2021: Global markets – Top 7 investment watchpoints
With 2020 just about in the rearview mirror, it’s time to look ahead to 2021’s potential challenges and opportunities. Importantly, effective vaccines are on the way, and the world economy is firmly in the early stages of post–recession recovery.
The early cycle period is when there’s non–inflationary growth and low short–term interest rates. This is the sweet spot for equity outperformance over bonds. Global equity markets have already rallied 60% from their March 2020 bottom (as of mid-December). Though we expect short–term interest rates to remain unchanged for years, longer–term bond yields may rise 25 to 50 basis points throughout 2021 as the market gradually prices slightly higher rates over the farther horizon. How should investors navigate this environment? Below, we address clients’ frequently asked questions and highlight important watchpoints for the new year.
1. November 2020’s rotation from growth to value stocks: Head–fake or here to stay?
If a post–vaccine recovery continues, we believe the rotation is here to stay. The pandemic disproportionally benefited technology–heavy growth firms in two key ways. First, social–distancing meant more online shopping, more entertainment streaming and more video conferences. This boosted the revenues of many technology firms. Second, low interest rates benefit net–borrowers and hurt net–lenders. Growth firms (such as tech companies) are closer to net–borrowers since their stream of (growing) cash flow is further out into the future. Value firms are more balanced. Value firms, which tend to be financials–heavy, rely on the spread between longer–term yields (what they can lend for) and shorter–term yields (what they can borrow at) to make a profit. The plunge in global bond yields in early 2020 helped growth more than value.
These forces are likely to reverse in the post–pandemic world. Economic reacceleration tends to benefit cyclical value stocks more than less–cyclical growth stocks. We believe that longer–term bond yields will rise modestly from historical lows, helping financial sector profit margins and increasing growth firms’ borrowing costs. The announcement of effective vaccines in November 2020 raised the likelihood that a post–pandemic world is coming and served as the catalyst for the rotation.
Watchpoints in 2021: The continued rotation to cyclical stocks could be interrupted if the global economic recovery gets derailed. The rotation will run its course when all positive catalysts are exhausted. This could be when the pace of growth stabilizes, or when all the anticipated yield–curve steepening occurs. Bottom line: There’s still runway left.
2. What could derail the economic recovery?
In the short–term, increased COVID–19 infections and lockdowns alone shouldn’t be enough to derail the economies permanently, so long as there’s fiscal and monetary support as a backstop until vaccines have been widely deployed. A more serious problem could arise if lockdowns continue but government support ends. A risk for the U.S. is that the next stimulus package may be small and come after government support programs have already ended. Job losses and solvency issues could create a more lasting downturn.
Stimulus is a bandage, not a long–term solution. The most significant drivers for the path of the economy are the COVID–19 vaccines. High efficacy results from Pfizer, Moderna and AstraZeneca drastically reduces the downside risk from COVID–19 in 2021. Vaccine deployment logistics, currently underway, are the next watchpoint. The other ongoing risk we see is geopolitical tensions, which could escalate quickly and generate market and economic volatility.
Watchpoints in 2021: Until vaccines have been widely deployed, we’ll monitor for solvency issues and permanent labor market damage. Post–pandemic, geopolitical tensions (like global trade relations) will likely return as an economic driver.
3. Short–term pain versus long–term gain: How will the stock market balance rising infections with anticipated vaccines?
While current economic growth and stock market performance are related, the two don’t always move together. The stock market is a forward–looking asset pricing machine that considers all future periods of economic growth. From the stock market’s perspective, the anticipated vaccines have a higher impact than any short–term disruption from rising infections and lockdowns. Asset prices are determined by the discounted stream of future expected cash flow. Because interest rates are so low, future cash flows have a higher–than–normal impact relative to near–term cash flows. A short–term blip doesn’t derail a string of strong post–vaccine activity.
The caveat is that investor emotion can sway the logical asset pricing machine. When investor emotion becomes too optimistic, negative shocks have a disproportional impact. As of mid–December 2020, investors are almost unsustainably euphoric.
Watchpoints in 2021: Monitor investor sentiment for extremes. Worry about the lack of worry.
4. What is the future of U.S. and China relations under a Biden administration?
A U.S. administration led by President-elect Joe Biden is less likely to use tariffs as a unilateral negotiation tool and more likely to favor multilateralism. That said, after multiple years of tension, the U.S. and China relationship is unlikely to simmer to pre–2017 levels.
Watchpoints in 2021: How Biden approaches the Phase One trade deal discussions with Chinese President Xi Jinping (enforcing or unwinding the tariffs) will set the tone for the administration.
5. What news is noise?
We view any news that doesn’t fundamentally change our cyclical outlook as noise—and we see any noise that prompts market overreaction as an opportunity. While we can’t predict what the inconsequential volatility events of 2021 will be, we do know how we’ll process the information. We built a composite contrarian indicator that tracks market panic and euphoria across a range of technical, positioning and survey indicators. Our strategy is to take advantage of changes in investor emotions. We do this in part by first evaluating if the latest news is a game changer. Then, we check to see if our composite contrarian indicator suggests that markets have overshot to an unsustainable extreme. If so, there may be a tactical opportunity.
That said, a common pitfall is when market timing is mistaken for investing. Clients frequently ask, if we missed the dip, is it too late to join the equity market rally now? No. We believe reaching your investment goals is not about trying to time the market—it’s about putting the bulk of your money to work now in a diversified portfolio. Early cycle recovery creates a long runway for equities to rise. Market overreactions may be an opportunity to add to positions. In the meantime, we believe it’s prudent to practice disciplined rebalancing.
Watchpoints in 2021: Keep invested for your goals. Monitor market reaction to news flow for tactical opportunities.
6. When will there be a transition to inflationary growth?
Not any time soon. Inflation pressure builds when an economy runs over capacity for years—a near impossible task when freshly emerging from a recession. Until unemployment falls to 2019 lows again, firms are unlikely to bid up employee wages. Higher employee wages create inflation pressure through higher aggregate demand. Higher employee wages also create inflation pressure through higher production costs, which are passed to consumers through higher prices.
Watchpoints in 2021: Inflation is unlikely to be an issue in 2021. Monitor economic activity for cost or demand pressures. Monitor breakeven inflation rates for market expectations.
7. Portfolio positioning in a low–yield environment: Where to go in the search for diversification and yield?
The alternative for government bonds depends on your goals. Are you looking for a diversifier for equity drawdowns? Or are you searching for a relatively safe source of income?
Diversification: At low interest rates, bonds only offer muted diversification power, since there’s a limit to how much more interest rates can fall, and prices can rise. Consider supplementing with safe–haven currencies or options.
Yield: Consider searching for yield in broader fixed income markets (e.g., emerging–markets debt, high–yield bonds, bank loans) and real assets. The trade–off for higher income is these assets have higher risk than bonds, though less risk than equities.
Watchpoints in 2021: With bond yields near historical lows, investors will likely need to get creative. Consider partnering with a multi–asset solutions provider for a broader suite of investments to fit your needs. We’ll be watching developments beyond bonds and equities.