What drives our optimism for 2021? Take a closer look at our rationales.
While the world is not yet completely out of the woods, we believe the year 2021 will see the global economy continue to heal. In our Outlook 2021: The global economy will heal. Embrace the optimism, we discussed that the contours of that healing process will likely be defined by five big forces in 2021: the virus, policy, inflation, the U.S. dollar, and equity valuations. In today’s note, we’ll give you our digest version of each.
1. The virus: Will a vaccine be the “silver bullet” that many hope?
We do expect a vaccine, and relatively soon. And, it’ll likely be a game changer, eventually…but it probably won't be a “silver bullet” in 2021. So why won't a vaccine be a complete solution? Critically, a material portion of the global population likely will not be vaccinated in 2021—due to personal choice, logistics or economic constraints.
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. 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, and overall output for the country has already fully recovered its COVID-19 losses. 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.
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.
2. Policy: Which governments and central banks will provide enough support?
In the U.S., we expect a very supportive mix of monetary and fiscal support. The Federal Reserve is already doing much to support growth; setting policy rates at zero, buying $120 billion worth of Treasury bonds and mortgage-backed securities per month, and shifting toward an average inflation-targeting framework to name a few. On the fiscal side, we expect another stimulus package, this time worth around $1 trillion. Such a package—critical for the workers and businesses that are still suffering—would likely be enough to ensure the recovery continues.
In Asia, we expect varying levels of additional stimulus. China was able to contain the virus relatively quickly and effectively, and was therefore less dependent on policy to help bridge the economic gap that lockdowns created. We also see less need for additional support as its recovery broadens. Japanese policies will likely remain supportive given that COVID-19 has exacerbated deflationary pressures. In Taiwan and Korea, growth has been resilient, reducing the need for more easing, and thus we expect policymakers to remain on hold. If the U.S. dollar does not appreciate, 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 also will likely try to ease policy, which could stoke inflation higher and deficits wider.
In Europe and Latin America, we see challenges ahead to providing more support. Europe’s interest rates are already negative and asset purchase programs are nearing self-imposed limits. The European Recovery Fund (agreed upon this summer) is a promising first step toward delivering fiscal support, but there are still hurdles to clear in actually distributing its funds. Latin American central banks have aggressively cut interest rates, but countries throughout the region have limited fiscal policy room given they lack the ability to borrow as liberally as “reserve currency” countries can (like China, Japan, Switzerland and the United States).
For investors, 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 beneficiaries of policy support: U.S. and Asian equities, high yield bonds, companies exposed to physical and digital infrastructure investment, energy transitions, and the next generation of transportation.
3. Inflation: Are prices going to rise too quickly, or too slowly?
Today, and for most of the past decade, 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 (by keeping interest rates low and buying assets to circulate more money through the economy), rather than trying to contain it.
We expect inflation to rise modestly over the next 12-18 months to just below 2% in the United States and around 1% in Europe – right where it was for most of the last cycle. That means that central banks will need to remain supportive for the foreseeable future to keep inflation expectations around their targets.
Forward inflation expectations have already 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. Overall, the likelihood that central banks remain accommodative bodes well for risk assets broadly.
For investors, this means that excess cash is not an investor’s friend and yield will be hard to find. To augment yield, we’re looking at Emerging Market corporate bonds, which offer yield enhancement relative to the developed world; hybrid securities to pick-up yield over corporate bonds; and alternative assets like real estate and infrastructure investment, which offer diversification, inflation protection, and higher yields.
4. The U.S. dollar: will it continue to weaken?
The value of the U.S. dollar will be one of the most important things to watch in 2021, because it can give us a good sense of whether or not the global healing process is happening in the way that we expect it to. But as the market caught on to the healing process, the dollar has depreciated. The U.S. Dollar index (DXY) is currently down about 11.5% since its peak on March 23rd of this year, and is down over 6.6% in year-over-year terms.
How much more can the U.S. dollar weaken? The dollar probably will weaken modestly against other currencies that make up the DXY index (like the Euro, Yen, and Pound), but it could weaken more against EM currencies like the Chinese Yuan, Mexican Peso, and Russian Ruble, as the global healing process continues. Those currencies have high real rates (which attract investor funds looking for yield), and solid current account balances (which means they are in a more stable external position that can keep foreign capital within their borders). In fact, one of the strongest arguments for continued U.S. dollar weakness is that it has the most negative real rates of the major currencies that we track.
For investors, a weaker dollar has a few important implications:
- Emerging markets (EM): EMs are perhaps the biggest beneficiary of a weaker U.S. dollar. One channel that helps EMs is financial conditions: EM countries and companies that borrow in U.S. dollars get an effective reduction in their debt service costs when the U.S. dollar declines relative to their currencies. Based on research from our investment bank, every 1% decline in the U.S. dollar results in a 3.5% boost to emerging market equity performance.
- U.S. equity earnings: A weaker U.S. dollar is good for U.S. Large Cap equity earnings, as overseas revenues translate into higher USD-denominated revenues. Further, a weaker U.S. dollar makes U.S. goods more attractive to consumers outside the U.S., so it also can boost manufacturing activity.
- Commodities: Typically, commodity prices and the value of the U.S. dollar are inversely related, meaning that commodity prices generally do well in a weak U.S. dollar environment.
5. Equities: are current valuations sustainable?
Most conventional metrics suggest global equities are expensive relative to their own history. However, we see several reasons why current valuations may be justified:
- The largest companies in the world have pristine balance sheets and stable growth profiles underpinned by secular growth trends. Now, with central banks 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.
- 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”.
- 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 also think they will). Of course, a risk to this view would be an unexpected rise in interest rates.
All in all, you may not be getting a bargain for stocks, but we believe they will outperform cash and fixed income next year. Further, it’s also important to be selective, as the “new normal” may not apply to all regions and sectors equally.
All market and economic data as of December 14, 2020 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.
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