The economy rebounded quickly after mass quarantines, but progress has slowed as the easiest gains have already occurred.

Economic activity rebounds

The world is on a much better footing than a quarter ago as economic activity has substantially rebounded, the threat of COVID-19 has moderated and progress toward a vaccine has progressed. The recovery began earlier than many investors expected, supported by unprecedented amounts of monetary and fiscal stimulus. Real-time measures of activity started to turn up in mid-April and continued to improve until just recently. At this point, developed economies have reclaimed a little more than half of their lost output. Economies are again expanding, but we expect 2020 GDP to be less than 2019 given the magnitude of the decline earlier in the year. We now forecast a contraction in global GDP of 4.0% in 2020, which represents a 0.6 percentage point improvement versus last quarter.

Where do we go from Here?

New headwinds emerge and the pace of recovery is slowing

The economy continues to face a variety of challenges on the journey back to normal. Many of the sectors that remain depressed are likely to be structurally limited until virus worries abate. Unemployment remains elevated and those who are still jobless may have difficulty finding work until their industries return to normal operation, which could be months or even years out. For corporations, credit problems usually occur with a lag, meaning the 2020 recession could result in increased defaults in 2021. The latest survey of senior U.S. loan officers suggests some tightening in credit conditions is occurring and that fiscal headwinds are starting to mount. The U.S. has already dialed back its support for the unemployed which could limit consumer spending. We do not believe that these challenges will derail the economic recovery, but they do suggest that it will occur at a slower pace than what we have seen so far.

U.S. presidential election looms

The U.S. presidential election is upon us and betting markets are favouring a Biden victory over Trump at the time of writing. The Biden platform proposes substantial changes compared with Trump’s mostly status quo plan. Some of Biden’s proposals could hinder economic growth, including higher taxes, increased regulation and limitations on the energy industry. But there are several policies that could boost economic growth, such as a more coordinated national approach to the coronavirus, a larger fiscal stimulus package, less protectionism and more immigration. Overall, Biden’s platform may be worse for growth in the short term, but better beyond a one-year horizon. Equity investors, however, may be more concerned with his proposed corporate-tax hikes than economic growth, so a Biden victory could pose a headwind for the stock market to the extent that this outcome is not already fully priced in.

U.S.-dollar weakness expected to persist

The downtrend in the U.S. dollar is now clearly established. The 10% decline in the trade-weighted dollar since March is just the beginning of a longer-term period of U.S.-dollar weakness, supported by a number of structural, cyclical and political factors. We expect G10 currencies, most notably the euro and the yen, to continue to outperform their emerging-market peers during this phase in the U.S.-dollar cycle. Our view on the Canadian dollar is more nuanced. We have shifted from bearish to bullish on the Canadian currency in acknowledgement of some new positive factors and recognition that the U.S.-dollar downtrend will likely prevail as a more important influence on currency markets.

Implications

• Global economic activity rebounded as lockdowns eased and the virus threat diminished through much of the world. Leading indicators of growth are once again pointing to expansion after falling deep into contraction territory in the winter/spring and Purchasing Managers’ Indices (PMIs) in some regions are now above their pre-pandemic levels. Although the economy is now moving ahead, we still look for a 4% contraction in global GDP for full-year 2020, followed by a notable rebound of 5.1% in 2021. We don’t expect a full return to “normal” conditions until a vaccine is developed and widely distributed, which experts suggest may be delayed until mid-2021 or even later.

• A variety of challenges continue to cloud the outlook. Social distancing measures still in place are limiting economic activity and extremely high unemployment is weighing on consumer confidence. The combination of schools reopening in the fall and cooler weather could spark more virus outbreaks. That said, we also recognize the potential for upside surprise if a vaccine or an effective therapeutic gets rolled out sooner than expected. Aside from virus-related risks, the U.S. presidential election and renewed tensions between U.S. and China are additional sources of volatility for the economy and financial markets.

• Policy makers delivered unprecedented stimulus this year to support the economy and markets given the massive disruption caused by COVID-19. Central banks are fostering liquidity by maintaining ultra-low interest rates and continuing large-scale bond-buying programs. Governments have also delivered trillions in aid via payroll support, funding for hospitals, and loans for small businesses among other efforts. The massive scale of the stimulus injected could cause consumer prices to rise, but downward pressure on prices from weak demand, slack in labour markets and weak energy prices should provide effective offsets, limiting the threat of unwanted inflation in the intermediate term.

For Equities Markets:

• The strong rally in global equities that began in March has extended through the summer and a number of markets have now completely erased their prior losses. Helped in large part by mega-cap technology stocks, the S&P 500 has climbed 56% from its March 23 low and is now up 8.3% year to date. COVID-19 caused a wide divide between winners and losers as work-from-home measures and mass shutdowns crippled certain businesses while boosting the proposition of technology companies in particular and retailers with strong online presence. As a result, the valuation gap between growth and value stocks has moved to an extreme matched only by the late 1990s/early 2000s technology bubble. That said, the elements of a rotation out of growth and into value are not yet in evidence (self sustaining economic recovery, rising inflation and pricing power, among others). With the S&P 500 now decidedly above fair value, forward return potential is reduced, but most markets outside the U.S. remain attractively valued according to our models and, in aggregate, global equities are reasonably valued.

• Profits are down significantly due to COVID-19, but the loss of earnings due to the virus will not have a lasting impact on markets if earnings rebound quickly. In the U.S., S&P 500 earnings fell 30% on a year-over-year basis in the second quarter (versus expectations of -43%) and are expected to be down 20% for the full year 2020. Analysts expect S&P 500 profits to reclaim their pre-COVID levels by the end of 2021. Our discounted cash flow analysis reveals that a temporary decline in profits, even if severe, has a minimal impact on the market’s value as the bulk of the stock market’s present value is based on a very long term earnings outlook.

For Fixed Income Markets:

• Bonds yields hovered near historic lows in the past quarter as the weak economy paired with aggressive central-bank buying maintained elevated demand for safe-haven assets. Yields are well below our modelled estimates of equilibrium in all regions and, even after adjusting for the impact of structural changes depressing real interest rates below historic norms, valuation risks appear elevated in sovereign fixed income markets. Nevertheless, through the forecast horizon, massive and price insensitive buying by central banks will likely dominate valuations, holding nominal interest rates at historically low levels.

For Asset Mix:

• In our view, the global economy will likely continue recovering, albeit at a slower pace than was experienced since March and corporate profits should continue their upward trajectory towards pre-COVID levels. In the current environment, sovereign bonds offer limited room for capital gains and the low yields offer little cushion against equity-market volatility. Some stock markets could be vulnerable in the near term as valuations have crept up, namely in U.S. large-cap growth stocks, but over the intermediate to longer-term we think stocks offer superior return potential versus sovereign bonds. As a result, this quarter we raised our allocation to equities by one percentage point, sourced from fixed income. Our current recommended asset mix for a global balanced investor is 62.0% equities, 37.0% bonds and 1.0% in cash.

How We Are Positioned To Take Advantage Of This Outlook:

Asset Class	BenchMark	Range	Last quarter	current recommendation
cash & Cash equivalents	5%	0-15%	2.0%	1.0%
Fixed income	40%	20-60%	39.0%	37.0%
total cash & fixed income	45%	30-60%	41.0%	38.0%
canadian equities	20%	10-30%	19.6%	14.9%
U.s. equities	20%	10-30%	21.1%	25.6%
international equities	15%	5-25%	18.3%	21.5%
total equities	55%	40-70%	59.0%	62.0%

Global Asset Mix:

Asset mix – boosting equity allocation by one percentage point, sourced from bonds

Monetary policy is expected to remain highly accommodative in order to support the economy and financial markets, and price-insensitive asset purchases by central banks will likely keep bond yields from rising. In this environment, we expect sovereign bonds to deliver low-single-digit to slightly negative total returns. Critically, at these low yield levels, sovereign bonds offer less cushion in a balanced portfolio against any deterioration in the macroeconomic outlook.

We recognize that elevated equity-market valuations and optimistic investor sentiment leave stocks vulnerable to correction in the near term, and that style exposures should be managed given the massive valuation gap between growth and value stocks. Over the longer term, however, stocks offer superior return potential versus bonds, a view supported by the still significant equity-risk premium that exists in today’s low-interest-rate environment. For these reasons, we shifted one percentage point from our bond allocation to stocks this quarter. For a balanced, global investor, we currently recommend an asset mix of 62 percent equities and 37 percent fixed income, with the balance in cash.

Geographic allocations are as follows:

• Canada 14.9%
• United States 25.6%
• International 21.5%

Risk / Reward to our Strategy

Sovereign-bond yields remain historically low

The weak economy and highly accommodative central-bank policies resulting from the pandemic pulled longer-term government-bond yields around the world to historically low levels. In the past quarter, yields remained near these levels and fluctuated in a narrow range. Our composite of global bonds suggests yields are well below our modelled equilibrium levels and represent severe valuation risk. Real, or after-inflation, yields are currently negative and we don’t think this situation is sustainable as investors will eventually demand compensation for tying up their funds. However, we don’t think yields will rise by a significant amount in the foreseeable future because of structural changes related to demographics, an increased preference for saving and the maturation of emerging-market economies. Even a gradual increase in sovereign-bond yields would generate low single-digit to slightly negative total returns, potentially for many years.

Stocks surge as investors bet on earnings recovery

The equity market rally that began in March extended into the summer, with most major indexes posting double-digit gains in the past three months to fully erase or greatly minimize their prior losses. To the extent that investors are looking beyond the pandemic, earnings lost due to COVID-19 have little impact on the present value of stocks as long as earnings ultimately regain their prior trajectory. Firms have experienced severe profit pressure during the shutdown and recovery, but investors are also focused on future earnings which are unlikely to feature COVID-19-related distortions. Within investing styles, the pandemic has accelerated the trend of growth-stock outperformance and the valuation gap between growth and value stocks has now reached extremes not seen since the late 1990s technology bubble. Valuations have crept up in the U.S. equity market, in particular. Our global fair-value composite is now above equilibrium and at its highest reading in over a decade. But valuation dynamics differ significantly among regions, with U.S. equities the most fully priced and other stock markets still at particularly attractive levels.

Conclusion:

The economy continued its V-shaped recovery over the summer and, until recently, so did much of the stock market. However, starting in September, several indexes including those of Canada, the U.S. and Japan peaked and have been consolidating or correcting for several weeks. Europe’s market began its consolidation back in July, while the U.K. market, encumbered with a new Brexit deadline, has been losing ground since June.

While the economy continues to post mostly strong numbers, we expect the coming months will see the dynamic “re-start” phase give way to an extended stretch of more grudging growth. That translates into the year-over-year GDP comparisons looking quite strong out to the third quarter of 2021 but the much more closely watched quarter-over-quarter growth rates looking much bumpier and less convincing.

Just as was true in the quarters and years following the last recession, which was over by the third quarter of 2009, we expect all economic data in 2021 and probably 2022 will be viewed within the context of a vocal debate about whether the current downturn has ended or not, closely followed by speculation about whether a “double dip” recession is in the offing. As things stand, that’s not what we expect. Rather we see the slower, bumpier growth of next year allowing the economies of both the U.S. and Canada to regain their late 2019 high-water marks by mid-2022 and their previous trajectory some time in 2023.

Earnings are likely to follow the same path. For this year, we look for S&P 500 earnings per share to come in at something less than $130, down sharply from last year’s $163 per share. For 2021, we see earnings rebounding to $155 with $170 our forecast for 2022. All of our earnings estimates are lower than the current general consensus.

With 2021 projected earnings, by our reckoning, not back to their 2019 peak but the U.S stock market averages trading recently above their 2019 highs, the argument can be made the U.S. market is excessively valued. The Canadian market, still well below its December 2019 highs, not so much.

Reconciling valuations

However, there is a reconciling factor at play: corporate bond yields are about 15% lower than they were at the beginning of the year, making the discounted present value of future S&P 500 earnings that much more valuable. Overall stock market valuations are not scarily expensive but they are certainly not cheap. In our view they are likely to remain more richly valued for an extended time for several reasons:

Central banks, led by the Fed, are committed to ultra-low short-term interest rates out through 2023, probably much longer. The Fed likely would also act to prevent long-term rates from moving high enough to threaten the recovery. This commitment dramatically reduces the risk of widespread corporate insolvencies among public companies and correspondingly supports equity valuations.

• We do not expect a big withdrawal of fiscal support as long as unemployment remains high and social distancing remains the order of the day, with its deeply constraining impact on some significant part of the economy.

• Second wave increases in the number of new COVID-19 cases notwithstanding, it is fair to say considerable progress has already been made in mitigating the most damaging physical effects of the virus. One doesn’t have to be a wild-eyed optimist to expect more progress to arrive over the coming year, permitting further reductions in social and business constraints and adding to both normalcy and the certainty of growth.

We expect the rocket ride the stock markets enjoyed off the depressed March lows is unlikely to be repeated in the coming months and quarters. The broad market averages, already correcting, could be in for a longer stretch of consolidation as conflicting economic forces play out.

Larger forces at work

Beyond the pandemic, economic growth in the developed economies is likely to be slower than even the subdued growth of the past decade. The non-partisan Congressional Budget Office, which regularly prepares long-term forecasts for the U.S. economy – and has compiled an enviable track record – in a September report estimates that the annual potential growth rate for the U.S. economy for the coming decade is 1.8% versus the 2.3% achieved from 2010 to 2019.