The Outlook: December 2020 Economic Commentary
What does 2021 have in store?
In this month’s commentary, our chief economist answers some of the questions investors are asking regarding the outlook for the economy and financial markets in 2021.
What is the outlook for the global economy in 2021?
The trajectory of the global economy will in large part be shaped by developments regarding the coronavirus. The current surge in cases in the US and the likely pick-up in Europe after Christmas argue for a soft start to the year, given the prospect of continued restrictions on activity 1. However, further out, the successful rollout of vaccine programmes as the year progresses bodes well for a normalisation in activity.
Loose monetary policy should support an upswing in growth. The major developed market central banks are likely to keep official interest rates at record lows, while continuing to expand their balance sheets via quantitative easing (QE, or buying bonds) programmes 2. With lockdowns and curbs on activity having enabled some households to build up excess savings through 2020, the lifting of restrictions should release pent-up demand and usher in solid gains in consumer spending3. Reduced uncertainty (not least as a result of a more predictable US trade policy under President Joe Biden – see our commentary of November 2020), easy financial conditions and low levels of inventories also bode well for an improvement in business investment.4
Following an estimated 4.4% contraction in 2020, the IMF reckon the global economy will expand by 5.2% in 2021, the fastest pace since 2010 5. However, it would not be a surprise if we see an even stronger performance.
What are the main downside risks to this scenario?
The expected economic recovery in 2021 depends crucially on vaccination programmes suppressing the coronavirus. Any major setbacks in this regard – adverse side effects, low vaccine uptake, production/logistical delays, virus mutation - would threaten the recovery.
Another risk factor is the possible premature withdrawal of stimulus measures. With unemployment likely to remain above pre-pandemic levels in most developed economies, the termination of emergency coronavirus relief programmes could threaten confidence and spending. In addition, the spectre of future tax hikes (that some observers have argued will be needed to rein in the huge public debts incurred during the crisis) could keep household precautionary savings high 7. As regards monetary policy, a ‘tapering’, or scaling back, of central bank QE programmes would increase the risk of market volatility that could jeopardise the economic upswing.
At the time of writing, negotiations regarding a post-Brexit UK-EU trade agreement are still ongoing. However, failure to secure a deal by the end of the year would result in a significant negative shock to the UK, and to a lesser extent the EU, economy. The Office for Budget Responsibility (OBR) estimate that leaving the EU on World Trade Organisation (WTO) terms would knock around 2% off UK GDP during 2021 7.
Will the rollout of vaccines benefit some economies more than others in 2021?
Yes. It is reasonable to expect economies that were hit particularly hard by the virus in 2020 to get a bigger boost from the successful deployment of vaccines in 2021. In terms of broad regions, this suggests that Europe and the US could potentially benefit more than China, which has already pretty much eradicated the virus 8. Logistics issues and the limited supply of vaccine suggest that establishing herd immunity in some developing countries will take longer than in the rich world 9.
What are the prospects for inflation?
Headline inflation seems set to move higher in 2021, not least as the plunge in oil prices witnessed in the spring drops out of annual comparisons during the coming months 10. A synchronised global recovery is likely to spur gains in commodity prices, which in turn will feed into input costs 11.
More broadly, as vaccines facilitate a reopening of economies, a surge in demand could come up against impaired supply (given that supply chains have been disrupted and capacity has been reduced in some sectors as companies have gone out of business) and lead to an uptick in inflation. Economists of a monetarist persuasion point to the spike in broad money supply growth in the major economies as a harbinger of higher prices 12.
This said, with inflation in Japan and the eurozone currently in negative territory, the pace of price increases in these regions will probably not breach 2% central bank inflation targets next year13. By contrast, a move above 2% in the US is a distinct possibility given that the recent depreciation of the US dollar is set to raise import prices 14, and business survey data has shown a marked increase in cost pressures 15.
Are we likely to see a sharp government bond sell-off in 2021?
The combination of above-trend GDP growth, an uptick in inflation and heavy debt issuance is likely to put upward pressure on core sovereign bond yields, and by implication, downward pressure on prices. However, the actions of central banks should mean that a sharp sell-off is avoided. Ultra-low policy interest rates should keep bond yields anchored, particularly at the short end of the yield curve. As we noted in our commentary of September 2020, the US Federal Reserve is keen to see inflation rise above 2% to compensate for an earlier period of below-target inflation, and US policymakers have indicated that rate hikes are unlikely before 2024.
In addition, ongoing QE programmes will continue to suppress yields. There is potential for higher inflation expectations to lift longer-term bond yields next year, but central banks will be wary of allowing rates to rise too far given the adverse impact on debt servicing costs and economic growth. As a result, we could at some stage see central banks shift their bond purchases to longer maturities to prevent an excessive steepening of yield curves.
In light of these considerations, the yield on the benchmark US 10-year treasury bond might be expected to edge up from the current 0.9% towards 1.5% by the end of 2021 16. Investors in core sovereign bonds should be spared a sharp sell-off, but prospects for positive returns next year nevertheless still look poor.
Will the big US tech companies continue to lead global stock markets higher?
A strong global economic recovery which ushers in a bounce-back in corporate profits, together with ongoing monetary stimulus, should provide a favourable backdrop for global equity markets in 2021. An easing of uncertainty and the prospect of negative inflation-adjusted returns from much of the fixed income universe could see investors switch from bonds and cash in to the stock market.
However, it is somewhat doubtful whether the US tech megacaps will continue to dramatically outperform next year. The likes of Facebook, Amazon, Netflix, Google and Microsoft benefitted from two key trends in 2020: firstly, the accelerated transition towards ‘online living’ brought on by the pandemic; and secondly, the sharp decline in bond yields that disproportionately boosted the valuations of so-called ‘growth’ stocks.
Although a lot of activity will no doubt stay online, a reopening of the global economy through 2021 could facilitate some rotation away from the ‘covid-winners’ towards the ‘covid-losers’ (e.g., hospitality, airlines, energy, etc.). The tougher regulatory approach to the tech sector being adopted by governments around the world is another potential headwind 17.
Higher bond yields could also prompt investors to reassess the elevated valuations that the online titans currently command. This year’s outsized run-up in the tech megacaps has left the US equity market looking expensive relative to other regions 18. According to JP Morgan, the forward price earnings ratio for the US market relative to the rest of the world is at its highest in over 25 years. Furthermore, survey data suggest that investor enthusiasm for US equities has risen to bullish extremes in recent weeks – a factor that could make continued outperformance difficult 19. All of this could suggest that more attractive opportunities might lie outside of the US in 2021.
15th December 2020