While COVID-19 rendered many 2020 forecasts obsolete within the first few months of the year, a number of our key calls proved accurate. We expected accommodative monetary and fiscal policy to continue and posited that a contentious U.S. political season would end without major disruptions to markets. Though 2020 was a year of many challenges, we are optimistic for 2021 and expect improved economic conditions and better times ahead.
A shot in the arm
2020 closes on an optimistic note as countries around the world begin to administer COVID-19 vaccines. The development timelines have been nothing short of extraordinary, as multiple companies were able to develop a vaccine, run trials, receive regulatory approval and begin distribution, all within a year. We expect ongoing vaccination in the first half of the year to set the stage for a vigorous growth recovery in 2021. The beaten-down services sector should be the principal beneficiary of this return to normal as the in-person economy roars back to life in the post-pandemic world.
By mid-year or late summer, we expect certain sectors such as travel and tourism to bump against capacity constraints as long-delayed holidays and other spending finally materializes. The return to normalcy and shift in consumer spending will also lead to greater demand for labor. While the U.S. unemployment rate by the end of 2021 may not match the pre-pandemic level of 3.5%, we do expect it to be meaningfully lower than the current rate of 6.7%, with strong momentum. The explosion in debt, which helped economies endure lockdowns, will linger for years, but we believe strong growth and low interest rates should minimize its long-term effects.
The policy pipeline will keep flowing
In response to the pandemic, 2020 saw unprecedented fiscal and monetary actions worldwide. Global central banks launched multiple initiatives including significantly lowering interest rates and purchasing financial assets in massive quantities. In parallel, fiscal authorities loosened the purse strings, spending aggressively to support their domestic economies. The combined fiscal and monetary support proved crucial to global economies, and by extension, global asset markets.
As we move into 2021, these levers of support will remain in place, and in some instances, expanded upon. In the U.S., for example, we expect further fiscal support from the federal government, with additional stimulus of nearly $1 trillion, or approximately 5% of the economy. We anticipate similar increases in fiscal support from major developed economies and select emerging economies as they look to bridge the gap to a full recovery. Central banks should remain accommodative in 2021 and beyond as well. The European Central Bank, for example, may increase asset purchases in the near future.
With continued fiscal and monetary accommodation, we expect a modest increase in longer global rates, as global growth accelerates and inflation ticks upward. At the same time, shorter interest rates should remain anchored at their current levels with central banks on pause for the coming year. Global yield curves should thus steepen modestly throughout the year. However, with absolute rates remaining historically low, this environment should be supportive for equities and broader risk markets globally.
Equities: Macro risks ease and earnings improve
We continue to have a favorable view on equities for 2021 due to our expectations for a vaccine-driven economic recovery and revitalized global corporate earnings. While earnings in the U.S. were negative throughout 2020, momentum turned sharply positive in the third quarter as a record high percentage of S&P 500 companies reported earnings above expectations.
MSCI all country EPS growth
Source: BMO Global Asset Management and Datastream, as of December 2020
The fourth quarter of 2020 saw a recovery in value stocks and small-caps, which had lagged their growth and large-cap counterparts significantly over the past few years. Despite this short-term reversal, we recognize that long-term secular trends are at work here and we remain relatively neutral on both value versus growth and small versus large.
We expect the U.S. economy and financial markets to perform well on the fiscal, monetary and vaccine developments discussed above. Elevated levels of personal income and savings that accrued from fiscal stimulus and reduced economic activity in 2020 should result in a burst of pent-up demand in the second half of 2021. Adding to spending power is a healthy housing market and mortgage refinances that in 2020 have run at almost twice the 2019 rate.
U.S. real personal income (trillions USD)
Source: Federal Reserve
U.S. pending home sales index SA
Source: National Association of Realtors
In past expansions, headwinds often built up as the Federal Reserve (Fed) lifted interest rates to head off inflation pressures. In August 2020, however, the Fed announced a new “average inflation targeting” approach that not only backs away from pre-emptive measures to contain inflation pressures but actually permits inflation to be above target “for some time.” This policy could play a prominent role in 2021 and beyond as an accommodative Fed provides support to risk assets.
At present, equity market valuations are front and center with some investors fearing they have gone too high. It’s important to understand that comparing P/E ratios across time excludes many important variables: growth, interest rates, inflation, risk appetite and structural shifts in the market. Our long-term valuation modeling, which includes these considerations, indicates that equities are reasonably priced at current levels. There may be pockets in the market where exuberance has taken hold, but overall valuations would have to march considerably higher before action is warranted based on that consideration alone.
The Canadian economy has recovered swiftly in recent months, but some of this strength is largely because of an epic debt surge, leaving Canada with the most aggressive fiscal response compared to other countries when measured as a share of GDP. At nearly $400 billion (or near 20% of GDP) for fiscal-year 2020/21, we think the federal deficit will easily run north of $150 billion for fiscal year 2021/22 as the economy remains on aggressive health support and the government continues substantial wage and income support programs.
Part of our thesis for expecting Canada’s economic performance to lag the U.S. and the global rebound is the longer-term scarring from depressed oil prices. Prior to COVID-19, the world was already awash in an excess supply of oil as OPEC+ countries were rationing supply to keep prices from falling further. COVID-19 amplified the market imbalance and has likely fast-forwarded peak oil demand, which will keep energy capital expenditures at depressed levels, especially as Canada focuses on promoting less carbon-heavy industries. Our third concern is the overreliance on housing investment, which has even surpassed business investment as a share of the Canadian economy. Although the housing market should get additional tailwinds when immigration resumes in 2021, the lack of breadth in the drivers of growth poses some challenges to the economy going forward.
In line with our expectations that the world gets back to something approaching normal in 2021, those regions and sectors that have suffered the most from the pandemic logically have the most to gain. On this basis, Europe should have a strong upside: it has suffered a much greater loss in terms of GDP and corporate earnings than either China or the U.S. The challenge to this argument is that Europe has repeatedly disappointed growth expectations in the past. Buying Europe also involves a significant sectoral bet, in that it has few technology companies and significant exposure to financials.
Therefore, our strategy is to be ready to overweight Europe but only after we see clear evidence of outperformance on the economy and earnings. The purchasing managers’ indexes will be important in this regard.
The U.K. faces its own challenges in the post-Brexit world. We closed our underweight on the U.K. earlier this year following significant underperformance and are now neutral. We expect to remain neutral, on the idea that the market will correctly price in the problems that the U.K. will face as it reconfigures its economy to the new world.
Emerging markets also look poised to benefit from a global economic recovery in 2021, with rates of growth again superior to those of developed markets. Debt-fueled fiscal expenditure and accommodative monetary policy should help to achieve this growth, albeit indirectly, as developed countries have more flexibility in both forms of stimulus. The burden of COVID-19 and the associated restrictions, heavier in Latin America, emerging Europe and South Asia versus East or Southeast Asia, should be lifted thanks to the growing number of vaccines. This is likely to contribute to the unleashing of employment and pent-up consumption. Improvements already seen in trade and manufacturing — especially in East Asia where COVID-19 was better contained — could well continue. Upward pressure on commodity prices, consistent with a recovery in manufacturing, is expected to have a greater impact in emerging markets as well. Finally, the Fed’s policy shift to “average inflation targeting” means that the external risk to emerging markets of a strong dollar and tightened liquidity as growth accelerates has reduced considerably.
Though it may take a few months to get the pieces in place for a pronounced recovery, we are optimistic that this can happen in 2021. In terms of positioning, we expect accommodative policy and a vaccine-driven recovery to support risk assets. As a result, we are currently overweight U.S. and emerging market equities and underweight fixed income.
Originally Posted in December 2020 – 2021 Outlook: A Rousing Recovery
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