A year ago, mere weeks before the COVID-19 pandemic sent the global economy into a tailspin, we laid out our list of wishes and worries that investors would face in 2020. On the wish list were a China trade truce and an accommodative Federal Reserve, while our worries centered upon meager growth conditions for corporate earnings and the global economy.
The worry list did not include the swift emergence and global spread of a novel, highly contagious virus.
Yet even though we could not have foreseen the unique challenges of 2020, the wishes and worries we outlined last year were, and still are, highly relevant to the investor mindset. After a rapid, V-shaped recovery in many parts of the economy, economic and earnings growth conditions are once again in focus as we think about where the recovery goes from here.
Our first 2020 wish-list entry—for a cooldown of the China trade dispute—failed to materialize this year. Trade tensions moved to the back burner but continued to simmer, aggravated by virus-related accusations. But our final wish-list item from our 2020 outlook turned out to be the most meaningful: an accommodative Federal Reserve. Aggressive policymaker response, both monetary and fiscal, is largely viewed as the linchpin of the rapid recovery in levels of economic activity and asset prices in the second half of 2020.
As we look ahead to 2021, we see a landscape that is both ripe for opportunity and marred by a continuing health crisis, lingering economic damage, and countless personal tragedies. The winter will likely bring more suffering, even as vaccine distribution begins in earnest and hopefully provides a return to something approaching normalcy sometime in 2021. Barring the disastrous effects of vaccine failures, virus mutations, or an acceleration of bankruptcies or job losses during what may be a very dark winter, the stage is set for a bifurcated year that provides two very different environments for investors.
As in years past, our 2021 outlook does not predict the levels of the S&P 500 Index, the 10-year Treasury yield, or global gross domestic product (GDP). Instead, we will focus on the drivers of those measures, and we begin to think about the implications of some of the changes this crisis has brought about.
Consumer Spending
The strength and resiliency of consumer activity has been a significant driver of the economic rebound in the second half of 2020. Unfortunately, it has also been extremely uneven, with those least able to withstand economic instability suffering the most from job losses and reduced income. The Coronavirus Aid, Relief, and Economic Security (CARES) Act—the largest economic relief bill in U.S. history—provided an important lifeline in the form of direct income replacement, enhanced and extended unemployment benefits, student loan payment suspension, and eviction protections, among other provisions.
Despite the crisis, many households that escaped the direct economic impact of the pandemic have found themselves in strong financial shape and have seen conditions further improve through falling energy bills and shrinking borrowing costs from record-low interest rates—mortgage rates in particular. Meanwhile, the combination of home price and investment portfolio appreciation and high levels of savings have driven household net worth to all-time highs.
Figure One illustrates the reduction in the increase in household net worth as well as consumer debt service cost. This degree of household financial strength is far from the norm when exiting a recession and may portend a stronger rebound once the crisis passes.
Sources: Federal Reserve, Cornerstone Macro. The financial obligations ratio includes rent payments on tenant-occupied property, auto lease payments, homeowners’ insurance, and property tax payments.
While consumers continued to spend in 2020, their spending behaviors were radically altered by the pandemic. For many decades, there has been a trend in consumer preferences away from goods and toward services, and from in-home dining and entertainment to dining, sleeping, and recreating away from home. In 1998, authors Joseph Pine and James Gilmore described this transition as the experience economy, emphasizing the creation of memorable events with goods as props and services as the stage.
Such experiences typically require the very kinds of physical interactions made impossible by social distancing requirements, and consumers adapted by rapidly shifting their spending behaviors. In the immediate aftermath of the pandemic, consumer spending of all types declined significantly, with an 18 percent decline in total spending in April compared to January levels. However, as significant policy support came online, restoring confidence, preserving jobs, and directly supporting income, consumers quickly shifted spending from services to goods, including physical items to support their stay-, learn-, and work-from-home experience and their sanity.
Figure Two shows the pandemic’s uneven effect on consumer spending. At the end of October, spending on goods was more than 7 percent higher than January levels, largely offsetting the decline in service spending.
In 2021, widespread vaccinations stand to reverse this trend and may spark a strong revival of the experience economy as pandemic restrictions and fears ease, and weary consumers emerge from their homes. Although some of the pandemic-altered consumer behaviors are likely to persist to some degree—namely the significant expansion of e-commerce across a much wider array of product categories, growth in streaming entertainment, online education, and where we live and work—we expect a reversion of spending behaviors in 2021 that stands to benefit some of the hardest-hit categories within travel and leisure. Of course, these businesses must survive a very tough winter to reach that point, underscoring the importance of the latest stimulus deal reached in December.
Policy Support
There are several important preconditions for continued strength in consumer spending. The first, and by far most important, is a resolution of the pandemic itself through effective vaccines and therapies. Until then, appropriately sized and correctly aimed policy support remains critical.
On a global basis, the combination of monetary and fiscal support in 2020 is estimated to approach nearly a third of GDP. This injection of cash and liquidity has eased financial conditions, buoyed struggling businesses and households, and stabilized confidence. We do not expect monetary policy support to disappear; the Fed has made clear its commitment to maintain exceptionally low interest rates and bond-buying programs for as long as necessary.
On the fiscal policy side, the streamlined $900 billion deal Congress reached in late December still represents the second-largest relief package in history. The package intended to shore up the economy until vaccines are widely distributed and provides targeted aid to consumers and small businesses, especially those within the hardest-hit sectors. The wide-ranging bipartisan package included:
- $600 direct payments to most Americans;
- $300 per week in enhanced unemployment benefits;
- $284 billion for the small-business targeted Paycheck Protection Program;
- $82 billion for schools and universities;
- $69 billion for vaccine development;
- $25 billion for rental assistance;
- A combined $44 billion for support of airlines, live performance venues, and public transit; and
- $36 billion for additional programs such as food stamp benefits, childcare, and farmer aid.
This stimulus package represents a massive and much-needed injection of cash for households and businesses fighting for survival. The question is one of timing: Will the package provide enough support, for a long enough period of time, until widespread vaccinations allow a full reopening of the economy?
The outlook for follow-on relief packages will be influenced by the outcome of the Georgia Senate runoff elections in January, which set the stage for a 50-50 split within the Senate for only the third time in U.S. history. This outcome brings the possibility of larger and swifter stimulus that may buoy investor confidence until widespread vaccination is achieved, alongside the potential for higher taxes or other less market-friendly policy shifts. As the dust settles, winners and losers are likely to emerge from the new policy environment.
Inflation
The degree of government borrowing and spending at the scale described above naturally leads to a discussion of inflation. A global pandemic, by its very nature, is a deflationary event as it causes capacity underutilization at a massive scale. The signature characteristic of the recession that followed the 1918 Spanish flu epidemic was significant deflation, with price levels declining by an estimated 18 percent.
Prior to the pandemic, and on the heels of an expansionary and pro-growth policy environment, we had begun to see some hints of inflation in the form of rising commodity prices and a tightening labor market. As shown in Figure Three, inflation expectations tumbled to near 0 percent at the onset of the crisis in March, as measured by the five-year breakeven inflation rate, before gradually returning to more normal levels of near 2 percent. Thus far, the greatest inflationary effects can be seen in asset price appreciation, including stock and home prices.
Source: Federal Reserve
The unprecedented amount of monetary and fiscal stimulus applied in 2020 creates natural concern about a period of higher inflation. Yet the same concerns were expressed during the financial crisis, which saw similar policies enacted (although smaller in magnitude), without the appearance of inflation. And Japan has not seen inflation materialize despite decades of large deficits relative to GDP and low (or negative) interest rates.
Our expectation for 2021 is for inflationary pressures to remain subdued. For excessive inflation to appear would require not only the recovery, but the rapid acceleration of economic activity, accompanied by wage growth. The global economic engine still has a long way to go before reaching full capacity, even after widespread vaccinations and a return to normalcy, and the U.S. economy still has nearly 10 million jobs to recover to reach pre-pandemic levels.
However, over the longer term it is important to consider the possibility of rising inflation. Monetary policy tools can be blunt instruments, sometimes with delayed effects—and with nearly every global central bank pulling out all the stops to stimulate and recover, the potential exists for policy overshoot. In addition, the Federal Reserve’s newly stated approach to average inflation targeting signals a tolerance for higher inflation for some period of time.
Investment Implications
The 2021 investment landscape represents a balancing act between short-term threats and longer-term promise. Of these, the emergence of effective vaccines represents the greatest promise, as it mitigates some of the extremely scary worst-case scenarios and a longer crisis timeline. Below are some of the key themes we are watching as we consider portfolio positioning for the new year.
We expect a continued, synchronized recovery in the U.S. and global economies, with corporate earnings reaching and exceeding pre-pandemic levels. Higher earnings could see stock price valuations—which are currently elevated by historical standards—return to more normal levels, serving to raise investor comfort.
We expect a broadening of equity performance, from the growth-oriented and work-from-home winners of 2020—namely technology, health care, and consumer staples—to more cyclical stocks within industrials, materials, and consumer-discretionary sectors. As the economy strengthens and growth resumes, we expect improving conditions for value stocks. Financials stand to benefit from relaxed restrictions on stock buybacks, as well as a steeper yield curve that improves the ability of banks to earn profits from lending activities.
After a decade of U.S. dollar strength, the combination of mushrooming debt, the Fed’s commitment to keep short-term rates lower for longer, and a reversal of safe haven demand may point to a weakening trend in the dollar. This could be positive news for U.S. exports and international stocks.
Within the fixed income landscape, we expect interest rates to remain low, with gradually rising yields for longer maturity bonds as growth conditions improve. This environment creates a lower return expectation for bonds. We continue to seek opportunities for higher yield from diversified sources, while minding quality, the amount of compensation offered by credit risk exposures, and the diversification and volatility dampening role of fixed income.
The COVID-19 pandemic has been a tragedy by any measure—from the personal loss of loved ones, employment, or business failures to the amplified stresses in workplaces, homes, and schools to the scale of the global economy.
For the optimistic, a comparison to the Roaring ’20s may be appropriate. A century ago, significant stresses from the conclusion of World War I and the Spanish flu pandemic caused a rapid acceleration of technological advancement that fueled gains in productivity and prosperity. Economist Ed Yardeni of Yardeni Research draws this parallel in his blog (blog.yardeni.com), noting that the pandemic has accelerated medical science in the search for treatments and vaccines, while lockdowns and social distancing have significantly accelerated the long-underway digital transformation of our economy. He explains: “Technological progress always confounds the pessimists by solving scarce resource problems. It also fuels productivity and prosperity, as it did in the 1920s and could do again in the 2020s.”
Although there is still much work to be done and significant risks remain, the prospect of widespread vaccinations offering a resolution to the COVID-19 crisis sometime in 2021 offers a very bright beacon after an incredibly challenging year, and what could be a dark and dangerous winter.
