The backdrop for markets heading into 2021 remains dominated by regional variations in the response to the Covid-19 pandemic, along with political dynamics that will shape relationships between key players for years to come. China, the global economy’s other bookend, is now beyond its “first in, first out” recovery phase and growing outright once again. This provides a much-needed upward pull to the global economy as the US and Europe slow amid resurgences of Covid-19. In the US, a Biden presidency doesn’t require Democratic control of Congress to shift foreign relations to a more multilateral posture, which would present a less hostile backdrop for China.
In the US, while control of the Senate will not be known until the conclusion of two runoff elections in Georgia in early January, it’s hard to envisage the outcome yielding both seats to Democrats in a “blue wave.” Pundits are already warning of gridlock, with a Republican Senate obstructing Biden’s agenda. However, we think this forecast draws too heavily from President Obama’s second term as the precedent. With control of both the House and Senate in his first term, the Obama administration made little effort to govern through compromise. When the Senate flipped to Republican control, Obama forwarded the domestic agenda by expanding the use of executive orders, while also shifting the overall focus toward foreign policy. This time, an unresolved pandemic will anchor Washington’s focus on the domestic agenda and insistence on progress. We believe President Clinton’s second term offers a better template for what’s to come. When Clinton lost control of the Senate, he quickly shifted his approach toward one of compromise. It worked, and markets boomed. President-Elect Biden’s skill set seems ideal for this setting. So do the times. Since personnel is policy in Washington, Biden’s appointments must be watched carefully for their leaning toward either the center or the left. The not-so-hidden message of this election was a rejection of extremes on both the left and the right. Perhaps another “purple patch” of more centrist leadership lies ahead.
Meanwhile, in response to the escalation of the virus, European and US monetary and fiscal reboots are beginning anew. The European Central Bank (ECB) has all but promised another wave of quantitative easing (QE) while waiting for the eurozone’s fiscal stabilizers to kick in. While stepped-up monetary and fiscal thrusts in the US are not yet visible, they too will likely fall into place with a Fiscal IV package to the tune of $500 billion-$1 trillion, depending on the arc of the virus.
We still see a sustainable recovery in its early phases for economies and markets, built upon the same three pillars that have been driving the recovery this year: 1) rebooting of monetary policy, 2) sufficient fiscal stimulus, and 3) an extraordinary scientific response to Covid-19 that will likely soon produce an effective vaccine – a process that took approximately one year instead of the normal four. The best returns typically occur in the first several years of recoveries. We see a temporary slowing, assuming total lockdowns of unknown duration do not return, and an above-average year in 2021 for most risk asset returns.
“Total lockdowns” have become among the most dreaded words in the English language. Back in February, we didn’t yet understand that social distancing and mask wearing were almost as effective in bending Covid curves as total lockdowns, yet without the massive economic damage. Germany understands this now, and has begun implementing surgical lockdowns of bars, restaurants, and entertainment venues for a defined period of four weeks, in comparison with March 2020’s total lockdowns of unknown duration. In France, while President Emmanuel Macron has announced what sounds like a much more severe lockdown through December, the fine print reveals the restrictions apply only to non-essential businesses. Meanwhile, Dr. Michael Osterholm, a member of Biden’s transition team and considered the “Covid czar,” has indicated that the US needs a six-week lockdown to avoid “virus hell.” This is still a defined period and is less severe than in March, but the country has changed since then: Gallup’s latest poll indicates less than half of Americans would comply. This could be President Biden’s first big test if the current spike in cases is not receding by late January.
It strikes us that this winter’s wave, while a serious risk, is likely to have far less severe health and economic consequences. Markets have learned that once social restrictions (or mask mandates) are put into place, case growth and fatalities generally peak within five to six weeks. They are also buoyed by the vaccine efficacy news. While fatalities in Europe are sadly soaring once again, up tenfold off the bottom, the Continent is now two weeks into the new restrictions and hopefully three to four weeks away from cresting. While any increase is too much, and US case growth has doubled off its bottom, fatalities are clearly not following with a two-week lag as they did earlier this year. What we do know is that the dramatic slowing of fatalities relative to cases reflects better treatments and more knowledge about how to protect our most vulnerable populations. For most industries, commerce has also learned how to work around partial lockdowns.
Until recently, there may have been too much focus on the timing of a vaccine approval and too little on its efficacy. While political pressures for early approval by the FDA did emerge, the early approvals did not. We see little evidence that companies compromised on safety steps by rushing their data. In fact, many signed a letter pledging they would not. Most appear to be pursuing vaccines barely above cost, as a public service, with no indication of a race to make a commercial killing. The rapid pace appears to have resulted not from skipping safety steps or garnering premature approvals, but instead from collaboration (rather than competition) among companies for scientific, manufacturing, and distribution resources. Government subsidies have also made it financially feasible for firms to pursue the various stages – discovery (Phases 1, 2, and 3), manufacturing, and distribution – simultaneously rather than sequentially.
As for the vaccine’s efficacy, current thinking is that efficacy above 75%, exceeding that of the flu shot (typically closer to 60%), is a critical threshold in pulling forward herd immunity. Early results pointing to at least 90% efficacy for more than one leading vaccine blow past this goal. That said, the ratio of poll respondents saying they will actually take a Covid vaccine has fallen to 40% from 70% previously, apparently due to concerns that the speed of progress is primarily due to political pressure for expedited approval. However, once the data used for approval become public – and Dr. Anthony Fauci and Bill Gates take the vaccine, to great fanfare – we believe the numbers will once again climb to around 70%.
Some have labeled 2020 as “the 90% economy,” with certain sectors facing a ceiling on the extent of their recovery until vaccination takes place. While comprehensive global vaccination will likely not be complete until well into 2023, market dynamics are always about changes at the margin. We think the next leg up in mobility, GDP, and cash flows will begin chipping away at this 90% ceiling once normal-use vaccination begins in the spring/summer of 2021 – not when it ends in 2023.
An equally important determinant of the investment landscape ahead is whether the policy mix that has dominated since the 2008 financial crisis – i.e., massive monetary thrusts, but with fiscal stimulus at the sidelines – will play out again in the current cycle. The answer will depend largely on politics.
Prior intervals of frustratingly slow economic growth have often led to populism and more fiscal activism. The EU recovery fund marks the first step in this direction, with fiscal policy working in concert with monetary policy instead of counteracting its impact on growth, as it had for the past 10 years. A Biden presidency with the Senate remaining Republican, in our “purple patch” view (adjusted from our previous “small blue wave” projection), should also move policy in this new direction, but to a lesser degree than would have been likely in a “small blue wave.” In any case, the backdrop will be less imbalanced than we’ve seen since the financial crisis. More fiscal stimulus would nurture faster growth, at the expense of ratcheting up government debt-to-GDP – a dynamic that in the past has led central banks to repress their risk-free rates well below inflation, sometimes for decades, to help inflate nominal GDP comfortably back to match the expanded debt.
Today’s record imbalance between excess capital and cash flows to invest in has continued to swell, in large part due to the imbalanced post-financial-crisis policy mix that helped markets much more than economies. Into this sluggish backdrop (don’t try this in an overheating environment), should fiscal thrusts remain part of the mix beyond the Covid crisis and be used productively, with meaningful and long-lasting fiscal multipliers – admittedly a big “if” – this policy mix should have a favorable impact on markets. A divided government that moves forward with compromise is the structural backdrop most likely to produce fiscal spending that balances economic and social objectives, and is thus productive.
On inflation policy, the old generals have been carried out on their chairs. Today’s central bankers can be counted on to fight the disinflationary war well beyond its time. Should fiscal thrusts complement or lead monetary policy, central bankers now seem willing to dance: i.e., to reorient policies largely toward neutralizing the financial market tightening caused by rising fiscal deficits so that the private sector is not crowded out. They would likely wait to tighten at least until the current massive output gap shortfalls disappear, inflation reappears, and a meaningful margin of inflation make-up emerges. If they wait too long, this might trigger inflation and end the long bull markets in financial assets that began in 1980. Yet today’s central bankers appear willing to take this risk. Importantly, this is not a 2021 risk; it’s likely several years down the road. But don’t forget that such Modern Monetary Theory-type policies are easier to enter than to exit. For that reason, investors might consider building infrastructure and real estate holdings while these markets are still in a disrupted state, creating a hedge for a policy mix moving toward the goal of lifting inflation above target.
Policy shifts hit developed market sovereigns, boost gold and other real assets. For the past 10 years, economic shortfalls invoked monetary but not fiscal responses, lengthening and strengthening bond rallies. With the political winds shifting, the rates curve is now betraying suspicions that the jig is up. Yields no longer decline as predictably, or as meaningfully, when the growth outlook weakens and stocks stumble. The yield curve reflects worries that economic setbacks might just as easily provoke fiscal as monetary responses. After years of chronic “late-cycle-itis” during 2016-2019, with markets rewarding the most defensive segments within each asset class, these “defensive” segments may no longer be so. Developed market sovereign bonds are hurt most by this newly emerging policy mix, while gold and real assets could become the biggest benefactors, to the extent that fiscal activism itself becomes addictive, outsized, or is aimed unproductively.
Equities could see a change in leadership. US stocks appear to have benefited the most from 2016-2019’s late-cycle sentiment, which herded allocations within asset classes into areas that would be hurt least in a recession. This created a feedback loop in which the US stock market, which contained the most secular winners, outperformed first for having the winners, and then for the markets’ growing preference for such investments almost irrespective of price. As the economy and markets broaden, some of the bloom will come off this rose. The FANG stocks (Facebook, Amazon, Netflix, and Google/Alphabet) in particular will also have to defend themselves against new anti-trust challenges.
Globally, earnings and cash flows held up far better than most expected and are bouncing back meaningfully for most sectors. Rebooted excess liquidity will linger for years, ensuring that improving cash flows remain generously capitalized. While growth has been pushed back a few months amid Covid’s third wave and may even reverse for a short, defined period, we expect growth to continue, with a broadening of its sources as 2021 unfolds – particularly in the second half. Timing-wise, this is near enough to facilitate continued broadening in the equity markets in the interim, as long as broad-based vaccination begins rolling out in the spring/summer of 2021. US equities will likely lose their global leadership status at that time, yet still perform in line with global stocks, opening up opportunities for European and select Asian stock markets in particular to lead.
While value finally looks poised to join the party as the economy recovers and broadens, this doesn’t have to be at the expense of true secular growth. We believe instead that it will be at the expense of defensive sectors like utilities, consumer staples, and many older healthcare companies, which also benefited from the serial recession forecasting from 2016-2019, which encouraged a herding into economically defensive earnings streams. In fact, new forms of secular growth appear to be on the rise. To paraphrase one US bank CEO, we’ve condensed about 10 years of digital disruption in markets into just three months. This isn’t going away. Covid has unleashed a “Hunger Games” environment, and many of the strongest – beyond the FANGs – will benefit.
Fixed income markets diverge based on policy support. Yields on most developed market government bonds now look set to remain repressed by central bankers below inflation for many years to come. What’s your definition of “capital conservation”? If it’s preserving buying power, as we define it, these monetary policies will degrade the purchasing power of developed market sovereigns for years to come. Meanwhile, these bonds’ “risk-off” hedging benefits are also deteriorating, as fiscal thrusts appear to be joining monetary excess when growth shocks appear. Those recalling the days when risk-free bonds rallied on a growth stall, only to see central banks subsequently piling on with QE for a double-barreled rally while fiscal policymakers sat on their hands, need to consider that fiscal authorities are now just as likely to come to the rescue as well. For that 20% of the time when we are “risk off,” the jig is up for developed market sovereigns, and they seem to know it. The other 80% of the time, DM sovereigns will lose purchasing power as a matter of policy. However, interest rates above local inflation can still be found in emerging countries, and these assets are part of our shopping list.
After a huge rally, credits backstopped by the Federal Reserve, including US corporate investment grade credit, have returned quickly to (and perhaps through) fair value. However, non-backstopped credits in the US and in many other countries remain attractive. With Asia’s sturdier hand in dealing with the virus as we head into winter, and the strongest economic prospects going into 2021, Asian investment grade credits may provide some of the best risk-adjusted returns in credit from here.
For more PineBridge views on what to expect across economies and asset classes in 2021, visit our 2021 Outlook page.
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Last updated 3 June 2021