The Outlook: November 2020 Economic Commentary

Biden plus vaccine offers hope for return to ‘normal’

Joe Biden’s victory in the US election and encouraging progress regarding a coronavirus vaccine have combined to trigger a sharp rally in global equity markets.¹ Both developments should ultimately serve to reduce uncertainty and offer hope of a ‘normalisation’ in the global economy. News of the 90%+ effectiveness of both the Pfizer/BioNtech and Moderna vaccines holds out the prospect of a world liberated from the shackles of social distancing. Meanwhile, the election of Joe Biden promises a more predictable style of economic management under which US businesses and trading partners alike no longer live in fear of a hostile presidential tweet.

This said, there are still hurdles to overcome on both the political and the coronavirus fronts. There is little doubt that a safe, effective vaccine is key to a recovery in the global economy; the OECD reckon that the rollout of a vaccine in early 2021 could add two percentage points to global GDP growth.² A successful vaccination programme would not only allow consumers to resume more normal consumption patterns and run-down the precautionary savings built up during the pandemic, it could also give businesses the confidence to invest.

However, there are still many unanswered questions regarding the Pfizer/BioNtech and Moderna vaccines (Are they safe? How well do they protect the elderly? Are inoculated individuals still infectious?), and rolling them out will be a challenging logistical exercise. It is also unclear whether there will be sufficient take-up of the vaccine to generate herd immunity.

Covid headwinds remain for now

Moreover, while there is talk that life could start to return to normal by spring 2021, in the meantime, the coronavirus is set to take more lives and usher in more economic disruption.³ In response to rising cases, several European countries have imposed renewed restrictions, and with hospital admissions in the US rising to a record high, some states are following suit.⁴ One adviser to President-elect Biden has indicated that a nationwide lockdown might be required to control the pandemic.⁵

This suggests that, in the near-term, the recent recovery in the global economy will be interrupted. A repeat of the severe economic contraction witnessed during the second quarter looks unlikely; activity in manufacturing and construction will be impacted less than during the spring, schools are generally staying open, and businesses have adapted to life under COVID-19. Weighed against this, continued gridlock in the US congress suggests that the generous fiscal response to the first wave of the pandemic (including stimulus cheques and unemployment benefit top-ups) is unlikely to be repeated. In this regard, near-term developments regarding the coronavirus still carry the potential for market volatility.

Divided congress limits Biden agenda

To the extent that the outcome of the November 3^rd election is not yet completely done and dusted, investors will also have to wait a while longer until the fog of political uncertainty dissipates. President Trump’s refusal to concede defeat is hampering the transition to a Biden presidency. And news that the commander in chief considered launching a missile strike on Iran’s nuclear sites after the election serves as a warning that a wounded, impulsive president could sow considerable chaos during his remaining two months in office.⁶

In terms of the longer-term economic and financial market outlook, the more pertinent political question is whether the Democrats can win the two Senate seats that are up for grabs in the run-offs due to take place in Georgia on 5^th January. If both Republican incumbents lose, the Democrats would take control of the upper house, thereby massively improving President-elect Biden’s chances of pushing through his domestic policy agenda. However, this does not look likely; betting markets put the chances of a Democrat-controlled Senate at just 19%.⁷

As a result, there is little chance that Biden’s more progressive policy proposals (e.g. tax hikes on corporations and wealthy households, higher government spending, more stringent regulation etc. – see our commentary of August 2020) will get through congress. There might be scope for cross-party agreement on a relatively small supplementary pandemic support package. However, a largescale, multi-year, green-focused fiscal stimulus which might have been possible under a ‘blue-wave’ scenario now looks unlikely.

Higher bond yields

In turn, this suggests that the prospects for a vaccine and a ‘reopening’ of the global economy are likely to play a bigger role in driving global financial market trends during the coming year than domestic US policy.

As regards the fixed income market, a reopening of the economy is likely to put upward pressure on government bond yields and steepen yield curves (i.e. the difference between short and long-term rates) as expectations for growth and inflation improve. The yield on the benchmark 10-year US Treasury bond has edged up following the Pfizer/BioNtech vaccine announcement, but at 0.9%, it is still around half the level prevailing before COVID-19 hit the US and Europe.⁸ The US Federal Reserve will be wary of allowing yields to rise too sharply for fear of a tightening in financial conditions which could hamper the recovery. However, it would not be surprising to see the US 10-year yield rise towards 1.5% over the next year or so. Given the outsized influence of the US on international markets, this upward trend could also pull up longer term rates around the globe, creating a headwind for fixed income investments more generally.

A ‘reopening’ rotation in equities

In terms of equities, a vaccine carries the potential to broaden and extend the rally that has been witnessed in recent months. Gains in global equity markets since the March lows have been led by the big tech names (Apple, Amazon, Microsoft etc.), which have benefitted from the accelerated trend towards ‘online living’ brought on by the pandemic.⁹ However, news of an effective vaccine has lifted shares in the global sectors hardest hit by social distancing restrictions (e.g. airlines, hospitality etc.) as well as those that benefit more generally from an upswing in economic activity (e.g. banks, oil, industrials). In contrast, the tech sector has underperformed¹⁰ as the prospect of a reopening of the economy has dented the appeal of so-called ‘stay at home’ stocks.¹¹

A successful roll-out of a vaccine and a ‘normalisation’ in the global economy would bode well for cyclical/value sectors to continue to outperform tech. Even after the reversal in market leadership seen in recent weeks, the outperformance of global tech (up around 30% year-to-date) relative to more cyclical sectors such as energy (down 34%) and banks (down 20%) has been huge.¹¹ Relative valuations are also at extremes.¹²

Furthermore, a move up in government bond yields would represent a headwind for ‘long-duration’ growth/tech stocks, as a higher discount rate dents the present value of future cash flows. Conversely, higher bond yields should benefit the banks as net interest margins improve.

The possibility of a more rigorous regulatory environment could also dampen sentiment towards the tech sector. Even under a divided US congress, big tech companies will still face the risk of lawsuits from the Department of Justice and the Federal Trade Commission. Across the Atlantic, recent charges against Amazon suggest the European Commission will remain a thorn in the side of big US tech.

A rotation on the part of investors away from tech stocks to more cyclical/value sectors would probably result in a narrowing of the performance gap between the US and the rest of the world.   US equities have outperformed their developed market counterparts this year, in large part due to a higher sector weighting for tech, which accounts for just over 28% of the US market, but only around 9% on average in the rest of the developed world. Since the announcement of the Pfizer vaccine, however, the US has underperformed other developed markets.

Reduced trade tensions

A less confrontational trade policy under President Biden should also be welcomed by America’s trading partners and could further support a narrowing of the performance gap between US and non-US equities. Although Biden shares some of President Trump’s protectionist tendencies and tensions with China seem set to remain elevated, he is likely to adopt a more conventional, multilateral approach to foreign affairs and trade policy. A partial dialling back of Trump’s trade war, the reduced threat of ad hoc tariffs, and more predictable policy could in turn give global investors greater confidence to diversify away from US assets.

In conclusion, while the challenge of rising coronavirus cases and associated hit to economic activity carry potential for near-term market volatility, the improved prospects for a sooner-than-expected vaccine rollout, combined with continued accommodative monetary policy, should limit downside risks. As 2021 progresses, the reopening of the global economy and a less disruptive US trade policy under President Biden should provide a tailwind for global equity markets and a headwind for core government bond markets. US equities typically perform well under a divided congress given the reduced risk of tax hikes and government regulation. However, with the pandemic having fuelled this year’s dramatic outperformance of the tech sector, there are potentially more attractive opportunities outside the US as the global economy returns to some semblance of normality.