Perspective on Current Markets Q4 2020

Buoyed by ultra-low interest rates and fiscal stimulus, financial markets calmed and stocks rose to record levels as economic normalization drew closer and the recovery progressed.

Looking past COVID-19 to an improving outlook for 2021

The pandemic remains the key challenge for economies in the New Year, with case counts and fatalities reaching near record levels. But the transmission rate is starting to slow and, while countries including the U.S. and Canada are battling a second wave, many European countries appear to be emerging from theirs. Tighter restrictions to combat the virus may lead to some economic slippage at the end of 2020, but there are reasons to be optimistic. The economic recovery has been exceeding expectations, vaccine developments are promising and markets have responded positively to the outcome of the U.S. presidential election. Although the economy may encounter hurdles in the very near term, our growth forecasts for 2021 have featured more upgrades than downgrades and are now situated modestly above the consensus.

Where do we go from Here?

A variety of risks threaten our base case, but upside surprises are also possible

We think the risks to our benign base case scenario are slightly skewed to the downside. The virus is still spreading and colder winter weather in the northern hemisphere could worsen the situation. It is also possible that a third wave of infections emerges in the spring as happened in the 1918 flu pandemic. Moreover, sentiment around vaccines is extremely positive, but a return to normal could be delayed should they cause unexpected side-effects or prove less effective than hoped, or should the recent distribution complications slow the pace of inoculations. While we expect inflation to remain low, there is the potential for prices to rise faster than our forecasts, and an environment of too much inflation would be worse than not enough. Note that it is normal for the balance of risks to lean toward the downside as there are usually more ways for the economy to stumble than to outperform meaningfully. We should, though, also consider the possibilities for better-than-expected outcomes. The virus could retreat on its own or vaccine delivery could out pace current expectations. Other sources of uncertainty include the amount and timing of U.S. fiscal stimulus, Brexit and structural themes related to demographics, high debt loads and globalization.

Inflation gains traction but not to problematic levels

Our thinking about inflation has evolved over the past quarter. We correctly predicted inflation would be low amid the pandemic, with falling oil prices and plunging demand. More recently, though, inflation has begun to stabilize as economic conditions have normalized. Our forecasts for inflation in 2020 and 2021 point to slightly higher inflation and we recognize that a weaker U.S. dollar and the outperformance of the U.S. economy may support faster price increases in the U.S. versus elsewhere. Over the longer term, potential upside risks to inflation exist. Massive monetary stimulus, higher inflation targeting by the U.S. Federal Reserve (Fed), elevated government-debt loads and a push to support sales of American-made products are all elements that could push inflation higher than we would have thought before the pandemic. That said, we don’t think inflation will rise to problematic levels as a number of structural forces such as demographics will continue to weigh on inflation pressures. All in all, any faster inflation that we do encounter is likely to be simply a return to more normal readings after decades of subdued price increases.

U.S. dollar weakness ahead

We expect a sustained U.S.-dollar decline in 2021 as structural headwinds take precedence over short-term factors that have slowed the decline of the greenback over the past year. U.S. twin deficits and the Fed’s intention to boost inflation, coupled with economic and political improvements and extraordinarily easy financial conditions, should cement the U.S.-dollar downtrend. Emerging-market currencies are likely to finally shine next year, and the euro, yen and loonie should outperform the British pound.

Implications 

• The global economy is progressing through a series of targeted lockdowns and subsequent re-openings as governments manage the delicate balance of people’s health versus economic growth. Service sectors have been hit the hardest with restrictions on travel, restaurants and entertainment, but manufacturing activity remains robust and leading economic indicators point to expansion in regions where lockdowns have been less severe. Data releases have been better than expected and economies are showing impressive resilience. Growth may stumble a bit in the fourth quarter due to a flare up in COVID-19 cases, especially in Europe, but the promise of a vaccine clarifies the path to normalization and a better outlook for 2021. We are upgrading our growth forecasts for most regions, boosting our estimates slightly above the consensus.

• Although vaccines are showing promise, challenges remain with respect to distribution and administration of the vaccine to the entire world’s population. Vulnerable groups will receive the vaccine earlier, but we expect that the vaccine won’t be widely available until the second to third quarter of 2021. Other potential risks include the transition of government in the U.S. and Brexit in Europe/U.K. Looking further out, unprecedented government spending during the pandemic has ballooned fiscal deficits challenging future economic growth. With all the stimulus delivered, inflation could rise somewhat in the medium to longer term, but several factors such as lower oil prices and high unemployment are likely to keep inflation pressures muted in the near term.

• With economies still grappling with the virus and little threat of inflation for now, central banks remain accommodative. There is no urgency to raise interest rates and many central bankers have expressed their intentions to keep interest rates low for an extended period. The Fed’s own projections suggest U.S. short-term interest rates will remain at the zero lower bound at least until the end of 2023. Moreover, massive bond-buying programs remain in place to support the economy and financial markets.

For Equities Markets:

• Global equity markets extended their gains on optimism surrounding the positive vaccine news, sending several major market indices to record highs. While U.S. large-cap growth stocks led through most of the COVID-19 pandemic era, the most recent rally featured outperformance by small cap, value, and international equities. As a result, the valuation gap between U.S. large-caps and other equity markets narrowed slightly from extreme levels. That said, the S&P 500 remains the most fully valued of the major markets that we track. Markets outside of the U.S. large-cap space are still attractively priced according to our models as are many sectors and styles outside of the COVID-period leadership.

• Corporate profits plunged amid the virus-induced recession, but the damage was not as much as initially feared and profits are already rebounding. Analysts currently look for S&P 500 earnings to decline 15% in 2020 compared to earlier expectations of a 25% drop. Analysts now forecast S&P 500 earnings growth of 20% in 2021 and for profits to reclaim their pre-COVID peak sometime this year.

For Fixed Income Markets:

• Although bond yields remain near historically low levels, they have inched higher in some regions as economies have gradually reopened and investor demand for safe-haven assets diminished. Sovereign yields are slightly higher in North America in the past quarter, but declined a bit in Europe given tightened measures to combat a second wave of COVID-19 infections. Bond yields are below our estimates of equilibrium in all major regions, indicating meaningful valuation risk. We look for yields to gradually rise over the longer term, but a number of secular factors including demographics, increased preference for saving versus spending, and the emergence of developing nations are likely to limit the extent of any increase.

For Asset Mix:

• Our base case scenario sees the economy reclaiming its prior peak over the next one to two years and approaching its long-term growth trajectory in 2023, still supported by significant fiscal and monetary stimulus. In this environment, government bond yields should remain low. As a result, we expect very modest and potentially negative returns in sovereign bonds over the year ahead. Stocks, however, offer superior return potential and, while valuations are demanding, the vaccine provides greater certainty in a positive outcome. Moreover, a number of signs we would look for to confirm an improving outlook are falling into place. In recent months, the yield curve has steepened, value outperformed growth, international equities gained relative to U.S. stocks, small caps outperformed large caps and the U.S. dollar depreciated. These factors are consistent with the early stages of early stages of an economic cycle, indicating the bull market has room to run. For these reasons, during quarter we increased our equity allocation by 2.5 percentage points sourced from bonds. Our current recommended asset mix for a global balanced investor is 64.5% equities , 34.5% bonds and 1.0% in cash.

Global Asset Mix:

Asset mix – boosting equity overweight, sourced from fixed income

With the economy entering a period of normalization supported by low interest rates and ample fiscal stimulus, stocks continue to offer superior return potential versus fixed income. Our forecasts look for mid-single to potentially low-double digit returns from stocks over the year ahead versus low single-digit or potentially negative returns from sovereign bonds. Moreover, extremely low bond yields mean that fixed-income markets may not provide as much protection against stock declines as they have in recent decades. In our opinion, traditional views on optimal asset mix should be reconsidered to reflect the impact of structural change in the global economy on returns, correlations and risk mitigation within the universe of investment options. For many, one option may be to invest over longer time horizons and add more equities to portfolios.

Supporting our positive view on stocks is long-term price momentum, which suggests equities could be in a long lasting bull market. We continue to position our portfolios with an overweight in stocks and underweight in fixed income. This quarter, we were further encouraged by the style rotation into value from growth, the increasing breadth in small- and mid-cap stocks, international equity outperformance, the steepening yield curve and the weakening U.S. dollar, all of which are frequently in evidence in the early stages of bull markets. As a result, we added 2.5 percentage points to our equity allocation during the quarter, sourced from fixed income. For a balanced, global investor, we currently recommend an asset mix of 64.5 percent equities and 34.5 percent fixed income with the balance in cash.

Risk / Reward to our Strategy

Bond yields hover around historic lows, scope for increase is limited

Central bankers have expressed a commitment to keeping short-term interest rates extremely low to stimulate economies and financial markets even as the recovery gains traction. Longer-term bond yields have a bit more room to rise, but the scope for increases is limited by secular pressures such as aging demographics, slowing population growth and an increased desire for saving versus spending. All of these factors have contributed to declines in real interest rates (i.e. the after-inflation interest rate) and these trends are unlikely to change anytime soon. We have evolved our modelling to incorporate these elements into our real-interest-rate projections. As a result, we now look for a more gradual and ultimately smaller rise in real rates of interest. Our new modelling suggests that sovereign bond yields everywhere will drift just slightly higher over the next year, acting as a modest headwind to total returns for bondholders.

Global equities soar to new highs and vaccines trigger style rotation

Stocks surged from their March lows due to a combination of massive stimulus, a gradual reopening of economies and, more recently, the promise and delivery of vaccines. The latest rally pushed the S&P 500 Index to a new record and many other markets are also showing gains this year. We recognize that optimism is elevated and, while stocks may be expensive by some measures, investors are paying up for a recovery in earnings that is just beginning. In fact, outside of U.S. large-cap stocks, markets remain attractively positioned with many below the mid-point of our fair value bands. The equity-market rally has broadened from a handful of U.S. mega-cap technology stocks to a much larger base of companies, industries and regions that are more economically sensitive, including value, small- and mid-cap stocks, as well as segments that were hardest hit by COVID-19 such as airlines, hotels, casinos and energy.

Conclusion:

Our view has not changed over the past quarter. We believe the V-shaped recovery that began in May for most economies is giving way to a less dynamic, possibly bumpier phase of growth. The U.S. and Canadian economies should regain their pre-pandemic high ground by late 2021/early 2022. For Europe, the UK and Japan, it will likely take a couple of quarters longer. China’s economy has already recovered all the ground lost to the first half’s COVID-19 shutdown.

Corporate earnings have followed the same path as the economy, quarters and rebounding in the third and fourth. Guidance provided by CEOs has also become more upbeat. As with GDP, we expect the earnings per share for both the TSX Composite and the S&P 500 will regain their 2019 high-water marks late in 2021 or early 2022. Earnings could surprise to the upside as some sectors and groups, crippled by the pandemic, eventually return to life.

As for the stock market, we look for equity prices to appreciate further over the course of 2021, although not by as much as earnings advance, bringing price-to-earnings ratios down modestly.

The drop in GDP, profits and share prices, followed by a rapid recovery of much or all of the lost ground is typical of most recessionary experiences. Thereafter, the GDP expansion settles into a trajectory more closely aligned to the economy’s longer-term potential growth rate.

The economy drives the bus

Since over longer time stretches GDP growth sets the pace for both corporate earnings growth and how fast average share prices appreciate, it would be useful from an investment standpoint to have a handle on how fast the U.S. and Canadian economies are likely to expand over the coming decade. The answer is: relatively slowly.

The Congressional Budget Office, a nonpartisan federal agency that prepares long-term forecasts of theU.S. economy for Congress, projects nominal GDP growth (that is, growth before removing the effect of price increases) will average just 4.3% from 2020 to 2030.

For the U.S., this is about the same as the average growth rate it delivered in the 10 years following the financial crisis but much slower than the 6.9% per annum it racked up between the end of World War II in 1945 and 2007.

Canada has followed a roughly similar path and is expected to experience the same continuation of slower, post-financial crisis GDP growth.

Slow or even declining growth in the working-age population will continue to be the chief constraint on economic growth, aided and abetted by the drag stemming from the large buildup in government COVID-19-related debt. RBC Global Asset Management estimates the latter will shave about 0.1% to 0.2% from the per annum GDP growth rate over the decade. All the developed economies, including Canada, are faced with these same two issues.

Competition will intensify further

Many businesses, large and small, can thrive when the economic pie is growing quickly, as it was in the 65 years following World War II. When that growth rate slows by a third, as it has done since weakest may get driven to the sidelines more quickly or taken over, and corporate concentration becomes more apparent. A handful of dominant leaders emerges in many sectors, internationally as well as domestically. These dynamics have played out over the past decade and are likely to do so again in the coming one.

Companies often respond to fierce competition for market share by boosting capital spending on technology in an effort to lower costs and respond to the rapidly changing competitive landscape.

This growth in technology spending is good for profits, employment and productivity when looked at across the total economy. But within an individual sector or industry group, the willingness and capability to spend what it takes – maybe more than it takes – becomes a differentiating factor that can separate dominant industry leaders from the rest.

Stock picking

As noted above, over the long term equity values have appreciated in line with earnings. And earnings have grown at a pace somewhat faster than, but close to, that set by economic growth.

That sets a useful yardstick for stock selection. In terms of long-term positioning, we think portfolios should be populated to the greatest extent possible with the shares of those businesses for which there is high conviction that sales, earnings and dividends can grow faster than the economy.

Those companies will almost always be trading more expensively than the average. If it turns out they are able to deliver that superior, sustainable growth, then they will likely go on being more expensive.

Positioning for today

We recently moved up our recommended exposure to equities in a global balanced portfolio from “benchmark” weight to “above-benchmark.” This is not a big tactical shift. Rather it is recognition that the driving force behind earnings growth and equity valuations is rapidly shifting away from the outsized volatility risks presented by the pandemic back toward the long-term expectations for sustainable economic growth.

The COVID-19 economic damage should diminish greatly through 2021, while confidence in a return to a recognizable social and business landscape will likely grow. As GDP climbs back toward its pre-pandemic peak, corporate earnings, already recovering, could perform better than expected through 2021 and 2022.  Stocks in the major markets have priced in some of this better earnings trajectory but not all. We expect equities could provide attractive all-in returns in 2021, and probably for 2022 as well.