap that lockdowns created.
As the recovery continues to broaden in China, there is less need for additional support. In fact, China already has started to unwind the limited amount of monetary easing it delivered in Q1 2020. We think the country's budget deficit will actually be smaller as a share of its GDP in 2021 and the following years than it was in 2020. So there may be reductions in fiscal spending, especially given the focus that policymakers have on ensuring the debt situation is sustainable. In particular, we expect more tightening measures in the property market over the next two or three years.
In Taiwan and Korea, growth has rebounded, reducing the need for more easing. Both countries, export-dependent, have benefited from demand for technology products. We expect policymakers to remain on hold until the global economy rebounds meaningfully and the Federal Reserve (Fed) starts to signal a more balanced outlook.
Japanese policies will likely remain supportive because the COVID-19 hit has exacerbated deflationary pressures. To make matters worse, the economy was already in a domestic policy-induced recession before the pandemic spread to this country. Yet another headwind the Japanese economy faces is a stronger currency relative to its trading partners.
Countries throughout the rest of Asia still have room to ease. The coronavirus recession may be over and growth recovering from the trough, but virus containment will continue to weigh on economic activity. If the U.S. dollar does not appreciate, then Indonesia, Malaysia and the Philippines all will have room to ease. Singapore will likely be able to refrain from further easing, due to its links to the stronger growth backdrops in China and the United States. India will likely try to ease policy, which could stoke inflation higher and deficits wider.
The United States has a very supportive mix of monetary and fiscal support. The Federal Reserve has shifted toward an average inflation-targeting framework, which means it wants employment to reach maximum levels and inflation to average 2%.
To achieve its goals, the Fed has set policy rates at zero and is buying $120 billion worth of Treasury bonds and mortgage-backed securities per month. If the Fed needed to do more to get what it seems to want, it could move its purchases to longer-term securities or deliver more forceful forward guidance regarding eventual rate hikes - or both. The Fed has committed to not raising policy rates until those employment and inflation targets are met - which could be years away.
On the fiscal side of U.S. affairs, the CARES Act came with a $2.2 trillion price tag - more than double the support provided after the Global Financial Crisis. Now that the dust has (mostly) settled on a contentious U.S. election season, we expect another stimulus package, this time worth around $1 trillion. It's expected to include support for state and local governments and augmented unemployment insurance. Such a package -critical for the workers and businesses that are still suffering - would likely be enough to ensure the recovery continues. We expect one, but a congressional failure to provide support could cause more permanent damage to the economy.
3. Will prices rise too quickly or too slowly?
We expect inflation to rise modestly over the next 12 to 18 months to just below 2% in the United States and around 1% in Europe - right where it was for most of the last cycle. This means that policy rates will remain anchored, and investors should be wary of holding excess cash.
Debates about the future path of inflation dominate investment conversations. That makes sense—inflation is a critical consideration for central bank policy and short and long-term interest rates. Of course, it also directly impacts the purchasing power of the cash in your wallet. Despite the debate, inflation was remarkably stable over the last decade.
Now, we believe, the inflation game has changed. In the past, higher inflation was a constant risk for economies. Central banks were designed to keep inflation down. Today, the risk that prices won't rise fast enough, or will actually fall, is more realistic than the threat that they will rise too fast. As a result, global central banks are actively trying to push inflation higher rather than working on keeping it contained. They have a tall task ahead of them.
There is still slack in the global economy, particularly in the labor market. The number of permanently unemployed U.S. workers is still elevated - even as headline employment numbers recover. The digital economy does not have many physical constraints that lead to price hikes. Also, the lack of a “blue wave” in the U.S. elections means that we likely won't see a large-scale government spending program that might push prices higher. Further supply chain disruptions from de-globalization could put upward pressure on prices, but we would expect that process to play out over several years, if not decades. Central banks will need to remain supportive for the foreseeable future to keep inflation expectations roughly close to their targets.
To be clear, modestly rising inflation would be consistent with an improving global growth backdrop, and central banks want to stoke inflation modestly higher. We think the Fed will be successful ultimately, but the path ahead will be more difficult for the ECB and Bank of Japan. Forward inflation expectations already have recovered to pre-COVID-19 levels in the United States, but are still below the Fed's 2%+ target. Meanwhile, expectations in the Eurozone and Japan are still depressed.
Because policy rates will likely remain near zero for a few years, excess cash is not an investor's friend, and yield will be hard to find. To augment yield, we think investors can rely on U.S. high yield bonds and preferred equities. Further, there could be opportunities in assets that do well when inflation is rising from low levels: real estate, infrastructure and commodities.
4. Are current valuations sustainable?
We think historically high valuations may be justified. You may not be getting a bargain in stocks, but they will likely outperform fixed income and cash next year.
Most conventional metrics (e.g., Price to Earnings, Price to Free Cash Flow, Enterprise Value to Sales, etc.) suggest global equities are expensive relative to their own history.
This assessment seems unreasonable to many observers. After all, the macroeconomic environment can be described as “early-stage recovery” at best. Also, there's a high degree of uncertainty on the horizon.
We disagree, and see several reasons why current valuations may be justified. For one, the largest companies in the world have pristine balance sheets and stable growth profiles underpinned by secular growth trends. One of them even has a stronger credit rating than the U.S. government. Now, with the Federal Reserve working to backstop lending and support markets, the largest weights in global equity markets have a low perceived risk of default, which supports higher equity valuations. They also tend to be technology and technology-adjacent, which have less volatile earnings streams.
Perhaps more importantly, interest rates are low globally. The yield on the JPMorgan Global Aggregate Bond Index is just barely above all-time lows. Low interest rates support equity valuations in two ways: (1) the rate at which future earnings streams are discounted is low; and (2) equities look more attractive to investors on a relative basis because dividend, earnings and cash flow yields are much higher than fixed income yields.
When you examine global equity valuations relative to bond yields, you find that valuations are closer to “fair” than “expensive.” To illustrate, we compare the dividend yield of the MSCI World Index to the yield on the JPMorgan Global Aggregate Bond Index. On this basis, the dividend yield of the market relative to bond yields is right around where it was at the depths of the EM balance of payments crisis of early 2016, and a far cry from where it was at more “exuberant” times, such as September 2018.
We believe there could be a “new normal” for equity valuations - as long as global central banks remain on hold (we think they will) and long-term interest rates remain near secular lows (we think they will). Of course, a risk to this view would be an unexpected rise in interest rates.
This ª”new normal” might not apply to all regions or sectors equally. Take Latin America, for example. While in theory, low interest rates could favor a rotation to equities, a slow recovery from the economic crisis could keep valuations depressed for some time. In addition, Latin American equity indices (or European ones for that matter) do not have a material weighting toward tech and tech-adjacent companies, which have commanded valuation premiums because of their growth profiles.
Those looking for value may want to look at the financial and healthcare sectors. They are trading at low relative valuations, reflecting the risks of indefinitely low policy rates (which hurt bank earnings) and potential changes to U.S. healthcare policy. We think both sectors may surprise to the upside.
5. Will it continue to weaken?
It probably will, but modestly from current levels. Investors are likely to move money from the safe haven of the United States into higher-return opportunities elsewhere as the global healing continues. Investors should be mindful of currency exposures and consider beneficiaries of a weakening dollar, such as emerging markets.
The value of the U.S. dollar relative to other currencies can tell investors a lot about relative growth and policy expectations, as well as broad sentiments about risk.
When the global outlook is worsening, investors tend to flock to safe havens, which drives up the value of the dollar. This happened during March and April, when the first-wave lockdowns rolled out around the world. When global growth expectations are rising (and the rest of the world is doing better), other currencies tend to gain against the dollar as capital flows toward opportunities with higher potential returns.
Through the summer and after the U.S. election, the U.S. dollar weakened. Risk sentiment around the world has been improving; global trade and manufacturing has rebounded; and, crucially, the “carry advantage” an investor might have earned by investing in the United States, which had higher real interest rates, has collapsed. Finally, a more predictable trade policy from the White House could encourage cross-border investment and commerce.
We expect the global economy to continue to heal. That argues for more modest dollar weakness relative to its trading partners. That said, we do not expect the U.S. dollar to lose its status as the world's reserve currency for the foreseeable future. If the dollar continues to weaken, it will be a sign that the global recovery is occurring, not that the world is on the precipice of a currency regime change.
What does that mean for investors? Be thoughtful about currency exposures. If the dollar continues to lose value, concentration in U.S. dollar-denominated assets could hurt relative performance.
A weaker dollar also leads to easier financial conditions for many emerging market countries, as well as companies that earn revenue in local currency but pay debt service in dollars. This dynamic would also help support the recovery in emerging markets, and makes us more positive on equities in the region.