2021+ Market Outlook

2020 was an unprecedented year for the global economy and society as a whole. Despite the destructive health and economic impacts of Covid-19, global financial markets have rebounded remarkably, reinforcing the way monetary policy (see below) can drive wide disconnects between asset prices and underlying economic reality.

People’s adaptability combined with business ingenuity have supported the economic recovery, and the rapid development of highly effective vaccines will help us return to some level of economic and social normality. We are not there yet, however, and tens of millions of people remain unemployed in the U.S. Virus cases remain high and new variants present risks. But absent any major surprises with regard to the virus, markets should remain focused on what the economy and corporate earnings will look like once Covid-19 has been fully contained.

In this outlook, we focus on four key themes that we feel will drive markets in a post Covid-19 world. While day-to-day developments in the economy, politics and the virus remain fluid, these are themes we feel will persist over a multi-year time frame.

1. Lasting impacts of Covid-19 to drive sustainably higher government spending.

One of the more curious aspects of the economic recovery in the second half of 2020 was how high unemployment remained despite significant rebounds in consumer spending. When counting all forms of government employment support, the number of people still on unemployment insurance far surpasses that experienced over the past 50 years.

“A structural change has occurred which will likely lead to a higher natural rate of unemployment going forward.”

This phenomenon is mainly due to a shift in consumer spending from services to the goods economy, but it also represents a step-change in businesses use of and reliance on technology. A common theme across publicly-traded companies is the significant increase in business productivity via the deployment and increased use of software and other tech solutions. While we should see a substantial fall in unemployment once the services side of the economy fully reopens, a structural change has occurred which will likely lead to a higher natural rate of unemployment going forward.

Policy makers and legislators will take notice, and unemployment levels that are higher than pre-pandemic will be a catalyst for new policy agendas and higher government involvement in the setting of economic policy. The new administration in the U.S. has set out some bold spending agendas across areas such as renewable energy and infrastructure. For as long as a single party controls both chambers of congress, the impetus will be present to pass significant legislation.

2. Global central banks will continue to provide meaningful support to financial markets.

Central banks responded forcefully to the Covid-19 pandemic by purchasing large amounts of both public and private sector debt securities, which is an effective tool to help prop our economy. These purchases have continued on regular intervals and will persist until at least economies have returned to pre-Covid levels and the outlook for inflation and unemployment is more robust. Traditionally the Federal Reserve has two mandates: maximize employment and maintain stable prices, i.e. manage inflation. In a notable policy shift the Fed has given primacy to improving unemployment with less short term concern about inflation. In other words, monetary policy makers will be looking to increase inflation to above target rates for some time.

“In the next economic downturn markets may anticipate (or demand) active Central Bank intervention to prevent credit and asset value deterioration. This new dynamic could alter the future cyclicality of economic and financial markets.”

The steady increase in the money supply provides an opportunity for governments to increase deficits in order to spur economic growth and bring down the rate of unemployment. On a different note, monetary policy actions taken in 2020 provide a new precedent of financial market backstops and support. In other words, in the next economic downturn, markets may anticipate (or demand) active Central Bank intervention to prevent credit and asset value deterioration. This new dynamic could alter the future cyclicality of economic and financial markets.

3. The prospect for higher inflation is much stronger now than when compared to the Great Financial Crisis.

Many investors anticipated an inflation problem following the great financial crisis as central banks kept interest rates low and embarked on multiple rounds of quantitative easing. In hindsight, much of that money printing/quantitative easing remained in the form of bank reserves, i.e. it never circulated throughout the real economy. Two factors behind this dynamic were tighter fiscal policy and higher business regulation.

  • Monetary policy addresses interest rates and the supply of money in circulation, and it is generally managed by a central bank.
  • Fiscal policy addresses taxation and government spending, and it is generally determined by government legislation.

Today, however, fiscal policy is highly expansionary. This fact is apparent in the record high rates of broad money growth that weren’t evident in the previous decade. Our first two themes above combine to ensure that both fiscal and monetary policy will remain in congruence, therefore providing a more robust backdrop for higher inflation in the future. To be sure, the upward productivity shock caused by a pull-forward in the use of technology will serve to hold back inflation; but as services spending returns and fiscal policy expands aggregate demand, the potential for much higher inflation going forward should not be taken for granted.

We are therefore carefully monitoring the interest rate environment and remain defensive in our client bond allocations, which means that we have continued to focus on high quality shorter-maturity investments to minimize the negative bond pricing impact of rising interest rates. The high-yield bond markets may become more appealing near-term, so we may again capitalize on this area. Our fixed income investments performed very well in 2019 and 2020, so some retrenchment of these outsized gains is to be expected.

4. Outlook for Asset Prices

The prospect of higher government budget deficits and spending will expand earnings growth beyond the Covid-19 beneficiaries of software, e-commerce and consumer goods. This shift in earnings growth will help to reverse the 2020 outperformance of growth over value and cyclical stocks. Higher inflation and increased government borrowing will continue to raise longer-term interest rates despite active central bank policy, i.e. central banks can only moderate this rise, not eliminate it altogether Continually rising rates will pressure fixed income returns as well as certain high-earnings-multiple stocks that have less relative pricing-power in an expansionary economic environment.

2021 should see a reversal, with value and cyclical stocks outperforming growth.

From a valuation perspective, both equity and fixed income pricing sit at or near record levels while valuations (pricing relative to earnings or cash flow) are far past historical highs. As a result, we anticipate that the themes above will primarily drive intra-asset class divergence as opposed to broad and strong advances in returns overall.

We are therefore making adjustments regarding the allocation of our stock exposure, locking in some robust 2020 gains from the growth sector and redeploying assets to areas with a value bias.

While the very near-term remains fluid as the unprecedented nature of the pandemic and resulting recession have yet to fully reveal their lasting impacts, our outlook for asset prices is based on the economic themes we believe will evolve throughout 2021 and beyond.

We continue to monitor the economic recovery and calibrate our allocations for asset prices, making corresponding reallocations of portfolios as conditions warrant. We are in a complex investment environment without precedence to guide us. This chart reflects the stock markets’ amplified 2020 performance impact from the Federal Reserve’s actions. We therefore must remain committed to logical and strategic planning regarding your portfolios in this current dysfunctional environment.