Barron’s – December 4, 2020
One year ago, if we were told the following 12 months would witness the worst global pandemic since 1918, precipitating the greatest global economic collapse since the 1930s, it would have been easy to envisage the lowest bond yields in history. But it would have been almost impossible to imagine functioning capital markets, much less equity markets flirting with all-time highs by year-end 2020.
Let’s resist the temptation to dismiss markets as irrationally exuberant and instead attempt to explain the seeming inexplicable. Then let’s turn our attention to how markets are likely to perform in 2021.
To begin, how did we get here?
First, after an initial pandemic phase characterized by aggressive lockdowns and strong risk aversion, which produced massive supply and demand-side shocks to economic activity, individuals, businesses, public health organizations and governments learned and adapted. By mid-year, extreme lockdowns gave way to less economically damaging and relatively easily adopted pandemic mitigation approaches, such as mask-wearing, social distancing and plexiglass installation at workplaces. Those measures opened the way for economic stabilization followed by recovery.
In China and parts of Asia, the rollout of high-frequency testing, tracking and quarantining measures achieved even more impressive degrees of infection containment, which in turn permitted a greater degree of economic re-opening.
Second, monetary and fiscal policy responded in tandem and in size. In advanced economies, large-scale fiscal stimulus, including effective direct transfer payments and increased unemployment benefits, enabled households to stabilize consumption. Loan guarantees, direct lending programs, ample liquidity and forbearance enabled companies to remain solvent. Wage subsidies supported employment. And central banks, backed by government guarantees, intervened in credit markets to stabilize economy-wide financing.
Third, medicine and science developed new ways to treat the infected, which cut mortality rates. Most important, researchers rapidly built and shared knowledge about the vaccine, which contributed vastly to the development of various vaccines in record time. This is truly an astonishing leap for science.
All three developments led to a sharp reversal in market expectations about how the pandemic would impact asset price fundamentals, above all growth, earnings and interest rates.
It is important to recall that financial markets are discounting mechanisms, deriving the present value of stocks, bonds and other securities by assigning probabilities to uncertain future cash flows. Accordingly, asset prices will almost always look beyond the present, no matter how wretched it may be, so long as a probabilistic assessment of the future offers something different.
Accordingly, while reasonable observers can still disagree about whether markets are currently under-, fairly or overvalued, there can be little objection to the statement that soaring equity markets, accompanied more recently by rotation into more cyclical sectors, styles and regions, reflect investor expectations that 2021 will produce stronger growth, better earnings and lower risks. The shape of yield curves, moreover, suggests that despite those fundamental improvements in the economic outlook, monetary policies worldwide will remain highly supportive via low interest rates and ongoing central bank balance sheet expansion.
As we look ahead to 2021, we see little reason to disagree. The combination of forthcoming promising vaccines alongside more predictable and less disruptive U.S. policymaking in a Biden administration offers compelling reasons to believe that global growth will accelerate over the next 12 months, accompanied by lower political risk. The development of vaccines, moreover, allows market participants to believe, as we all hope, that today’s shockingly rapid rates of Covid-19 infection, hospitalization and death, will be successfully mitigated before long. Expectations for further “normalization” of economic activity also permit investors to fret less about waning political prospects for U.S. fiscal stimulus.
That is not to say that 2021 is without real risks. The Biden administration must still convince a recalcitrant Republican Senate—depending on the outcome of the Jan. 5 Georgia Senate run-off elections—of the need to bolster aggregate demand until effective public vaccination permits the economy to expand more sustainably on its own.
President-elect Biden is also expected to announce further senior members of his administration and Cabinet. Thus far, Democratic progressives have been missing from key posts. Investors will be keen to see if other senior Biden administration appointees might indicate shifts in policy objectives that could present bigger risks to important market sectors, such as mega-capitalization technology (antitrust) energy (carbon pricing) or health care (Medicare as a public option).
Equally, market participants would be wrong to believe that the end of the Trump administration heralds the end of divisions and disputes. The U.S. remains a fundamentally split society, and effectively bridging this chasm may take decades. Massive gaps in income and wealth inequality, in the provision of education and health care, and in the treatment of individuals according to race and gender will have to be addressed. The associated policy changes will almost certainly include tax reform, increased transfer payments, antitrust action and other steps that could rattle investor expectations about growth and earnings.
The same is true globally. The Trump administration may have deployed unorthodox and cavalier approaches to international relations, but the drift of the U.S. away from its postwar commitments to alliances and institutions, the growing mistrust between an aging and an arriving superpower (the U.S. and China), the need to address borderless cyber threats or the critical imperative for global cooperation to tackle climate change will produce uncertainties that will occasionally test investor optimism.
So, how do we see 2021 in market terms?
First, given the starting point of historically lofty valuations in sectors, styles and regions that have led equity markets higher over the past decade, we believe that leadership in the market must change if indices are to sustainably advance in 2021. Recent outperformance of cyclical, value, small capitalization and emerging market equities offers promise that long-awaited rotation is finally arriving. But for rotation to take hold, investors must believe that global economic activity will, indeed, accelerate next year. For reasons outlined above, we think it will.
Second, central banks will maintain highly accommodative monetary policies for most, if not all, of 2021. Partly, this is because inflation remains significantly below their objectives, with few signs that it will suddenly accelerate. But expansive monetary policies will also reflect the receding chances for meaningful second-round fiscal expansion in the U.S., the United Kingdom, the European Union or Japan. The onus for nurturing the recovery is, once again, reverting back to its customary source—central banks. Accordingly, while yield curves may steepen modestly in expectation of improved economic conditions, interest rates at all maturities and spreads between different classes of credit are likely to be dominated by steadfast monetary adherence to low policy rates supported by quantitative easing.
Third, the arrival of an effective global vaccination program and an acceleration of economic growth is likely to disproportionately benefit non-U.S. economic activity and corporate profitability. More cyclical industrial economies in Asia and Europe, as well as producers of commodities in emerging markets, Australia or Canada will witness sharp gains in output and even some prices. Global equity market rotation will therefore favor emerging markets, Europe, Japan and Asia-Pacific. One consequence is that the U.S. dollar, which has recently softened on the world’s foreign exchange markets, is likely to decline further.
In sum, we are optimistic about growth and markets for 2021. Great companies will continue to offer investors attractive returns. Still, the better equity and credit performers are likely to be found among candidates overlooked by most investors, not just in 2020 but for much of the past decade.
If we are right, 2021 will be the long-awaited year of the great rotation.
Larry Hatheway and Alex Friedman
Larry Hatheway and Alex Friedman are the co-founders of Jackson Hole Economics, and the former chief economist and chief investment officer, respectively, of UBS.
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