Market Outlook 2021 – The Great Rotation

by | December 2, 2020

One year ago, if we were told the following twelve months would witness the worst global pandemic since 1918, precipitating the greatest global economic collapse since the 1930s, it would have been easy to envisage the lowest bond yields in history. But it would have been almost impossible to imagine functioning capital markets, much less equity markets flirting with all-time highs by year end 2020.

In what follows, we resist the temptation to dismiss markets as irrationally exuberant and instead offer observations that help explain the seeming inexplicable. We then turn our attention to how markets are likely to perform in 2021.

To begin, how did we get here?

First, after an initial pandemic phase characterized by aggressive lockdowns and strong risk aversion, which produced massive supply and demand-side shocks to economic activity, individuals, businesses, public health organizations and governments learned and adapted. By mid-year, extreme lockdowns gave way to less economically damaging and relatively easily adopted pandemic mitigation approaches, such as mask-wearing, social distancing and plexiglass installation at workplaces. Those measures opened the way for economic stabilization followed by recovery.

In China and parts of Asia, the rollout of high-frequency testing, tracking and quarantining measures achieved even more impressive degrees of infection containment, which in turn permitted a greater degree of economic re-opening.

Second, monetary and fiscal policy responded in tandem and in size. In advanced economies, large-scale fiscal stimulus, including effective direct transfer payments and increased unemployment benefits, enabled households to stabilize consumption. Loan guarantees, direct lending programs, ample liquidity and forbearance enabled companies to remain solvent. Wage subsidies supported employment. And central banks, backed by government guarantees, intervened in credit markets to stabilize economy-wide financing.

Third, medicine and science developed new ways to treat the infected, which cut mortality rates. Most important, researchers rapidly built and shared knowledge about the vaccine, which contributed vastly to the development of various vaccines in record time. This is truly an astonishing leap for science.

All three developments led to a sharp reversal in market expectations about how the pandemic would impact asset price fundamentals, above all growth, earnings and interest rates.

It is important to recall that financial markets are discounting mechanisms, deriving the present value of stocks, bonds and other securities by assigning probabilities to uncertain future cash flows. Accordingly, asset prices will almost always look beyond the present, no matter how wretched it may be, so long as a probabilistic assessment of the future offers something different.

Accordingly, while reasonable observers can still disagree about whether markets are currently under-, fairly or overvalued, there can be little objection to the statement that soaring equity markets, accompanied more recently by rotation into more cyclical sectors, styles and regions, reflect investor expectations that 2021 will produce stronger growth, better earnings and lower risks. The shape of yield curves, moreover, suggests that despite those fundamental improvements in the economic outlook, monetary policies worldwide will remain highly supportive via low interest rates and ongoing central bank balance sheet expansion.

As we look ahead to 2021, we see little reason to disagree. The combination of forthcoming promising vaccines alongside more predictable and less disruptive US policymaking in a Biden Administration offers compelling reasons to believe that global growth will accelerate over the next twelve months, accompanied by lower political risk. The development of vaccines, moreover, allows market participants to believe, as we all hope, that today’s shockingly rapid rates of Covid-19 infection, hospitalization and death, will be successfully mitigated before long. Expectations for further ‘normalization’ of economic activity also permit investors to fret less about waning political prospects for US fiscal stimulus.

That is not to say that 2021 is without real risks. The Biden Administration must still convince a recalcitrant Republican Senate majority (depending on the outcome of the January 5, 2021 Georgia Senate run-off elections) of the need to bolster aggregate demand until effective public vaccination permits the economy to expand more sustainably on its own.

This week, president-elect Biden is also expected to announce further senior members of his administration and cabinet. Thus far, ‘Democratic progressives’ have been missing from key posts. Investors will be keen to see if other senior Biden Administration appointees might indicate shifts in policy objectives that could present bigger risks to important market sectors, such as mega-capitalization technology (anti-trust) energy (carbon pricing) or healthcare (Medicare as a public option).

Equally, market participants would be wrong to believe that the end of the Trump Administration heralds the end of divisions and disputes. The US remains a fundamentally split society, and effectively bridging this chasm may take decades. Massive gaps in income and wealth inequality, in the provision of education and healthcare, and in the treatment of individuals according to race and gender will have to be addressed. The associated policy changes will almost certainly include tax reform, increased transfer payments, anti-trust action and other steps that could rattle investor expectations about growth and earnings.

The same is true globally. The Trump Administration may have deployed unorthodox and cavalier approaches to international relations, but the drift of the US away from its postwar commitments to alliances and institutions, the growing mistrust between an ageing and an arriving superpower (the US and China), the need to address borderless cyber threats or the critical imperative for global cooperation to tackle climate change will produce uncertainties that will occasionally test investor optimism.

So, how do we see 2021 in market terms?

First, given the starting point of historically lofty valuations in sectors, styles and regions that have led equity markets higher over the past decade, we believe that leadership in the market must change if indices are to sustainably advance in 2021. Recent outperformance of cyclical, value, small capitalization and emerging market equities offers promise that long-awaited rotation is finally arriving. But for rotation to take hold, investors must believe that global economic activity will, indeed, accelerate next year. For reasons outlined above, we think it will.

Second, central banks will maintain highly accommodative monetary policies for most, if not all, of 2021. Partly, this is because inflation remains significantly below their objectives, with few signs that it will suddenly accelerate. But expansive monetary policies will also reflect the receding chances for meaningful second-round fiscal expansion in the US, the UK, the EU or Japan. The onus for nurturing the recovery is, once again, reverting back to its customary source – central banks. Accordingly, while yield curves may steepen modestly in expectation of improved economic conditions, interest rates at all maturities and spreads between different classes of credit are likely to be dominated by steadfast monetary adherence to low policy rates supported by quantitative easing.

Third, the arrival of an effective global vaccination program and an acceleration of economic growth is likely to disproportionately benefit non-US economic activity and corporate profitability. More cyclical industrial economies in Asia and Europe, as well as producers of commodities in emerging markets, Australia or Canada will witness sharp gains in output and even some prices. Global equity market rotation will therefore favor emerging markets, Europe, Japan and Asia-Pacific. One consequence is that the US dollar, which has recently softened on the world’s foreign exchange markets, is likely to decline further.

In sum, we are optimistic about growth and markets for 2021. Great companies will continue to offer investors attractive returns. Still, the better equity and credit performers are likely to be found among candidates overlooked by most investors, not just in 2020 but for much of the past decade.

If we are right, 2021 will be the long-awaited year of the great rotation.

About the Authors

Larry Hatheway

Larry Hatheway has over 25 years experience as an economist and multi-asset investment professional. He is co-founder, with Alexander Friedman, of Jackson Hole Economics, LLC, which offers commentary and analysis on the global economy, policy & politics, and their broad implications for capital markets. Prior to co-founding Jackson Hole Economics, LLC Larry worked at GAM Investments from 2015-2019 as Group Chief Economist and Global Head of Investment Solutions, where he was responsible for a team of 50 investment professionals managing over $10bn in assets. While at GAM, Larry authored numerous articles on the world economy, policy-making and multi-asset investment strategy. Larry was also the lead investment manager for various mandates, funds and an actively managed multi-asset index. Larry also served on the GAM Group Management Board, was Chairman of the GAM London Limited Board and served as member of the GAM Investment Management Limited Board. Larry was also Chairman of the GAM Diversity & Inclusion Committee. During his tenure at GAM, Larry was based in London, UK and Zurich, Switzerland. From 1992 until 2015 Larry worked at UBS Investment Bank as UBS Chief Economist (2005-2015), Head of Global Asset Allocation (2001-2012), Global Head of Fixed Income and Currency Strategy (1998-2001), Chief Economist, Asia (1995-1998) and Senior International Economist (1992-1995). During his tenure at UBS, Larry was also a standing member of the UBS Wealth Management Investment Committee. While at UBS, Larry worked in Zurich, Switzerland, London, UK (various occasions), Singapore and Stamford, CT. At both GAM Investments and UBS Investment Bank Larry was widely recognised for his appearances on Bloomberg TV, CNBC, the BBC, CNN and other media outlets. He frequently published articles and opinion pieces for Bloomberg, CNBC, Project Syndicate, and The Financial Times, among others. Before joining UBS in 1992, Larry held roles at the Federal Reserve (Board of Governors), Citibank and Manufacturers Hanover Trust. Larry Hatheway holds a PhD in Economics from the University of Texas, an MA in International Studies from the Johns Hopkins University, and a BA in History and German from Whitman College. Larry is married with four grown children and a loving Cairn Terrier, and resides in Wilson, WY.

Alex Friedman

Alex Friedman is the co-founder of Jackson Hole Economics, LLC, a private research organization which provides commentary and analysis on economics, politics, the environment and finance, and develops actionable ideas for how sustainable growth can be achieved. Friedman is a senior business leader with two decades of experience growing and transforming businesses in the financial and non-profit industry. He was the CEO of GAM Investments in London and chairman of the firm’s executive board. Previously, he was the Global Chief Investment Officer of UBS Wealth Management in Zurich, chairman of the UBS global investment committee, and a member of the executive board of the private bank. Before moving to UBS, Alex Friedman served as the Chief Financial Officer of the Bill & Melinda Gates Foundation. He was a member of the foundation’s management committee, oversaw strategic planning, and managed a range of the day-to-day operating functions of the world’s largest philanthropic organization. Friedman also created the foundation’s program-related investments group, the largest impact investing philanthropic fund in the world. He started his career in corporate finance at Lazard. Friedman served as a White House Fellow in the Clinton administration and as an assistant to the Secretary of Defense. He is a member of the Council on Foreign Relations and the Chairman of the Advisory Board of Project Syndicate, the non-profit opinion page that provides world-class commentary to over 500 newspapers globally. In addition, he is a board member of the American Alpine Club and the Jackson Hole Community Housing Trust, and has served on the boards of the Gates-Cambridge Trust, the Seattle Art Museum, and a number of other non-profits. Friedman is a regular contributor to several newspapers and thought leadership groups and has published numerous opinion editorials on topics including economics, finance, philanthropy, and politics in Project Syndicate, Bloomberg, The Wall Street Journal, The Financial Times, The Guardian, CNBC, The South China Morning Post, The Chronicle of Philanthropy, and other news outlets. He is also the author of Babu’s Bindi, and The Big Thing, both children’s book. An avid mountaineer and rock climber for 30 years, Friedman has climbed some of the world’s highest mountains and led the first major climb to raise money for charity through an ascent of Mt. McKinley. He holds a JD from Columbia Law School, where he was a Harlan Fiske Stone Scholar, an MBA from Columbia Business School, and a BA from Princeton University.

Related Posts

Pin It on Pinterest

Share This