Richard Dunbar, Head of Multi-Asset Research, Aberdeen Standard Investments
I write this outlook with some trepidation and indeed some humility, as we exit a year like no other and certainly a year whose outcome few, if any, had forecast. It was a year where the virus, and its economic and market implications, coloured everything.
We saw a bull market and a bear market in the space of a few weeks. And perhaps surprisingly, both were entirely rational. The collapse in markets in March was a reasoned response to a global economy that had almost completely ground to a halt. The survival of many businesses and sectors was immediately called into question and even the financially strong saw huge downgrades to their earnings prospects. But the rise in markets in response to unprecedented fiscal support was also rational. Governments sought to protect workers and businesses with packages such as the furlough scheme in the UK. Meanwhile central banks continued to cut interest rates and kept money flowing through the financial system.
The initial recovery from the first wave of the Covid-19 pandemic was very rapid, for a while at least tracing out a “V” shape. However, the outlook has since become much more mixed, as the virus has become endemic, particularly over the northern hemisphere winter. This said, the prospect of a number of effective vaccines being rolled out through 2021 offers an ‘escape hatch’ out of the pandemic and its economic effects. Meaningful loosening in lockdown restrictions in the US and Europe likely won’t get underway until the second quarter. But assuming initial safety and efficacy results hold up under further scrutiny, these economies should benefit strongly from vaccine rollout through the second half of 2021. This leaves us expecting above average global economic growth over the next two years.
As regards inflation, we still expect the Covid-19 crisis to prove net disinflationary. The global economy has enormous spare capacity, which will put sustained downward pressure on wage growth and firms’ pricing power. And while there has been speculation about ‘inflation regime change’, the disappointing timidity of central bank framework reviews and increasing reactivity of fiscal policy is not pointing in that direction.
All this means is that monetary policy should remain very loose, with central bank balance sheet expansion the marginal tool of policy. We expect the Fed to lengthen the duration of its asset purchases around the turn of the year, suppressing long-term bond yields even as the economy recovers. The ECB and Bank of England are both set to increase asset purchases further. And while Chinese monetary policy has stopped loosening amid a renewed focus on financial stability, we are not forecasting rate hikes.
As regards politics/geopolitics, one of the debates continues to be whether globalisation is rolled back further as countries seek to shorten their supply chains and become more self-sufficient, and tensions between China and the rest of the world increase. Or whether the shock eventually gives way to more multilateralism (including a shift towards fiscal union within Europe) as governments and voters recognise that public health, climate change and crisis management can only really be solved collectively. While the election of Joe Biden in the US was seen as heralding the greater predictability of US foreign and trade policy, we would note that the underlying drivers of the US-China conflict have not gone away.
The last month, since the confirmation that a vaccine roll-out was possible, has seen a huge change in market and sector leadership. We expect to see continued large dispersions in returns within asset classes, reflecting the significant fundamental gaps that are opening up across countries, sectors and companies. This broadening of market leadership should be regarded as healthy and is probably required for markets to move forward from here. While ‘value’ and ‘growth’ are often discussed in this context, it is our view that these monikers are somewhat simplistic. We are happy to ‘lean’ into more cyclical markets and sectors, but at the same time remaining aware of the challenges faced by some of the constituents of these areas of the market.
Interest rates and short dated bond yields will remain low for the foreseeable future, partly due to wider output gaps / spare capacity and partly due to central bank actions to manage large government deficits and debt levels. Hence sustainable yield higher yielding debt, selected global equity and selected real estate will become even more attractive. While “carry” is in principle attractive in this environment, our message would remain one of continued selectivity in security selection.
‘Following the money’ and assessing what the central banks are buying is likely to remain an important support. However, as above, while central banks are intervening in some of the lower quality ends of the market (i.e. selected areas of High Yield), it is not in all areas – selectivity remains key. Central banks may not always be there for you. It is also worth noting that this support is now much more fully reflected in valuations.
This leaves our ‘House View’ portfolio overweight equities, favouring a mix of global developed market equities and emerging market equities. In bond markets, as noted above, we still favour high yield and emerging market bonds, but would also hold some developed market government bonds to give balance and diversification to the portfolio. We have recently taken our global investment grade credit positions back to neutral. While issuers continue to trade satisfactorily and defaults are low, the continued spread tightening off the March levels leave more meagre returns from here. As regards currencies, we would expect modest weakening of the dollar, and would continue to prefer the Yen in the portfolio.
As I said at the start, we are leaving 2020, the outcome of which was not foreseen in many ‘Year Ahead’ papers this time last year. A reminder, if any were needed, of the importance of diversification in portfolios. As ever, portfolios should be built to withstand the ‘bumps in the road’ that we can see, but more importantly those that we do not. With this reminder, could I wish you all well for 2021.