15 Jan 2021
08 JANUARY 2021 | David Giroux, CIO Equity and Multi Asset | Mark Vaselkiv, CIO FIixed Income | Justin Thomson, CIO Equity
After facing one of the most testing environments in history following the Covid-19 outbreak, investors are increasingly optimistic of a strong recovery in 2021 due to recent positive vaccine news and additional fiscal and monetary stimulus announcements. However, as the unprecedented health crisis continues to lock down many parts of the world, risks to the recovery remain.
In the following update, T. Rowe Price investment leaders – David Giroux, CIO Equity and Multi Asset, Justin Thomson, CIO Equity, and Mark Vaselkiv, CIO Fixed Income – highlight the four factors investors need to focus on for 2021.
The first factor discusses the current threats and opportunities for investors, particularly as the recovery is somewhat already being priced into asset markets. The second factor examines the backdrop for hard-hit value stocks, with expectations rising of a rotation in market leadership toward cyclical sectors in 2021 – in light of the vaccine news. The third factor centres on the current low interest rate environment and the need for fixed income investors to think creatively in order to extract yield in 2021. Finally, factor four looks at how the global pandemic has accelerated economic inequality and appears to have worsened political divisions in some countries, and what this means for investors.
As many uncertainties remain, the T. Rowe Price investment leaders all agree on one crucial element in the year ahead – the need for active management. With the uneven impact of the pandemic and the recovery likely to lead to bouts of heightened volatility, strong fundamental analysis and skilled active security selection is likely to be a key driver of investment success in 2021 and beyond.
Although most global economies saw a relatively rapid economic rebound from the initial onset of the pandemic (figure 1), the world still has not returned to normal.
As 2020 ended, a major spike in COVID‑19 cases in the US and Europe posed a renewed threat to the recovery. While the new vaccines and improved treatment therapies are encouraging signs for 2021, the economic effects of the pandemic are likely to echo for some time and uneven progress could produce periods of market volatility.
The first quarter of 2021 could see a trough in economic activity, but assuming the new vaccines can be distributed on an accelerated scale – especially to higher‑risk populations – economic conditions could improve rapidly in the second quarter. People are going to want to travel, to get back to work, to have deferred elective medical procedures. If so, the second half of 2021 could look more like 2019 than like the first half of 2020.
A key economic variable will be whether governments in the US and Europe will provide additional fiscal support to supplement the monetary stimulus provided by the US Federal Reserve and the European Central Bank.
Fed Chairman Jerome Powell has emphasised fiscal stimulus needs to take priority over additional monetary stimulus because it has a more significant impact on the real economy. The size and timing of any additional US fiscal stimulus may depend on the partisan balance of power in Washington. A divided government could require lengthy negotiations and limit the scope of any aid package.
In Europe, on the other hand, the fiscal outlook appears encouraging. Unlike in past economic emergencies, such as the 2012 European sovereign debt crisis, the European Union is not imposing austerity but rather has committed to fiscal stimulus. It finally appears Europe is acting in a concerted, cohesive fashion.
China’s recovery appears robust, relative both to the developed world and to other emerging market economies, and the country should see positive economic growth for 2020 as a whole. However, Chinese corporate bond yields have started to rise, which could limit credit growth in 2021.
A bullish 2021 case can be made for Japan, based on historically close correlations between Japanese equities and the global cyclical sectors that could benefit most from a pandemic recovery. Increasing shareholder activism is another potentially positive factor for the country.
“A lot of the recovery already is priced into the markets”.
— David Giroux, Chief Investment Officer, Equity and Multi‑Asset
For US and global equity markets, a rapid economic recovery could bring an accelerated earnings recovery. Following the last three recessions, it took the S&P 500 Index three, four and five years, respectively, to regain its previous earnings per share peak. This time, it potentially could happen in 2021.
However, rapid earnings growth might not translate into strong equity returns in 2021. Despite the sharp earnings decline seen during the pandemic, most global equity markets finished 2020 with strong gains and a lot of the recovery is already priced into the markets.
A broader economic recovery could also produce a modest uptick in inflation, which decelerated in early 2020 as the pandemic spread. Forward‑looking measures of inflation expectations, such as spreads between nominal and inflation protected government bonds (figure 2) have rebounded sharply since mid‑2020. There is a risk the US could pierce the 2% inflation ceiling – not quickly, but perhaps in 2022 or 2023.
When uncertainty is elevated and markets are choppy, investors should balance return‑seeking and defensive assets to navigate volatility and ensure true diversification. Offensive assets such as stocks, corporate bonds and emerging market debt can be balanced by defensive assets like high‑quality long‑dated duration, safe‑haven currencies and other defensive strategies. In addition, procyclical assets tend to outperform during economic recovery. Some of these assets – such as small‑cap stocks and credit markets – have lagged in the 2020 rally in risk assets, so valuations may be attractive. Finally, volatility and change cause prices to diverge from valuations. This is an environment for skilled active managers to add value, in particular when some valuations are rich. Fundamental‑driven security selection and tactical asset allocation can adapt to new conditions rather than relying on past behaviours.
By David Giroux, CIO Equity and Multi Asset, and Justin Thomson, CIO Equity
The pandemic has dramatically accelerated the adoption of the technologies and business models – from video conferencing to remote medicine and home meal delivery – needed for companies and consumers to function amid a public health emergency.
In 2021, the key question for equity investors is whether mass vaccinations and a rapid decline in new COVID‑19 cases could spur a rotation in market leadership toward cyclical sectors that are positioned to benefit from more normal economic conditions.
The pandemic fundamentally changed how consumers spent money and time and did it over an unprecedentedly short horizon. Spending on goods and services such as gym memberships, elective surgery, dental care, theme parks and restaurants fell by 50% to 80%. We have not seen anything like it since probably World War II.
The second half of 2021 could see a partial reversal of those trends. If vaccination progress accelerates the economic recovery, the fundamentals of many of the industries badly damaged by the pandemic could improve rapidly. Some companies could get back to 2019 earnings levels relatively quickly.
By the same token, however, a spending shift toward the COVID-19 losers could come at the expense of the sectors many equity investors bought aggressively during the pandemic – particularly technology, e‑commerce, social media and housing.
In style terms, a more normal cyclical recovery could continue to boost value relative to growth, a reversal of the powerful trend toward growth dominance – and unprecedented dispersion of stock returns – seen since the 2008-09 global financial crisis (figure 3). Signs of such a rotation appeared in late 2020 in response to the news about vaccine development. However, valuations for many ‘pandemic winners’ also have continued to rise, even though those firms could face difficult year‑on‑year earnings growth comparisons in 2021.
A return toward pre‑pandemic consumer spending patterns could further improve the attractiveness of sectors such as financials and energy – areas heavily represented in the value universe relative to the tech stocks dominating the major growth benchmarks (figure 4).
The backdrop for selective value investing has not been this strong in a decade. However, the gains seen in many value sectors in late 2020 suggest the market already has priced in some of the benefits of a faster recovery. It is a little less of an easy call now than it was before the vaccine news.
“The backdrop for selective value investing hasn’t been this strong in a decade”.
— David Giroux, Chief Investment Officer, Equity and Multi‑Asset
As mentioned, the financials and energy sectors could offer particularly attractive shorter‑term value opportunities in 2021. Within financials, steepening yield curves have improved net lending margins and the reserves set aside to cover expected pandemic loan losses appear to be larger than needed. European banks appear especially cheap based on price-to-book value multiples.
As for energy, a broad collapse in capital spending should reduce excess oil and gas supplies, potentially supporting prices. An easing of the pandemic could boost travel in 2021, reviving demand. However, the longer‑term outlook for traditional fossil fuel producers remains challenged by renewables and regulatory pressures.