Interest rates remain low, unemployment is elevated but improving, and the economy is being supported by massive fiscal stimulus with potentially more on the horizon. All things considered, we think the economic expansion has further room to run, possibly for several years. The coronavirus remains a key challenge to our outlook, with new variants spreading rapidly and case counts rising in many regions of the world. However, progress on vaccinations should ultimately curb the spread of the virus and the economic hit from COVID-19 is unlikely to be severe given the economy’s impressive resilience during the pandemic. We look for the world’s major economies to grow between 4% and 8% in real terms in 2021 followed by slightly slower, but still strong, growth rates in 2022. Our own growth forecasts remain above the consensus, but slightly less so than before because the consensus has moved higher.
Where do we go from Here?
Outlook is less clear with many variables at play
Although our base case scenario is quite constructive, a number of moving parts make the growth outlook less clear than usual. Some of the risks include the unprecedented nature of the pandemic, uncertainties related to the distribution of vaccines and their efficacy against new variants, and the possibility of another virus wave. Uncertainties also exist around the potential for inflation and amount of additional fiscal stimulus on the horizon. Our assessment is that these risks are roughly balanced in terms of their ability to turn out better or worse than expected. The vaccine and the virus represent greater downside risks, but the reverse is true regarding fiscal support.
Inflation concerns mount but upward price pressures are limited
The combination of significant ease in monetary policy, central banks’ willingness to accept faster inflation, historically high sovereign-debt loads and a push for local production of medical supplies has investors concerned that inflation could run too hot. Prices are indeed rising, albeit off a low base, and we should recognize that inflation expectations remain in line with levels of the past decade. Expectations in previous crises that significant growth in the money supply would lead to inflation haven’t materialized because increases in the supply of money have ended up in savings or been returned to banks as excess reserves. It’s also worth keeping in mind that demographics and sector effects related to technology, health care and education are putting downward pressure on inflation. Our view is that the underlying inflation trend will move higher but that it will remain at low levels relative to history.
Expecting further U.S. dollar weakness amid tailwinds for cyclical currencies
The U.S.-dollar bear market is still in its early stages and longer-term factors point to further declines. The recent rise in U.S. bond yields has given the greenback a short-term boost, offering investors a more attractive opportunity to sell the dollar. An environment of stronger global economic growth and higher commodity prices is supportive for cyclical currencies. We expect emerging-market currencies to outperform their developed-market.
Implications
Key Conclusions
Market signal improving outlook as pandemic enters new phase
With vaccines in hand, the pandemic is moving to a different, more manageable stage and the economic recovery that began in the second half of last year is kicking into a higher gear. Supported by ample fiscal and monetary stimulus, we look for a powerful recovery in GDP growth from the sudden and deep contraction of 2020. That said, the dynamics of this recovery may be unlike those in the past due to the potential for lasting impacts from the pandemic, and it remains uncertain how economies will evolve over the next several quarters. We don’t know how consumers and governments will respond to their varied situations in a post-pandemic world, but consumers are actually in solid shape as a result of government support and ultra-low interest rates.
What we do know is that financial markets have responded in a big way. Government-bond yields have moved significantly higher in recent weeks, with 10-year Treasury yields rising back to levels not seen since before the COVID-19 crisis. Stock prices have also surged. The S&P 500 Index has climbed more than 70% from its March 2020 low, and elevated equity valuations suggest the potential for strong corporate-profit growth ahead. Small- and mid-cap stocks, as well as emerging-market equities, have also enjoyed significant gains over the past six months and eliminated much of the deep discount that existed between those groups and U.S. large-cap stocks. All in all, markets look very different now compared with a year ago, suggesting that fears engendered by the pandemic are fading and that investors are embracing a brighter future for the economy and corporations alike.
In this environment, we look for low single-digit returns from bonds and mid-single-digit to possibly low double-digit returns for stocks over the year ahead. For many quarters, our base-case return forecasts for sovereign bonds had been mildly negative but, with the recent rise in yields, these return expectations have now climbed slightly above zero. This change represents a major shift in the outlook for fixed-income markets, where investors may actually be able to earn their coupons without suffering capital losses. In certain equity markets, valuations are somewhat concerning and we acknowledge that froth exists in some areas, setting a high hurdle for earnings improvement to sustain the bull market. Aside from large-cap technology and momentum-driven stocks, though, many equity markets remain appealing on a valuation basis and continue to offer attractive upside potential.
For Equities Markets:
Equity-market valuations creep higher as stocks extend rally
Stocks rallied to records in most major markets as vaccinations progressed, virus case counts declined and earnings exceeded expectations. Rising share prices pushed our global valuation composite to its highest level in over a decade. For historical context, our global composite was more than 40% below fair value at the depths of the 2008 financial crisis. After trading at a discount for over a decade, stocks clawed back all of that undervaluation and have only recently climbed slightly above fair value. While there has been major change in the valuation underpinnings for equities, it’s important to differentiate between stock markets. The S&P 500 has risen to more than one standard deviation above our modelled fair-value level, and even the MSCI Emerging Markets Index, which had extremely favourable valuations, now trades above fair value. On balance, stocks appear to be expensive and we should moderate total-return expectations and expect higher volatility. However, not all markets are as expensive as U.S. large-cap technology stocks and others that have exhibited extremely strong positive momentum. For example, equities in Europe, the U.K., Canada discounts to fair value and offer the potential for compelling returns.
For Fixed Income Markets:
Surge in bond yields alleviates valuation risk
Moving out the yield curve, we have seen big changes in fixed-income markets as fears of the crisis faded and bonds started pricing in a better outlook for the economy. The U.S. 10-year Treasury yield rose roughly 55 basis points over the past quarter to above 1.50% for the first time since the pandemic. As a result, the U.S. 10-year yield climbed back into the normal range around our modelled equilibrium level. Rising yields have been a feature in all major regions and the acute valuation risk that existed in the bond market has been dampened as a result.
The latest increase in bond yields was the result of real yields rebounding from historically low levels. While the inflation premium contributed to the boost in yields, we observe that the real yield has increased nearly 100 basis points since the summer and is now close to zero. We still think real interest rates can continue to rise, but structural changes related to demographics, an increased preference for saving versus spending and the maturing of emerging markets will likely limit how high yields can ultimately rise. Incorporating these factors into our model has flattened the upward trajectory of the equilibrium band and, as a result, our view of what constitutes elevated yields going forward will be somewhat lower than it was.
For Asset Mix:
As long as the economy grows and earnings rise in line with our expectations, stocks are likely to deliver superior returns versus fixed income, though perhaps that advantage will be somewhat less than we’ve seen since early 2020. As a result, we are maintaining an overweight stance in stocks and underweight in bonds. 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.
How We Are Positioned To Take Advantage Of This Outlook:
| Asset Class | BenchMark | Range | Last quarter | current recommendation |
| cash & Cash equivalents | 5% | 0-15% | 1.0% | 1.0% |
| Fixed income | 40% | 20-60% | 34.5% | 34.5% |
| total cash & fixed income | 45% | 30-60% | 35.5% | 35.5% |
| canadian equities | 20% | 10-30% | 15.6% | 15.5% |
| U.s. equities | 20% | 10-30% | 26.7% | 26.5% |
| international equities | 15% | 5-25% | 22.2% | 22.5% |
| total equities | 55% | 40-70% | 64.5% | 64.5% |
Global Asset Mix:
Asset Mix – maintaining overweight in stocks, underweight in bonds
In our base case scenario, the economy enjoys a powerful rebound in 2021 as virus threats fade and normalcy draws closer. We’ve seen a substantial jump in fixed-income yields, and, for the first time since early 2020, we now expect slightly positive returns for sovereign bonds over the year ahead. Given the expectation of a solid cyclical recovery in economic growth and corporate profits, we believe a bias toward risk taking remains appropriate. Although the advantage of stocks over bonds has diminished somewhat as a result of rising yields, equities continue to offer an attractive risk premium versus fixed income. As a result, we are maintaining our overweight position in stocks and underweight in bonds. 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.
Geographic allocations are as follows:
Canada 15.5%
United States 26.5%
International 22.5%
Risk / Reward to our Strategy
Bond yields surged, valuation risk recedes
Longer-term bond yields have surged as investors’ expectations of faster inflation and better economic growth are offsetting the impact of central-bank efforts to hold rates down. The U.S. 10-year Treasury yield rose roughly 50 basis points over the past quarter, moving above 1.50% for the first time since the pandemic. Part of the increase was due to real, or after-inflation, interest rates rising from unsustainably low levels. We think real rates could rise even higher but structural changes related to demographics, an increased preference for saving versus spending and the maturing of emerging markets will ultimately limit how high they can go. Moreover, the recent surge in global yields has dampened the acute valuation risk that existed in the bond market and we think that bond prices could find near-term support at current levels.
Stocks rise to record levels led by economically sensitive segments
Global equities rose to new highs as the pace of COVID-19 vaccinations progressed, virus counts declined and earnings exceeded expectations. The S&P 500 Index gained 5.6% in the past quarter and has climbed above fair value. We recognize there is froth in some areas of the market and that valuations are elevated, but our modelling suggests the possibility that price-to-earnings ratios could rise even further as fears of the crisis fade and interest rates return to normal levels. While U.S. large-cap technology and momentum stocks are expensive, equity markets in Canada, the U.K., Europe and Japan remain below their fair values and offer compelling upside. Furthermore, the economic recovery has stoked a rotation out of traditional U.S. large-cap leadership into other more economically sensitive areas of the market, driving rallies in small- and mid-cap stocks, financials and industrials, and value stocks overall.
Conclusion:
The Canadian and U.S. economies are clearly in the “recovery” phase. Usually, once a recession is left behind, economic activity accelerates for several successive quarters. Pent-up demand, restocking of depleted inventories, easy credit conditions and people going back to work all act in concert to bring the economy roaring back to life. This period usually features the fastest GDP growth rates of the new economic cycle.
Corporate profits and stock prices follow the same path, collapsing in the recession and rebounding energetically as the economy begins to recover. Typically, the stock market overdoes it in both directions, falling further than earnings decline in the recession, and then rising more steeply and sooner than earnings recover.
At some point a year or so into the new cycle, “roaring” growth gears down to a more sedate pace of economic expansion. The transition from “fast” to “sustainable” growth usually provokes some soul-searching about whether it is a portent of something worse. This is often accompanied by volatility in equity markets.
Classic pattern
Despite being unique in so many ways, this recession and subsequent recovery have so far followed the classic pattern. And there may be more upside for GDP and earnings. Governments have committed to more stimulus. Importantly for every other economy, including Canada’s, the U.S. has added a $1.9 trillion relief package on top of the $2.9 trillion last year, as well as a probable large infrastructure initiative, although the latter likely wouldn’t have a big impact before 2022. Government spending initiatives in Canada and elsewhere will keep the economic fire well fueled as vaccine rollouts progress into the summer.
But the largest stimulus will come from the reopening of the global economy. Sectors hardest hit by social distancing and travel restrictions will have a chance to reopen with positive knock-on effects for many other sectors, employment and confidence. Much of the money transferred from governments to households is sitting in bank accounts. Some significant proportion of that will be spent in the coming couple of years as conditions become more normal.
On top of all this, surging corporate profits, the pressing need for inventory restocking and the desire to lessen reliance on Asian supply chains are driving capital spending in the U.S., which should also yield positive benefits to the Canadian economy.
Estimates rising in anticipation of reopening
Index earnings estimates for this year in both the U.S. and Canada have been rising, reflecting better times arriving in the second half of the year. Markets have priced in much of this improving outlook—some would say all of it in the case of the U.S. market, where the S&P 500 sits at 22x consensus earnings estimates for this year, although that consensus number continues to rise. Price-earnings (P/E) multiples for Canada and other developed country markets mostly sit much lower, in the mid-teens.
We expect the momentum provided by reopening, the delayed impact of fiscal and monetary stimulus, infrastructure spending, and strong business capital spending will provide further solid GDP and earnings gains in 2022. In anticipation, share prices should advance over the coming 12 months.
Our long-term investment stance can be stated succinctly: “If there is no U.S. recession in sight, give global equities the benefit of the doubt.” Most of our leading indicators that would warn us in advance that a recession is on the way are saying the opposite. This economic expansion appears to have room to run for some time yet. In our view, that pushes the next bear market out somewhere beyond the horizon.
Curveballs
Corrections, however, are another matter. We see at least two risks (among many) that could induce unsettling volatility in equity markets. One is the pandemic. Recent months have provided a reminder that the virus remains capable of tossing nasty curveballs. With new, more challenging variants, vaccine production/delivery issues, vaccine hesitancy forestalling the arrival of herd immunity and the possibility of some vaccine shortcomings revealed over time, the road to convincingly vanquishing the pandemic is likely to be a bumpy one.
The other risk is inflation and the effect it can have on monetary policy and P/E ratios. We are about to encounter some larger-than-usual increases in consumer price indexes mostly because of comparisons with a year ago when consumer prices were falling in April and May. In addition, gas prices are surging. The Fed has made it clear it sees these inflation increases coming but expects them to subside later in the year and further in 2022. However, the prices of many industrial commodities are also on the rise, suggesting finished goods inflation is likely to be stronger in the coming 12 months than previously anticipated. Agricultural commodity prices are also climbing, portending higher food prices down the road.
If these inflation increases look as if they are becoming persistent rather than transitory, then investors will start to worry that central bank rate hikes could begin sooner than the late 2023 timeframe currently priced into debt markets. Inflation expectations are also an important component of the equity valuation equation—a dollar of earnings earned 10 years from now is worth approximately 13% less today than it otherwise would be if inflation runs over that interval at 3% per annum rather than today’s prevailing rate of 1.5%.
Favour equities
Considering all of the above, we are left with a positive outlook for global equities for the coming 12 months. We expect the impact of the pandemic will continue to subside over the remainder of this year and into 2022. The forecast rising tide of GDP and earnings should permit broad market indexes to advance further from today’s levels, worries about near-term overvaluation notwithstanding.