Needless to say, 2020 was an eventful year. So, what’s next? George Lin from the Colonial First State Investments team shares his outlook for the year ahead.
After suffering a sharp decline in Gross Domestic Product (GDP) in 2020, we anticipate the global economy will continue to recover in 2021 – particularly in more developed economies. In fact, a number of countries (including Australia) are already out of an official, technical recession after recording positive September quarter GDP growth. This trend should continue over 2021, with both the US and Australia back to their pre-pandemic GDP levels by the end of the year. Conversely, Europe and Japan are expected to lag and will likely not return to their pre-pandemic levels until 2022 (see Figure 1). Importantly, many economies are not expected to recover to their potential GDP output (that is, their pre-pandemic growth trend levels) for the next two years.
SO, WHAT WILL SUPPORT THE GLOBAL ECONOMIC RECOVERY IN 2021?
The first (and perhaps most obvious) driver is the availability of a Coronavirus vaccine. Vaccines developed by Pfizer/BioNTech, Moderna and AstraZeneca/Oxford University have all reported efficacy rates that far exceeded even the most optimistic forecasts. The Pfizer vaccine has already received emergency regulatory approvals from the UK, Canada and the US. The European regulator is expected to follow soon, while the Moderna vaccines are expected to be approved for emergency use by US and European regulators before the end of 2021. The wide availability of a vaccine should allow for the gradual “re-opening” and normalisation of more developed world economies – starting with the US and Europe, followed by other economies including Australia, and East Asian nations such as Singapore, Hong Kong and Taiwan.
The second driver could be the low-interest rate regime of central banks in 2021. Many central banks reacted to the pandemic by reducing policy rates to or close to zero, and conducted large-scale asset purchase programs to help support their economies. Several have also changed their monetary policy frameworks and forward guidance to allow for longer periods of low policy rates. The Reserve Bank of Australia is one example – announcing in November it would target actual inflation rate (instead of the forecast inflation rate) for setting the policy rate, as well as stating it “will not increase the cash rate until actual inflation is sustainably within the 2–3 per cent target range” and that “the Board is not expecting to increase the cash rate for at least three years”. The US Federal Reserve also changed its policy framework from targeting inflation to targeting average inflation – in effect, signalling it will tolerate (at least for a time) inflation higher than the target.
Finally, as the world releases itself from various pandemic constraints, we anticipate a third driver could be expansionary government fiscal policy. While there may be a gradual reduction in the level of support, overall fiscal support should remain in 2021 as the pandemic fades. There will be debates on the need for fiscal repair, but for now the consensus on using aggressive fiscal policy to support economic growth will likely remain intact through to the end of 2022.
Overall, given the macro environment of improving economic growth along with ongoing monetary and fiscal support in 2021, we believe the underlying themes in markets for the new year will be reflation and abundant liquidity – with an uptick in risky asset classes such as shares, which should continue to outperform bonds. Beyond this, 2022 should generate respectable returns for investors.
Shares should have a supportive environment as economies continue to reopen. However, many share markets have rallied significantly over the last six months and have already priced in a lot of good news. This is especially true for US share indices. For example, the S&P 500 and the NASDAQ are currently 10.5% and 32.1% above their pre-pandemic levels, respectively. On both a trailing and forward-looking perspective, the main share indices are generally not inexpensive, with the exception of the Hang Seng – a casualty of China’s national security law in Hong Kong. However, the valuation of US share indices is especially high. The NASDAQ’s valuation, in particular, looks to be vulnerable to any negative economic shocks. Despite these reservations, however, the positive momentum of improving earnings driven by economic re-openings and supportive liquidity should drive share markets higher. Given the more attractive valuation of markets, we also believe 2021 should see the European and Asian share indices playing catch-up with US shares. Similarly, depressed cyclical stocks which were the worst affected by the pandemic, such as airlines, banks, hotels and REITs, should benefit more from the re-opening of economies.
We expect sovereign bond yields to rise modestly from historically low levels in 2021. As the appetite for safe-haven assets wanes, stronger economic growth will exert some upward pressure on yields. Central banks’ ongoing quantitative easing programs and low inflation will also have an impact on yields. For corporate bonds, we expect the low interest rate regime may exert further downward pressure on spreads as investors chase higher yields and returns. While default rates in corporate bonds have increased, the situation has not deteriorated as significantly as some may think. Further, the gradual re-opening of economies should also improve the ability of corporates to service their debts, which suggests a generally constructive environment for these bonds in 2021.
FOR NOW, THERE ARE MAJOR MACROECONOMIC RISKS TO THIS MARKET OUTLOOK
The first and more likely risk is the economic re-opening occurring later than expected as a result of delays to herd immunity. So far, market consensus is that many of the more developed economies will achieve herd immunity by the end of 2021, followed by less developed economies in 2022. While markets have rallied strongly, there remain two issues that could derail this optimism:
1. THE MANUFACTURING AND DISTRIBUTION OF A VACCINE.
With a global population of 7.8 billion, herd immunity requires up to 5.5 billion doses of a vaccine. Under the assumption that everything goes to plan, this production volume could be achievable by the end of 2021. However, there are several logistical issues here. For instance, Pfizer cut its production in half due to undisclosed supply chain issues, while storage and transportation could pose challenges to vaccines that need to be stored at sub-zero temperatures. Such vaccines necessitate sophisticated cold storage infrastructure, and some countries may not be able to build this infrastructure in time.
2. THE WILLINGNESS OF THE POPULATION TO BE VACCINATED.
Surveys have suggested that only around 73% of people are willing to be vaccinated. The proportion varies considerably across countries and is lowest in France (54%) and highest in India (87%). Australia has one of the higher rates of vaccine acceptance at 79%. Governments will likely launch information campaigns, which markets anticipate will be successful. However, this may not eventuate – or at least not as quickly as expected.
If markets are disappointed with economic progress and pandemic developments, we may have another deflationary scare in 2021. This would be a poor environment for higher-risk assets like credit, shares and commodities, while lower-risk assets like bonds could experience another period of strong returns as yields fall and test their 2020 lows. However, central banks have shown they are prepared to bail out financial markets and would likely respond aggressively under this scenario.
The second risk includes a possible reluctance of households and businesses to consume and invest. For example, while household income was supported by various governments’ transfer payments during the pandemic, they have understandably increased their rate of saving as they became more cautious in the face of economic uncertainty. At this stage, with unemployment still high in many parts of the world, it is unknown how quickly households will start spending again.
Conversely, if consumers instead binged on spending after becoming more confident about the state of affairs, we could experience a significant increase in inflation. If combined with supply side bottlenecks, this has the potential to create an inflationary shock. World central banks would likely tolerate this shock (at least for a period of time) as a necessary price to pay for the economic recovery. Long-term bond yields would rise while the short end of the curve could remain “well-anchored” as central banks maintain low cash rates. This would be a poor environment for bonds and any duration-sensitive assets such as property and infrastructure. The impact on shares, on the other hand, would be nuanced and could depend on whether economic data strength is sufficient to convince investors that earnings will increase sufficiently enough to offset the rise in yields.
Finally, as we explored in more detail in our article on the geopolitical risks to markets, a third risk to this scenario is the uncertain geopolitical outlook for 2021. For now, the greatest geopolitical risks to the global economy remain the strategic rivalry between China and the US and its allies – with Australia placed in an uncomfortable and challenging position on the frontline.
While a return to a pre-Trump Sino-American relationship highly unlikely, a Biden administration will likely change the tone but not the substance in Sino-American relationship. We anticipate that under a Biden administration, there will be fewer policy announcements, less focus on trade as a policy instrument, and a greater focus on cooperation with traditional allies. An increase in US tariffs on Chinese exports is less likely compared to a second Trump term, but a complete dismantling of existing tariffs is also unlikely. Such a move would require significant Chinese concessions on a number of issues in both the economic arena (for example, intellectual property and restrictions of foreign investment) and political arena (issues such as human rights, Hong Kong and the South China Sea) which seem difficult for President Xi to accept. Nonetheless, the US will continue to pursue a containment policy on China, focusing on technology and financial linkages. The world is still in the early stage of a decoupling between the US and China, so the pace and outcome of this is uncertain.
In this context, the deteriorating Sino-Australian relationship is best seen as a small but important subset of a grand chess game between the two powers. China is leveraging its economic power to crack the US alliance in Asia Pacific. This makes Australia an inviting target due to its economic dependency on China, its historical position as a strong and dependable US ally, and Canberra’s public criticisms of China on a range of issues. China may continue its intimidation campaign against Australian exports, using highly strategic measures – targeting sectors that are not fundamental to Chinese economic growth. This could mean more critical exports to the Chinese economy, like iron ore, may be excluded. After all, there are more attractive targets such as tourism and study in Australia, which are significant earners for Australia but are non-essential luxuries for China.
Source: Colonial First State (28/01/2020) written by George Lin.