Andrew Pease

GLOBAL HEAD OF INVESTMENT STRATEGY

2020 was a year of surprises. There was the speed at which the pandemic escalated, the severity of the lockdowns, the size of the government stimulus measures globally and the magnitude of the equity market rebounds. Perhaps the biggest surprise is that global equities, as of late November, have gained around 12% since the beginning of the year—an outcome few would have predicted during a global pandemic. With the U.S. election behind us and effective vaccines on the way, investors have become bullish, pushing the S&P 500® Index to record highs.

Likewise, we have a positive medium-term outlook for economies and corporate earnings. We’re in the early post-recession recovery phase of the cycle. This implies an extended period of low-inflation, low-interest rate growth that favors equities over bonds. There are some near-term risks, however. Investor sentiment has become overly optimistic following the vaccine announcements, markets vulnerable to negative news. This could include renewed lockdowns in Europe and North America as virus cases escalate, logistical difficulties in distributing the vaccine and negative economic growth in early 2021 if government support measures are unwound too quickly. Geopolitics could also deliver negative surprises from China, Iran or Russia as the new Biden administration takes power in the U.S.

Our cycle, value and sentiment (CVS) investment decision-making process scores global equities as expensive (with the very expensive U.S. market offsetting better value elsewhere), sentiment as overbought and the cycle as supportive. This leaves us slightly cautious on the near-term outlook, but moderately positive for the medium-term with expensive valuation offset by the positive cycle outlook.

Overall, we see the following asset class implications for 2021:

• Equities should outperform bonds.
• Long-term bond yields should rise, though with steeper yield curves likely limited by continued low inflation and central banks remaining on hold.
• The U.S. dollar will likely weaken given its countercyclical nature.
• Non-U.S. equities to outperform given their more cyclical nature and relative valuation advantage over U.S. stocks.
• The value equity factor to outperform the growth factor.

A return to normal by the second half of the year should help extend the rotation that began in early November away from technology/growth leadership toward cyclical/value stocks. During the COVID-19 pandemic, technology and growth stocks enjoyed tailwinds from a boost to earnings and lower discount rates. These tailwinds should become headwinds once a vaccine is available and lockdowns have been eased. This should allow the normal early-cycle recovery dynamics to resume, with investors rotating towards relatively cheaper value and non-U.S. stocks that will benefit from the return to more normal economic activity.

The major economies have escaped the pandemic and lockdowns with relatively little long-term economic damage thanks to substantial monetary and fiscal support. Wage subsidies and job retention schemes have prevented unemployment rates from rising significantly in most countries. In the United States, corporate bankruptcies and delinquency rates on consumer loans were lower in the September quarter than the same period in 2019. The hospitality, tourism, transport and retail sectors have been hit hard, but the overall balance sheet damage to corporates and households has been relatively limited despite the large lockdowns.

The most notable damage from the pandemic is rising government debt. The International Monetary Fund (IMF) projects that gross government debt for the G7¹ economies will rise by 23% of gross domestic product (GDP) in 2020. High debt makes government finances vulnerable to rising interest rates. This is unlikely to be a significant problem in the next couple of years, but it will matter when spare capacity is eventually exhausted, and inflation starts to rise.

There is speculation that governments will soon start to trim deficits through tax hikes and lower spending, slowing the recovery. This seems unlikely anytime soon. The two charts below show that despite the increase in debt levels, net interest expenses are projected to trend lower for all the major economies. By 2023, Japanese government net interest payments are expected to be close to zero, despite gross debt in excess of 250% of GDP. Two-thirds of Japanese government debt has a negative yield.

Governments will come under pressure to reduce deficits only after bond yields rise meaningfully and markets question debt sustainability. We expect fiscal austerity and tighter monetary policy are still some years away.

Government bond yields to rise

Long-term government bond yields are likely to come under upward pressure from a vaccine-led recovery in 2021. Dovish central banks and the lack of inflation pressure in most countries as output gaps remain large should limit the rise in yields. The major central banks have made clear that they will wait until after inflation rises before raising rates. This was highlighted by the recent move by the U.S. Federal Reserve (the Fed) to target average inflation and allow an overshoot of its 2% target. A slow-to-react Fed should limit the rise in the 10-year Treasury yield to between 1.1 to 1.4% from the current 0.85%. It’s reasonable to expect similar increases of between 25 to 50 basis points in German bund and British gilt yields. Japanese government bond yields, though, are likely to remain close to zero with the Bank of Japan continuing with yield curve control.

Equity market rotations to continue

The announcement of a successful COVID-19 vaccine in early November has led to tentative signs of a market rotation away from technology-heavy growth stocks towards more cyclical value stocks. Technology stocks received two benefits from the lockdowns. The first was the boost to earnings as consumers worked from home, spent online and made technology purchases. The second was from the decline in government bond yields. Technology stocks are regarded as long-duration as they are expected to grow their earnings over the longer term. The decline in bond yields made the present value of those future earnings more valuable.

The rotation away from technology stocks is likely to continue into 2021. The boost to tech-stock earnings from the lockdowns has peaked and there could be a demand shortfall in coming quarters since the pandemic brought some technology spending forward. Higher bond yields will also be a headwind for tech stocks. In contrast, the global recovery and higher bond yields should help value and cyclical stocks. Financial stocks are heavily weighted in value indices, and we expect these will benefit from higher margins as yield curves steepen, and from stronger revenues as credit growth improves. In late 2020, banks, globally, are trading at a large discount to the broader market.

The post-vaccine recovery outlook should also help non-U.S. markets outperform the U.S. The S&P 500 is overweight the tech and healthcare stocks that dominate the growth factor, while the rest of the world has more of the financial and cyclical stocks that make up the value factor. Investors are likely to favor the relatively cheaper value and non-U.S. stocks that will benefit from the return to more normal economic activity.

The vaccine announcements and passing of U.S. election uncertainty have removed two of the near-term worry points about the outlook. The major risk now is the amount of investor optimism since the vaccine announcements. Our composite contrarian sentiment indicator is not yet at the overbought threshold in early December, but it is getting close. Investors are positioned for upside gains, which makes markets vulnerable to disappointing news. This could come from the current upswing in virus cases and a potential demand shortfall in early 2021 as government support programs expire and are not renewed. In particular:

• Infection rates are picking up across the United States. Schools have been closed in New York and there is a growing risk of more widespread lockdowns.
• Although infection rates are coming down in Europe following the recent lockdowns, there is the risk of a renewed spike in infections in early 2021 as lockdowns are eased.
• It seems likely that the Republicans will retain control of the U.S. Senate in 2021, making a further fiscal stimulus package subject to difficult negotiations with Democrats in the incoming Biden administration. A stimulus package may be small and delayed until late Q1, creating the risk of negative GDP growth in the first quarter of 2021.

The other risk for equity markets in 2021 is rising bond yields. Equity markets can often navigate rising bond yields if the reason is better prospects for economic growth, but a rise in excess of 50 basis points may provide a test. Technology stocks received a large boost to valuation from lower discount rates. The large tech stocks make up around 25% of the S&P 500 capitalization. They have accounted for almost all the gains in the overall market for 2020 through November. A bond market-led reversal in tech stocks could stall the overall market even if the remaining 75% of the S&P 500 makes post-pandemic gains.

Our cycle, value and sentiment investment decision-making process in early December 2020 has a moderately positive medium-term view on global equities. Value is slightly expensive, with the expensive U.S. market offset by fair value in the rest of the world. Sentiment is slightly overbought following the post-vaccine announcement optimism. The cycle is supportive of risk assets for the medium-term. The recovery from the recession means a long period of low-inflationary growth supported by monetary and fiscal stimulus.

• We prefer non-U.S. equities to U.S. equities. The post-vaccine economic recovery should favor undervalued cyclical value stocks over expensive technology and growth stocks. Relative to the U.S., the rest of the world is overweight cyclical value stocks.
• We like the value in emerging markets (EM) equities. China’s early exit from the lockdown and stimulus measures should benefit EM more broadly, as will the recovery in global demand and a weaker U.S. dollar.
• High yield and investment grade credit are slightly expensive on a spread basis but have an attractive post-vaccine cycle outlook. Bank loans and U.S. dollar-denominated emerging markets debt in our view offer the best opportunities.
• Government bonds are expensive. Low inflation and dovish central banks should limit the rise in bond yields during the recovery. U.S. inflation-linked bonds offer good value with break-even inflation rates well below the Fed’s targeted rate of inflation.
• Real assets: Real Estate Investment Trusts (REITs) sold off heavily in March 2020, with investors concerned about the implications of social distancing and online shopping for office buildings and shopping malls. Sentiment appears overly bearish, while value is positive. These should be a pandemic recovery trade. Listed infrastructure should also benefit from the global recovery, boosting transport and energy infrastructure demand.
• The U.S. dollar should weaken into the global economic recovery given its counter-cyclical behavior. The dollar typically gains during global downturns and declines in the recovery phase. The main beneficiaries should be the economically sensitive commodity currencies: the Australian, New Zealand and Canadian dollars. The euro and British sterling are undervalued. Both currencies should be boosted by the post-vaccine recovery.