By Simon Tryzna, Chief Investment Officer
I've spent the first couple of weeks of the New Year holding meetings with asset management firms, sitting in on countless webinars, and reading numerous market outlooks in order to get an idea of what other investment strategists are thinking and how our active portfolio managers are positioned to begin 2021. Not every manager/team/asset management firm have the same outlooks, which makes this a very productive exercise. Doing this thorough research project is an undertaking I do twice a year – once in January and July. As part of this process, I compile different market perspectives to help myself and our team formulate our views and what portfolio changes, if any, we should consider.
A significant point of my conversations circle on risks in the capital markets and within different asset classes. However, the problem is that some risks are easy to identify while others we don't see coming at all. COVID-19 and the ensuing global pandemic was the latter. As I dive deeper into the outlook, I want to highlight the fact that this could all be moot. As long-term investors, our job isn't to market time or deviate significantly from our long term allocations to chase returns. Instead, it's to create risk-adjusted portfolios that help meet our client's goals while adhering to their risk tolerance levels. While we do make tactical shifts to steer towards areas of the market that we think are best for our portfolios given our outlook, our primary job is to work with clients and have difficult conversations when an unexpected event derails everyone's expectations. Understanding market risks and what to look out for is part of that process. The other part is admitting that there are some things no one sees coming, and we must be prepared for that as well.
With that caveat aside, below is our market outlook for 2021. This includes research from our partners at Goldman Sachs, JP Morgan, Doubleline, State Street, Litman Gregory, Pioneer, and a significant number of our portfolio managers.
Provided that the pandemic gets under control, there is a lot of optimism for a roaring economy to get underway. The consensus expectation is that by late summer, things should start to get back to normal. At the moment, the U.S. consumer, on aggregate, has the best balance sheet in history, with the biggest liability being their mortgage. With interest rates at historic lows, many opted to re-finance their mortgage to lower their monthly payments. As a result, the consumer household debt service ratio (debt payments as a percent of disposable personal income) is at a record low 9.1% (per JP Morgan). Household net worth is at record highs. Most consumers are "a coiled spring of potential future spending" - those with jobs and can work from home are feeling very flush. Once it's safe to do so, the expectation is that those consumers will look to go out and spend on travel and leisure, and entertainment. That should help bring back jobs to those sectors of the economy and get them back on track. One thing to keep an eye on is consumer confidence. In the short term, it has fallen amid a spike in COVID-19 cases. Reduced consumer spending could hamper economic growth in the short term.
While the process to distribute the vaccine globally gets underway, central banks and governments across the globe will continue to provide monetary and fiscal support, respectively. With the end of the pandemic in (relative) sight, companies are now beginning to plan for the year ahead. That will contribute to global output and demand rebounding strongly in 2021. PIMCO forecasts global GDP to be the highest in the decade, while Goldman Sachs believes that the U.S. GDP will grow past 2019 levels in late 2021. Per the WSJ, U.S. economists, on aggregate, have GDP growth at 4.3% following a contraction of 2.5% in 2020.
China will once again lead Emerging Market growth. The Chinese economy was the only large economy to post a positive GDP growth in 2020, and we expect it to continue to grow in 2021. Goldman Sachs is forecasting all 27 MSCI Emerging Markets countries to have positive real GDP growth. E.M. exports should rebound as the global economy recovers. Commodity and memory chip prices have the scope to rise on the back of supply/demand imbalances, further supporting E.M. economies and their corporate profits. One important item of note for China is that their Central Bank, which provided a lot of stimulus in 2020, may raise rates to de-lever the economy and better set it up for the long run. If they make any miscalculations, it could curb growth in 2021 and may spill over to neighboring Asian EM countries.
We do expect a slower recovery out of the Eurozone and Japan. Both of those regions are service-oriented economies that are going to feel the effects of lockdowns more. There is a consensus that those countries will see 2019 levels of GDP in mid-2022.
Lastly, with the rebound that we've seen, we're entering a new secular economy that is going to be characterized by early cycle economics. We'll likely see new businesses emerge (2020 saw the highest amount of new business applications on record, per the IRS) and grow to meet changing consumer bases. This could lead to job creation and contribute to the economy taking off once more.
One of the most significant economic risks is the impact of the scarring due to the length of the pandemic. It's a big question mark of how COVID-19 will affect consumer spending and behavior, how it will impact corporate investment and hiring decisions, and how that will spill over to the broader economy. While the economy has been resilient, growth has slowed down, and if the pandemic goes longer than anticipated, we could see some contraction before another rapid boom.
There is a bullish consensus for global equities in 2021. A major component of that is low-interest rates – at the moment, equities are relatively cheaper than bonds. With a low discount rate, future cash flows are discounted at a low rate, pushing companies' intrinsic value higher. While equities are considered expensive on a historical level, they are, in fact, cheaper than their relative historical average when accounting for the historically low interest rates. Also, a significant portion of the value of the S&P 500 is based on intangible assets (R&D, intellectual property, software), which complicates using historical comparisons. P/E ratios of the asset-heavy U.S. corporate sector of the 1950-1980s aren't a fair comparison for the less capital-intensive universe today.
Another factor that investors will be looking for in 2021 is corporate earnings. There is a lot of optimism already priced in, and this year corporations will need to deliver. Per JPM, at the current pace of improvement, S&P 500 earnings should exceed pre-pandemic levels by the end of 2021.
One of the biggest drivers of the S&P 500's performance in 2020 was the ten largest companies' performance. This year, the expectation is that the remaining 490 names will be larger contributors as they should exhibit the highest year over year earnings growth, which is not that hard to do when most had negative earnings growth in 2020.
A couple of risks to look out for – 1. US-China relations, and 2. Biden's Corporate Tax Hikes. The current expectation is that the Biden administration will be tough on China while being more calculated and predictable. The issue for U.S. corporations is that U.S. companies are doing the same amount of business in China as Chinese companies are doing in the U.S. China could make things difficult for U.S. firms to operate there. Any bilateral disengagement will impact U.S. Company earnings in small but measurable ways. There will be pressure for U.S. companies to replace Chinese supply chains, perhaps bringing some jobs back to America, which would put pressure on operating margins. However, it's in the best interest of both China and the U.S. to resolve tensions, so while this risk remains, the expectation is that it won't be an issue in 2021.
With regards to tax cuts, it's still a known unknown. At the moment, per JPM, Biden's corporate tax plans, on aggregate, would raise $2.2 trillion compared to the $740b Trump's tax cuts saved. This plan could reduce the S&P 500 Earnings Per Share by 10%; however, that doesn't consider any economic (and subsequent corporate earnings) benefit provided by the additional stimulus.
Internationally, a rebound in global growth is a positive tailwind to equities. While we remain bullish on China and E.M., the US-China tensions will affect Chinese equities as well. Chinese companies that are now listed on the NYSE are now subject to a 3-year countdown to delisting. Also, strategists write that China will also look to restructure its supply chain dependence on the U.S. On the flip side, China is set for more foreign investment given its growth potential and its underweight in investor's portfolios. Them being proactive in announcing antitrust measures against its own tech firms is a big positive in several investors' eyes. However, others have argued that it could be a negative. A growing Chinese economy also has a spillover effect on neighboring countries, and a rebound in growth will boost the Chinese and emerging markets' exports as a whole. From a macro-fundamental point of view, E.M. has improved current account deficits, undervalued currencies, and lower equity valuations – all positive reasons for increased investments.
Regarding Japan and Europe, who predominantly make up the international developed market, growth will be harder to come by. Japanese and European companies generally have lower profitability than their U.S. counterparts. The bank sector is the largest sector in Europe, and their recent rise in profits has come from reduced loan provisions (how much they write off their balance sheet due to expected loan losses) instead of organic growth.
With central banks doing whatever they need to help support the capital markets and the global economy, interest rates worldwide hit record lows in 2020. According to TCW, Investment Grade credit yields hit an all-time low of 1.7%, translating to negative real yield after adjusting for inflation. Negative yielding debt hit an all-time high of $18T. Investors, hungry for yield, piled into high-yield and investment-grade debt. Companies issued debt at record levels, taking advantage of low rates to re-finance their previous loans. On aggregate, investors have seen corporate leverage mount, quality deteriorate, and the duration of the corporate credit index extended. Downgrade risks remain high going forward - 50% of I.G. companies have leverage consistent with a H.Y. rating, and of those, 36% have total debt that is four times annual earnings. Interest coverage – the measure of a company's ability to pay interest on outstanding debt - has declined to the lowest level since 2003. On the flip side, with a growing economy, most companies should be able to improve their financial situation and be in better financial health. Many recent issuances that have come to market are being used for business and capital expenditure spending (as opposed to re-financing and retiring old debt). The issue is how and if companies recover and if there is another large default cluster. In their outlook, the private equity firm Carlyle wrote that "instead of allowing an illiquidity spiral to push otherwise solvent companies into bankruptcy, central banks ensured that all but the most underwater businesses would remain liquid." We'll be keeping a close eye on default rates and which areas of the credit market they occur in.
Like corporations, municipal bond issuers have too come to market with new bonds in order to re-finance and retire old issuances. While local governments have suffered revenue shortfalls due to lockdowns, they were in a much better situation to handle it due to the establishment of rainy-day funds. The continued revenue shortfall is still a risk, although the new stimulus package and additional ones should have funds for local and state governments. Any personal tax increase will drive investors to the muni bond space. At current valuation levels, the muni space (particularly High Yield munis) is more attractive than its corporate counterparts.
In a low interest rate environment, emerging market debt is an attractive solution for investors. Countries like Mexico, Brazil, and Indonesia offer attractive opportunities as they stand to benefit from a global economic recovery. The valuations are attractive as investors will be better compensated for taking on the risk. A significant portion of E.M. debt is considered high yield, which correlates to economic growth rather than rising interest rates, another tailwind for the asset class.
There is an expectation that government bond yield curves will steepen as growth and inflation outlooks improve, although not at major levels. Government interest rates rising higher than expected would cause a re-pricing in the equity markets.
The overall feeling that I got in my conversations with portfolio managers, strategists, and other investment professionals is one of optimism. The late market melt-up of December lowered expected returns in 2021, as a lot of optimism became priced in. The biggest worry, of course, remains the pandemic. This recession has been health-related, and until health issues are no longer a factor, this risk will persist. This past year taught us that the market is clearly forward-looking. But, the minute things start to deviate from investor's expectations, a risk-off trade is likely. It's best to be prepared for any situation. As I often tell myself - expect the worst and hope for the best.