Save for a few very nervous weeks in Q12020, investors saw excellent returns across nearly every asset class as policy stimulus boosted the economy and vaccine breakthroughs permitted greater optimism about the coming year. As we head into 2021, our investment outlook remains constructive. But the most immediate concern is: how much more lasting damage will the virus do to the global population and its economy before vaccines bring it to a close?
Global economy still in the tunnel
Global Covid-19 cases are rising daily including in the US and Europe (Fig 1), even as multiple vaccines are weeks away from becoming publicly available.
For many businesses and whole industries, activity never returned to anywhere near normal even when the virus’ severity temporarily subsided. At the same time, the parts of the global economy that can function during a pandemic are doing so, and many are thriving. Global manufacturing has staged a V-shaped recovery, as has the US housing market, thanks to shifting demographics, low interest rates and consumer preferences migrating toward the suburbs.
Global economic recovery is growing more uneven across regions. In particular, Asian economies are improving more quickly than the US or Europe. For example, we remain negative on US retail and office space, but are more positive on Asian housing, office properties and logistics. Most importantly, consumers are exhibiting considerable resilience. Savings rates remain unusually high and incomes have risen with the help of global fiscal policy stimulus, even in the US, where consumers tend to spend more of what they make each month (Fig 2).
The better-than-expected cumulative economic recovery has been extremely supportive of global equity and credit markets. But that progress may not continue in a straight line, especially if the latest wave of Covid-19 causes businesses to close and workers to lose their jobs. The global economy remains in a dark tunnel, but we expect it to emerge by the second half of 2021.
Markets are already seeing the light
An effective vaccine will eventually supply a much-needed boost to global GDP, but markets have already reacted to tomorrow’s good news today. It is rare for equity valuations to surge past their pre-recession levels so soon after the recovery begins.
Even so, we believe both equity and credit risk will add to portfolios’ performance in 2021. The expected earnings recovery — we see S&P 500 earnings up at least 25% next year — will ease pressure on valuations and still allow for reasonable returns on stocks. Corporate credit spreads have narrowed impressively but could compress further given the very low level of underlying rates and the outlook for better growth by the second half of the year. Bond markets seem to recognise two truths: Central banks are intent on keeping rates low, and the likelihood of worryingly high inflation is minimal in 2021 — although we anticipate inflation could start to rise beyond that.
Two major events at the end of 2020 — the US election and the success of multiple Covid-19 vaccine candidates — have greatly reduced uncertainty about the 2021 outlook. The US election appears to have produced divided government, a welcome surprise to markets that prefer incremental — if any — change to public policy. And while investors were counting on vaccines to arrive eventually, the ones we know about so far are apparently more effective than expected and may be delivered ahead of schedule on a large scale. The lower uncertainty has contributed to lower volatility and high valuations for both global stocks and credit markets.
Remarkably, 2020’s events have left valuations barely changed, if not somewhat more expensive (Fig 3). Current yields on municipal bonds and high yield corporate credit remain historically low, while the earnings yield on global stocks likewise points to lower returns in the years ahead, even if 2021 delivers beyond our hopeful expectations.
Broadly speaking, the most obvious opportunities lie where normalisation still hasn’t been priced in. Cyclical parts of the global equity market performed better in the fourth quarter of 2020 but have not recovered their underperformance against defensive sectors. With the significant shift to online commerce, industrial real estate should continue to benefit from demand for storage, shipping and logistics and greater localisation of majority industries. And the weaker US dollar, which we expect to fall further as the US passes more stimulus and the Biden trade policy comes into focus, should support emerging markets fixed income, including both US dollar and local-currency bonds.
What if we’re wrong?
Investors’ most common questions still centre on government deficits and the sustainability of growing debt loads. This also plays into concerns about inflation in 2021 and beyond.
A roaring economy by the second half of 2021 could potentially put central banks in a bind given their strong commitments to maintaining very low levels of interest rates. Even a hint that this commitment was wavering could cause interest rates to rise and the yield curve to steepen. But this risk would have less to do with concerns about debt sustainability and more to do with the core driver of inflation: too much demand met with too little supply. When both growth and inflation are accelerating from low levels, equities have traditionally performed well, as have real assets.
The main downside risk to our outlook — a failure to end the health crisis — looks less likely by the day. But the global economy may sustain more damage before vaccines arrive. In particular, unsupported US small businesses are at greater risk of failure as states lock down or customers simply stay away. School closures are also affecting the labour market (Figure 4), with parents forced to choose between working and supervising at-home students.
The number of people leaving the labour force is alarming and could lead to a sluggish recovery as it did following the last recession. An economy too scared to quickly recover following the end of the pandemic would produce flat yield curves and favour the shrinking number of higher growth assets in portfolios, particularly technology and consumer discretionary sectors.
Investing in 2021
The lesson of 2020 for investors is that staying invested and rebalancing is more often than not the right move. That approach does not change simply because headwinds seem likely to turn into tailwinds in 2021. While the next few quarters may be bumpy, the probable end to the health crisis by summer should help distressed parts of the economy — and distressed assets — stage a strong recovery bolstered by unusually good household fundamentals. But as the twists of a dark tunnel give way to a brightening exit from Covid-19’s dominance of daily life, investors confront a new risk: building portfolios that deliver durable income and total returns for the balance of the decade.
Brian Nick is chief investment strategist at Nuveen.
