February 1, 2021
With the Democrats taking both Georgia seats on the U.S. Senate, on January 5, 2021, the major political uncertainties of 2020 were behind us. With only the narrowest of majorities, in the senate and a reduced majority in the house, a unified Biden administration can be expected to push for greater fiscal spending, limited tax increases and regulatory burden and an overall easier political nominations process. But there is no mandate, nor likely majority support for, the more ambitious elements of the progressive policy agenda.
The economic impact of the election outcome will likely be more stimulus, offsetting some tax increases, to drive modestly faster economic (GDP) growth. Hence the recent rise in longer-term bond rates to reflect the faster growth and inflation expectations.
By far, the biggest driver of an expected robust U.S. and global economic recovery in the year to come is the ongoing rollout of COVID-19 vaccines. While the next couple of months will be extremely dire in terms of COVID-19 cases and deaths, this will likely be the last wave as vaccine rollouts continue to pick-up steam in the coming months, despite short-term hiccups.
The rollout of the vaccine will enable further economic re-opening into the spring and summer months, and we expect an extreme burst of pent-up demand fueled by households with elevated savings enhanced by fiscal spending supports, and wealth effects from the strong housing and asset markets. Growth will be further supported by inventory re-stocking, capital expenditure (Capex) and mergers and acquisition (M&A) activity as the recovery unfolds.
The year, 2020 had one of the worst economic outcomes in decades, and 2021 will likely be one of the strongest, with GDP growth expected to be well above 5%. We believe that such growth, in turn, will drive a robust earnings recovery and support the run-up we have seen across equity markets. Monetary policy will keep short-term interest rates at zero through 2021 and beyond. We maintain an overweight position in equities.
PANDEMIC AND POLICY
In terms of forecasting, the economic outlook for 2021 is one of the clearest we’ve seen in years. While exogenous shocks can always occur, as COVID-19 showed in 2020, a forecast is dependant on the various endogenous forces that shape the economy and business cycle, usually a mix of offsetting forces. Unusually, in 2021, almost all of the endogenous factors are pushing in the same direction. It is our expectation that, economy-wise, and hence earnings wise, 2021 will begin with a slow start that will rapidly snowball, as spring approaches, and continue right into 2022.
Since the pandemic began, last year, we have advised that any forecast has to be highly dependant on the trajectory of the COVID-19 virus and the resulting policy responses deployed by governments, to offset the economic impacts. Last year, the magnitude of both forces was highly uncertain and working in different directions. Policy objectives were aimed at offsetting the economic damage from the virus and bridging economies, households and companies through the crisis.
Looking ahead, the narrative couldn’t be more different. While the virus and fiscal and monetary policies remain the key drivers, today the settings for both are far more certain, and are pushing in the same direction. While the economy remains significantly below pre-pandemic levels, the growth momentum, seen in the back half of 2020, could help 2021 post one of the fastest economic growth rates for developed economies in decades.
THE BIG V
The year, 2020 was all about the virus; 2021 will be all about vaccines. While we expect a tough couple of months ahead, the deployment of effective vaccines has begun. While there have been hiccups and logistical challenges in the rollout, we have a high degree of confidence that these will be sorted out in short order and, that as we enter spring and summer, meaningful portions of the general public will be vaccinated.
As case numbers begin to fall, from the holiday induced high, coupled with inoculation of the most vulnerable and health care workers, we expect a significant easing of the current case loads threatening to overwhelm health care systems. We believe the numbers will start reflecting this in February and March.
As confidence builds, the preconditions to commence re-opening more segments of the economy will be in place and the population will begin to re-engage in an increasingly broader range of services and close-contact activities. While we don’t expect to hear an all clear signal, we do expect the process of re-opening to start in the second quarter and continue to build right through to the fourth quarter. In short, 2021 is all about the vaccine, and for the economy at least, everything else is secondary. (Spoiler alert, as we discuss below, from an investment perspective, there is another key driver.)
THE PENT-UP ECONOMY & THE PRO CYCLICAL FISCAL PUSH
As the virus recedes and the economy reopens, we all want to get back to the activities, travel and social interactions we are used to. There is a massive pent-up desire to engage in such activities, but uniquely, when contrasted with past recessions, this year there is also a significant ability to finance such activities. Household saving levels are bulging and rallies in housing and asset markets have significantly boosted net wealth. One recent calculation for the U.S., estimated that excess household savings above pre-COVID trends amount to roughly $1.4 trillion! That is a lot of spending power. While it is, in part, driven by the inability to spend when in a lockdown, it also reflects the unprecedented fiscal support that saw household incomes rise even as employment income fell as the government introduced multiple stimulus bills and allocated trillions of dollars in transfers and enhanced unemployment support.
This level of savings excludes the impact from the latest $900 billion package passed in December, and the expected $1-$2 trillion in extra stimulus likely to come in 2021 as the Democrats take control of the Senate. The extra stimulus, potentially as high as 10% of U.S. GDP, will be hitting an economy that is already accelerating! As the service economy reopens, and as confidence returns, the willingness and the ability to spend ensures, in my mind, that we will see a growing tsunami of consumption spending in the coming year.
Growth will not be driven by consumption alone. Corporations will also be opening the spending spigots, first on inventory restocking followed by pent up Capex spending and M&A activity. For corporations, the mix of strong end demand, growing CEO confidence, more predictable and professional driven trade policy in the U.S., and rock-bottom interest rates will be a potent combination.
While the U.S. is leading, in terms of scale, and doubling down with robust savings and extra fiscal support, we expect the vaccine-led recovery, and supportive fiscal policies around the world, will trigger a globally synchronized recovery and the associated positive feedback loops as all major global economies accelerate.
FRIENDS AT THE FED
But support for the economy doesn’t end with the vaccine and fiscal drivers, there’s more, and for markets this is as significant as the vaccine. Normally, with the building economic head of steam easily visible ahead, one would expect that the U.S. Federal Reserve (The Fed), and other central banks, would start to rein-in and tighten monetary policy – thus removing the punch bowl as the party is starting to rock. Simply put, that is not going to happen! The Fed has committed to keeping interest rates at ZERO, likely into 2023/24, and will maintain the current quantitative easing (QE) pace of buying at $120 billion a month, right through 2021. GAME ON!
The Fed has fundamentally changed its monetary policy framework as outlined by Fed chairman Jay Powell, on 27 August 2020, in his speech at Jackson Hole. It is worth revisiting that speech. In it, the Fed effectively abandoned its inflation fighting mantra of the past 40 years, introduced by Paul Volker to fight inflation in the 1970s. Today, the Fed is in an all-out battle to defeat deflation. It is fighting to generate, not beat, inflation. With interest rates at zero lower bound and inflation persistently below target, concern is building, within the U.S. Federal Reserve, regarding the risk of global Japanification, as economies becoming mired in subpar disinflationary stagnation, as we have seen in Japan since the 1990s. It is our belief that the Fed views this as a longer-term structural risk with significant negative implications and hence are willing to allow short-term cyclical inflation to run hot in an attempt to re-anchor longer-term inflationary dynamics. In short, the Fed knows how to fight inflation, but not deflation. If the current average inflation targeting framework unleashes the higher inflationary dragon, perfect! We know how to deal with dragons. But the real risk is that global developed markets have been consistently slipping into disinflationary patterns. We have not seen any Dragons in over thirty years!
MODERN PORTFOLIO THEORY: RIP
The Fed’s shift is an absolutely critical change in monetary policy with massive implications from an investment perspective. As I wrote in 2019, (MPT: RIP), for the foreseeable future we will be living with negative real interest rates. In other words, we believe the so-called safe assets, that risk-adverse investors use to generate income (cash, government bonds, GICs etc.), will not generate positive rates of return above the expected level of inflation. With the current U.S. 10-year real rate of return at approximately -1%, investors are effectively locking in losses of 1% a year for ten years by lending money to the U.S. government. That is not my definition of risk free! New Thinking Required.
One major outcome of central banks committing to zero interest rates is that rates that low drive-up valuations of other assets. As confidence in the economic outlook improves, it may drive more investors toward riskier assets with the goal of achieving positive real yield or total return. I would argue that near free money, mixed with growing confidence, are the two key ingredients that drive asset market bubbles. Furthermore, I would remind investors that bubbles can be fun during the inflating period, but the busts can really hurt.
The investment landscape in the coming years, with rates at or near zero, will be particularly challenging to navigate. It is likely that reasonable returns will be possible but achieving them will require an active approach to navigating markets and a willingness to embrace, and manage, short-term volatility, as the price of earning a longer-term return greater than the rate
Clearly, we have a very positive economic outlook for 2021 so long as the deployment of effective vaccines continues. The biggest risk to our view would be what we refer to as a COVID failure. Some form of negative COVID surprise, such as an extended hold-up in vaccine deployment, lack of lasting efficacy or new resistant strains arising. For many reasons, we feel these are low likelihood events, but they would be hugely impactful and we continue to monitor the situation very closely, led by the head of our health care team, Dr. Jeff Elliott.
ALL PRICED IN
A second risk, or challenge for investors, is insight into how much of this scenario is already reflected in equity markets that are at all-time highs. Our outlook is not unique and is pretty close to consensus. However, I believe the extent of the recovery and subsequent earning growth will surprise to the upside. It is precisely when the cycles turn that estimates tend to miss the extent of the recovery. As such, while equity prices today are high, based on current earnings, stronger than expected growth will allow companies to grow into their valuations. In broad terms, one could imagine earnings rising by 25%, over last year’s pandemic impacted levels, and markets rising by 10%. In short, markets could end the year higher, and cheaper than they started.
A broad-based economic recovery also expands the range of industries and companies that will benefit and broadens out the drivers of equity performance from the handful of sectors and industries, such as Information Technology and E-commerce, that gained on the pandemic to include the more cyclical sectors such as Consumer Discretionary, Industrials, Materials, and Energy. This broadening may allow overall markets to rise as lagging sectors play catch-up, a trend that has been underway in recent months and is a sign of healthier markets.
Within our core funds, such as Signature Global Income and Growth, we have been increasing exposure to equities (target up to 66%) since October, in part by shifting to the more cyclical sectors as mentioned above. We remain overweight Financials as we see a reflationary economy driving a steeper yield curve, even with the short end anchored at zero, its a positive backdrop for Financials. With real rates in negative territory we maintain a significant underweight in government bonds, nearly 20%, with about half of that allocated to investment grade credit where the yield, while low, is still better than government bonds. In short, we remain risk-on and tilted towards cyclicals within equities.
POST BOUNCE: ROARING 20’S PARTY OR LOST DECADE HANGOVER?
As we move into 2021, our discussions are shifting to what comes next? In other words, 2021 is all about the cyclical bounce, an easy call, but what lies beyond the bounce? Are we shifting toward a structurally higher growth trajectory versus that of the past decade, enhanced by a new policy framework driven by a new fiscal monetary paradigm? Or do we settle back into the sluggish disinflationary trajectory of secular stagnation influenced by the three Ds: Debt, Demographics and Digital Disruption? These are important questions with broad investment and positioning implications. They may not be important for today, but they will be for 2022, and markets always look ahead. Today, I lean toward a slower three D outcome, but that also comes with significant risks for economies, politics, with implications for inequality and societies. The outcome will be highly dependent on the political economy and policy choices made by individual countries. Nothing is set in stone. What is certain is that we remain in an era of accelerated structural change in business, in economies, in geopolitics, and in our societies. Staying informed will be crucial to managing what is expected to be an ongoing, tumultuous decade ahead. 2020, was the opening act for a decade that by all the indications could be one of the most tumultuous in a century.
Source: Bloomberg Finance L.P. and CI Global Asset Management as at January 11-15, 2021.
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Published January 26, 2021