13 November 2020

Three cheers for the world’s scientific community! The recent announcement that an effective vaccine may be on the way is a very welcomed, early Christmas present at the end of a tough year. Of course, there are numerous medical questions and logistical challenges that still must be solved. But, along with everyone else, financial markets already are celebrating the increased likelihood of a V-shaped economic recovery.

In light of these festive developments, I think it is a good time to begin pondering the 2021 financial market outlook. And, of course, there is the US election outcome to consider! Indeed, the possibility of a vaccine–driven, liquidity-fueled economic recovery would appear bullish for financial assets. But, have markets gotten ahead of themselves? Should the differing Covid experiences of individual countries be reflected in global asset allocation decisions in 2021? Are there attractive opportunities in world-wide currency markets? (See the table above for key 2021 projections). For your convenience, as usual, I will rely on a load of my favourite charts to identify the key drivers of the 2021 economic and market outlook (more detailed consideration of the issues can be found in individual blogs in the Archives of my website).

Covid Second Wave: Not Out of the Woods

Despite the hopeful vaccine news, much of the world is now in the grips of a dramatic Covid second wave. The number of daily confirmed cases is a multiple of those recorded during the first wave. To be sure, much of this rise reflects the successful expansion in testing capabilities. However, the Chart above reveals that positivity rates (the share of tests with positive results) is also rising sharply. This summer, for example, Europe’s positivity rate was less than 1%, and now virtually all countries are well above the WHO’s 5% threshold. Europe probably indicates what lies ahead for the United States in coming months. Daily US infections are likely to top 200,000 soon, and deaths per day could exceed 2,000 (topping the grim outcome in the first wave). Despite the current US political drama, I hope the Administration finds time to deal with this emergency. Otherwise, an additional 100,000 Americans could die before 20 January.

With much of Europe now re-imposing lockdown restrictions, will the health and economic consequences of the second wave be less severe than in the first episode? I hope so. The Chart above illustrates, so far, the fatality rate has been far lower than during the initial outbreak. However, as hospitalisations and death rates are climbing, I am not sure if my forecast if one of hope over expectation. For example, hospital admissions in France and Italy are again approaching the levels of last Spring, and new UK hospital arrivals are rising quickly (certain regions are nearing previous peaks). Germany is a bit better: hospital stays are still less than 40% of past peak levels, but rising. I fear a similar pattern may await the USA this winter (for more detail see my blog “Second Wave: Bracing for a Long Winter”).

The second Covid wave takes place in an environment in which the global economic recovery has lost momentum in recent months (Chart above). This points to the need for continued macro-stimulus through next year. Central banks have already signaled their intension to maintain ultra-loose financial conditions for the foreseeable future. The following Chart illustrates the impressive fiscal stimulus so far, led by the USA, Germany, Japan and others. Hopefully, the United States will not wait till Inauguration Day to provide additional relief. Europe has fiscal space to act, but will they dither?

Overall, I am hopeful (guardedly) that a V-shaped recovery will continue in 2021, and that lost GDP will be recouped by the end of the year (or early 2022). After an earlier and more severe recession, I expect Europe to outperform the USA next year: GDP expanding 6.8% and 4% respectively. There are tenative indications that Europe’s new restrictions are working. America’s reluctance to follow suit is likely to be a headwind to recovery next year. In recent days, Biden’s Covid advisors have floated the possibility of a 4-6 week shutdown early next year. I suspect American compliance with such measures would not be great.

Long Covid: Time to Consider Long-term Impact?

Amidst the warranted enthusiasm about the vaccine, we will need to consider eventually some of the pandemic’s possible long-term economic consequences. I will tick off just a few. The Chart above illustrates sharply rising government debt levels. With interest rates low, budgetary support should remain the priority in 2021, but eventually restraint will be necessary. Asian (especially) and parts of Europe appear better positioned than the USA.

Following the Global Financial Crisis, rising government debt and extended unemployment led to a sharp deceleration in labour productivity (Chart above). With the health implications of Long Covid still unknown, the pandemic may well adversely impact worker efficiency further. Government budgets, therefore, should focus on productivity-enhancing priorities, e.g. broadband, education, infrastructure, and climate initiatives.

Following the GFC, labour force participation declined in many countries, especially the USA (Chart above). Workers may be wary about returning to the workplace, even after the vaccine.

Long before the Covid pandemic, income distribution was becoming more skewed in virtually every country (Chart above). As low-income groups appear to have been most adversely impacted, the Covid crisis has likely resulted in worsening inequality. I am hopeful that election results in New Zealand and United States indicate that populist strategies are waning. But, the issue must be addressed; hopefully, through education and re-training rather than trade protectionism (which is not the solution).

As Covid has disproportionately impacted certain ethnic minorities, racial issues will need to remain on the political agenda in many nations (Chart above).

Of course, you could add to this list of concerns. Overall, however, I anticipate long-term global GDP growth will confront formidable headwinds for several years even after the pandemic runs its course.

Bidenomics: Build Back Better or Going Bust?

Will the US election outcome be a boon or bust for financial markets? Prior to the election, I considered the implications of President-elect Biden’s tax and spending plans (“Biden: Build Back Better or Going Bust?”). Justifiably, many question the wisdom of hiking taxes $3.5-trillion as the economy struggles out of recession. I am a little less concerned. First of all, the potential tax hikes are accompanied by the stimulus provided by nearly $6-trillion of additional government spending. In addition, the tax increases will be borne completely by the top 1% of income earners, whose spending patterns are less likely to be adversely impacted (Chart above). Further, the US consumer has been very cautious during the pandemic. As a result, the following Chart illustrates the US household savings rate has risen sharply. Thus, higher private consumption could offset any depressing impact of tax hikes.

In addition, financial markets have been cheered by the prospect of the US Senate remaining in Republican hands; requiring the Biden Administration to curb its budgetary ambitions. To be sure, President-elect Biden will have to deal with push-back from the left-wing element of the Democratic Party. I am assuming the Rebulicans will win at least one Senate season in January’s election in Georgia. On the other hand, the Republican Party will face its own internal challenges. President Trump’s continued control of his base supporters is likely to complicate efforts of more mainstream Party members to pivot policies in a more traditional conservative direction.

The Biden plan outlines $1-trillion in corporate tax hikes. How much would this hurt American competitiveness? The following Chart indicates that US firms will not be overly taxed even if levies rise 0.5% of GDP.

America’s poor Covid track record is another reason the US economy may underperform other regions next year. Even though Johns Hopkins ranks the United States as the most prepared country to cope with health emergencies, the US mortality rate is more akin to Latin America, not Asia’or top-performing European countries (next Chart).

In a previous blog (“Trump’s Economy: Greatest Ever?!”), I suggested the US Federal Reserve’s extremely accomodative monetary stance — not the out-going Administration’s economic program — was largely responsible for rising equity valuations in recent years. Indeed, the following Chart illustrates that the S&P 500 Earnings Yield Rate has not change much since 2016; suggesting low interest rates led to the recent expansion in PE ratios.

Therefore, I do not expect the change at the White House to be a main driver of market performance. But, US equities are not cheap. Indeed, despite continued low interest rates and EPS growth of up to 50% in 2021, my S&P 500 target is only 3,500 — essentially today’s level. While the market could overshoot near term, a renewed Covid lockdown could lead to a 5-10% correction. I doubt the Biden Administration will be providing regular market commentary!

US Dollar Confronts Formidable Headwinds

Weak economic recovery, continued Covid underperformance, accomodative monetary policy, and chronic twin budget/current account deficits are all headwinds for the US dollar. The Chart above also illustrates America’s subpar track record on Carbon Dioxide emissions compared to Europe, which may be an additional structural weakness. I expect the overvalued US greenback to depreciate up to 10% in 2021 (next Chart).

Asia’s Uneven Recovery: Providing Leadership

Nowhere in the world is the false choice between economic growth and addressing the pandemic more evident than in Asia. The Chart above illustrates Asia’s success in dealing with the health emergency compared to other Emerging Market regions (and the USA).

At the same time, the Covid-induced economic recession was less severe than in many areas, and the Chart above illustrates the recovery has been earlier and stronger than the rest of the world. Asia’s performance, however, has not been uniform. China, Taiwan, Korea, and Vietnam have curbed the pandemic more successfully than India, Indonesia, and the Philippines. Not surprisingly, this achievement has been reflected in the nations’ relative economic performance.

The Chart above (provided by Morgan Stanley) indicates Asian equities are cheap relative to developed markets. Low government debt and interest rates, relatively attractive valuations, superior growth, better Covid outcomes, and a weak US dollar all point to Asian outperformance. I expect double-digit returns.

Latin America: Another Lost Decade?

The Chart above illustrates that Latin America was experiencing a secular growth slowdown even prior to the pandemic. In addition, no region has suffered as greatly during the health crisis (see my blog of the same name for more details), which continued to be reflected in the region’s economic underperformance. The following Chart highlights the poorly-educated and low income groups have been most adversely impacted. Thus, the area’s already highly skewed income distribution is likely to worsen.

The 1980’s debt crises lead to a decade of stagnation in Latin America. Similarly, I fear per capita GDP may not return to pre-crisis levels until 2028.

Emerging FX: Big Opportunities for the Brave

As a result of the pandemic, opportunities exist in Emerging Market currencies. For the more timid (like me), Asia is a safer bet, especially Korea, Taiwan, and Chinese Yuan. The Philippines and India do not reflect their subpar Covid performance. Brazil and Mexico are hugely undervalued, mirroring Covid poor outcomes. A vaccine would be a game-changer. But, I fear the drugs will not reach poor rural areas until 2022. I favour the Chilean peso. Peru’s overvaluation is at odds with its Covid track record. Atrractive EM Fixed Income opportunities exist in Brazil, Mexico, Indonesia, Russia. Turkey and South Africa are for those who do not mind sleepless nights!

Can Europe Finally Outperform?

A lesson one learns repeatedly in financial markets is that it rarely pays to bet against the USA. For Europe to outperform the USA, a few conditions must be met. The Covid second wave must not derail Europe’s economic recovery. The Chart above illustrates that, as in the USA, the upturn has lost some momentum in recent months. Fortunately, the manufacturing sector continues to expand. However, household spending has weakened, as cautious consumers have dramatically increased their savings rate (next Chart). If confidence returns, households are well-positioned to support a rebound in the flagging services area (see my blog “Europe: Will Covid Second Wave Derail Recovery?”).

In large part, Europe’s underperformance reflects the region’s ongoing banking problems and investors’ focus on growth-oriented sectors (which Europe lacks). Rising bond yields and a shift towards “value” industries — both of which I expect — world favour Europe relative to the USA. The following Chart illustrates Europe has rarely been cheaper relative to the US market (but, I have heard that before). Consequently, I anticipate Europe to outperform in the coming year.

Brexit: Would a Trade Deal Boost Sterling?

In the coming weeks, we should know if the United Kingdom and European Union have successfully negotiated a post-Brexit trade deal. The Chart below illustrates sterling is cheap. The degree of undervaluation depends on how damaging one believes Brexit is to the United Kingdom. I believe the pound is probably at least 5% undervalued. A pre-Christmas trade deal, therefore, could boost Euro/GBP towards 1.17.

Strategic Implications

• A widely available, effectve Covid vaccine is a very welcome early Christmas present; making a sustained global recovery even more likely in 2021. The prospect of a vaccine reduces the risk that the Covid second wave will derail the economic upturn.
• The prospect of continued low interest rates, additional fiscal stimulus, and economic recovery should support financial assets next year. But, much of this good news is already discounted in the USA. Thus, I expect modest gains, if any, in the S&P 500 in 2021. My target is 3,500. Renewed Covid lockdown early next year (still seems unlikely) could lead to a 5-10% correction.
• The US Dollar confronts serious headwinds, and will decline up to 10%.
• Asia should deliver 10% returns — the world’s top performer.
• EM currencies provide opportunities for both risk averse and more aggressive investors. I favour CNY, TWD, KRW, and CHL. Selective EM bonds provide some attractive possibilities, e.g. Mexico, Brazil, Indonesia, and Turkey.
• Europe should outperform the USA; producing 7% returns.
• Sterling could appreciate 5% if an EU trade deal is reached in the weeks ahead.