2021 Investment Outlook: Blue Skies on the Horizon
Before we dive into our outlook we need to recognize that several large uncertainties remain to be resolved during 2021. How they play out will impact our outlook. At this time we are making the following assumptions. First, that the global vaccine rollout, while not completely eradicating the virus, succeeds in largely removing social distancing constraints by the summer. And second, that a hard, no-deal Brexit is avoided.
As social distancing constraints ease, the economic picture is set to dramatically improve as pent up demand and high cash levels rush into the void created by social distancing. U.S. personal savings increased by over $1 trillion year-to-date through October 2020. A survey performed by the New York Federal Reserve indicated that over two-thirds of the government stimulus initially went to either savings or paying down debt. Corporate America has also built up significant cash reserves from debt issuance and budget tightening. Moody’s Investors Services estimates that cash holdings of companies in the S&P 500 have increased by over $2 trillion. Consumers will rush to take part in activities from which they have been restricted. For example, on the day the FDA approved Pfizer’s vaccine for use, travel bookings spiked. Consumers REALLY want to come out of the basement. This anticipated spending growth, coupled with capacity reductions due to business closures could trigger higher prices. However, we anticipate this increased pricing pressure will be temporary as investment spending is unleashed to rebuild much of the reduced capacity. We believe the forces of increased demand and investment spending will serve as the foundation for the next economic cycle – and it will be a global phenomenon.
But the Markets Have Already Rebounded
This backdrop should be widely conducive for global risk assets. Yet we recognize that risk assets have already begun to discount this positive outlook. 2021 may be a much better year for consumers than for the markets. However, not all markets have advanced in lockstep. Notably the S&P 500, with a forward P/E ratio of almost 22x (as of mid-December), appears to be well ahead of the economic rebound and may be indicating an expectation that earnings will be reported much better than current analyst estimates. Other markets look more reasonably priced. Given that the backdrop appears to be positive for most all economies, we believe it may be more fruitful to turn to markets where the expectations bar has been set lower.
One area where the expectations bar looks more reasonable is outside the U.S. We see more opportunity for equities beyond the S&P 500 as the global economy reopens and rebounds. The MSCI EAFE and EM indexes are more economically sensitive and therefore we believe, poised to recover more strongly in anticipation of the easing in social distancing constraints. In addition, there is the potential for further upside if the dollar were to weaken as local currency returns get translated into cheaper dollars. During 2020, the U.S. Federal Reserve (Fed) and U.S. government were much more aggressive than other nations in their response. In a global recovery, a portion of this aggressive stimulus could be given back in the form of a weaker currency. Through November the U.S. trade weighted dollar has declined by about 5% and estimates of fair value suggest it could lose another 10%. Worth noting: a hard, no-deal Brexit would temper our enthusiasm for European equities.
Exhibit 1: 2021 P/E Ratio and Estimated EPS Growth
*based on 2021 consensus bottom up earnings estimates
Too Top Heavy
For the S&P 500, 2021 may simply be a year of earnings catch-up and rotation within the Index. It is notable that the S&P is heavily influenced by the names at the top in market cap. At the end of November the top 10 largest weights in the S&P 500 accounted for 33% of the Index, giving them an outsized influence on overall index returns and valuation. Tesla’s entry into the Index will only exacerbate this. We believe there is more opportunity to be had in the remaining 490 stocks in the Index, as well as among mid- and small-capitalization stocks. It also suggests a more conducive backdrop for active managers as the economic reopening changes the complexion of earnings winners and losers.
Exhibit 2: Weight of Top 10 Stocks in S&P 500
Bonds Will Be Bonds
After a brief run up in yields in the first quarter of 2020, we are back to a landscape of meager yields and diminished return expectations. Within fixed income, our economic recovery outlook leads us to emphasize lower duration securities and overweight credit where more attractive yields can be found. The Fed has indicated that near zero Federal Funds rate could be maintained through 2023. With short rates anchored near zero, the economy recovering and investment grade yields near all-time lows, we think investors are likely to move down in credit quality to capture more yield, further tightening their spreads. Conversely, inflationary pressures that accompany economic expansion are likely to increase yields on longer duration securities, meaning that the prices of these bonds will go down.
All in the Same Boat
I have to admit that this market outlook may sound familiar, as it appears similar to what many other strategists are saying. And it seems that the consensus is more unified than in past years. This makes me uncomfortable, and it prompts me to explore where we could be wrong. Namely, economic growth and earnings could either overshoot or undershoot expectations. Let’s look at what could drive either of these outcomes and what signals may provide an indication that we are going down a different path. Consideration of a more diversified portfolio may help to mitigate some risks.
Too Hot or Too Cold?
Estimates for U.S. real GDP growth in 2021 range from 3% to 6%. This is a very wide range. Since 1970 there has been only one year – 1984 – with GDP growth over 6%. Higher than expected economic growth might not sound like a market risk, but stay with me. Much higher economic growth would likely stress capacity, creating inflationary pressures. Higher than expected inflation, coupled with the Fed testing a new policy approach that will allow higher inflation, is a recipe that could disturb the markets. I would expect long duration assets such as growth stocks and longer maturity bonds to sell off under a scenario where higher than expected growth spurs concerns of higher and more persistent inflation. On the other hand, less richly valued cyclical stocks and credit sensitive bonds would likely benefit. Support for this scenario comes from the large monetary and fiscal stimulus that helped provide a bridge over the downturn as well as a relatively strong U.S. consumer balance sheet with an interest burden near all-time lows. We will be watching consumer data for signs that they may be spending down their savings at a faster than expected pace as well as showing a desire to borrow and spend on credit.
For the above scenario to occur, we need to get to where social distancing is on the wane. Anything that could push out the timeframe such as logistical difficulties in rolling out the vaccine or other factors that prolong social distancing could cause economic growth to track below expectations. The Fed has already stated that there is little more it can do to stimulate the economy and a divided and polarized government may thwart any further fiscal help. A prolonged delay without government assistance could leave economic and psychological scars that could hinder economic growth for years. In this scenario, earnings are likely to be disappointing with cyclical sectors and credit exposure taking the brunt of a market correction. For this risk we will be watching the vaccine rollout and whether it is proceeding as expected as well as employment data, and for signs of new consumer stress such as an increase in foreclosures and/or evictions.
Exhibit 3: U.S. Real GDP
Will David Crush Goliath Again?
Another risk factor that we will be watching relates to antitrust law. The current cases brought against Facebook and Google will take years to resolve. But could we see a significant shift in the interpretation of antitrust law that leads to the eventual breakup of many corporate titans? Robert Bork a court of appeals judge appointed by President Reagan is viewed as having been instrumental in reshaping antitrust doctrine during the 1980s. He argued that corporate mergers could benefit consumers. This perspective influenced future antitrust cases and served as a precursor to a wave of M&A activity in the decades to follow. In order to win cases against the likes of Facebook and Google, it is probable that antitrust law will again need to be reinterpreted. While not a near term risk, should this occur it would sow the seeds of a wave of corporate breakups much like the trust-busting years of the early 20th century. Evidence of a change in antitrust doctrine could introduce a headwind for the stocks of dominant corporations, and not just technology companies, as a few huge corporations sit atop most every industry.
The chart below (Exhibit 4) provides a comparison of where we are in the current cycle relative to past bull markets.
Exhibit 4: Bull Market Comparisons in Months
S&P Composite Index, Source: Robert J Shiller
Notwithstanding the risks discussed, the main message I want to convey is that we are at the start of a new bull market cycle. And while yes, markets have already run and we have already seen some rotation toward more cyclical sectors, now is not a time to de-risk. Early in a cycle, one generally wants to be fully invested with a bias toward risk assets.
The information provided represents Touchstone’s views and observations regarding past and current market conditions and investor behaviors. The information and statements provided herein are believed to be true and accurate. There can be no assurance however that the beliefs expressed herein will be consistent with future market conditions and investor behaviors.
J.P.Morgan Global Manufacturing PMI™ provides the first indication each month of world manufacturing business conditions.
The S&P 500® Index is a group of 500 widely held stocks and is commonly regarded to be representative of the large capitalization stock universe.
The MSCI EAFE Index is a free float-adjusted market capitalization index that is designed to measure developed market equity performance excluding the U.S. and Canada.
The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets.
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