Investment outlook 2021 - A brighter future is possible
- Policy support and hope for a vaccine enabled a defensive bull market to develop post-March 2020
- A broader-based cyclical rally in risk assets should come in the wake of vaccine deployment in 2021
- An end to the pandemic, ongoing policy support and a focus on green investment should all contribute to a brighter outlook. Equities should benefit.
- Fixed income returns will likely remain constrained at low levels of yield and credit spread. What happens to yields will be important for all markets in 2021.
Follow policy - and the science
For investors, there are vital lessons to be learned from the past year. The first really echoes the experience of the 2008/2009 global financial crisis – namely when the going gets tough, policymakers show up. Since it became clear how severe the impact of the pandemic was going to be, monetary and fiscal policy has underwritten the global economy, and by extension, financial asset prices. Importantly, this is continuing, and from a long-term perspective the benefits of aggressive policy support massively outweigh the costs. Concerns over rising budget deficits, debt and bloated central bank balance sheets should be judged against the fact that policy continues to limit the risk of devastating wealth destruction, mass unemployment and an outright depression.
Another lesson is to pay attention to the science. The fragility of our way of life has been exposed by a pandemic, which in hindsight, we were woefully unprepared for. The success or otherwise in managing the crisis has been determined by our understanding and application of epidemiology and virology research. Sadly, policymakers have not always followed the science, and arguably, there have been human and economic costs which potentially could have been avoided. It also means that the legacy of the pandemic will persist beyond the good news on vaccine developments. Lost jobs and businesses, as well as changes in how people live, work and interact will be the legacies of 2020. But so ultimately will be the successes of economic policy and the development of vaccines in record time.
For the coming year, changing expectations of the shape and strength of the recovery will be important in influencing returns and volatility. What we can count on is that interest rates will remain extremely low, and therefore companies and governments alike will continue to enjoy low-cost funding. What happens to bond yields will be determined by the on-hold super-easy monetary policy, and the potential for expectations of growth and inflation. There may be scope for higher levels of government borrowing to push yields up. Many anticipate higher yields, given where they presently are, and the potential for a reversal of the past year’s moves. However, forecasts of higher bond yields have been subject to systematic errors for some time. Without inflation, investors really should mull over whether central banks will want higher long-term real yields.
Since the middle of 2020 global bond returns have been flat - and given the backdrop of low yields, alongside the fact that credit spreads are almost back to pre-crisis levels, returns from fixed income strategies will be challenged. Higher underlying yields would make it even more challenging. Either central banks continue to repress yields and volatility in bond markets, allowing only modest returns, or – in a more positive economic environment – markets start to price in a “tapering” of monetary support. Under such a scenario, returns could be negative. This would also impact credit and equity returns too, as was the case in 2018.
Emerging market debt, high yield and loans may be more interesting to yield-hunting investors. High yield and loans offer more protection against any upward shift in risk-free rates and credit concerns should alleviate in a recovery. Of course, 2021 will be challenging from a growth point of view, just as the environment was after the previous financial crisis. But these credit-intensive assets still performed well back then. Emerging market bonds witnessed significant inflows towards the end of 2020 and should be a beneficiary of the impact of vaccines, even if the distribution to populations in developing markets may be somewhat fragmented.
The outlook is equity-friendly
The outlook remains equity-friendly. Policy support and investor faith in a scientific solution to the pandemic have been the twin pillars of market performance since last March. Growth has resumed and should continue while interest rates will remain low. There is upside in consumer spending and industrial production in many economies. Sectors trashed by the pandemic will have the opportunity to recover over the next 12 to 24 months. Life won’t be a bed of roses though. Equity markets are likely to reflect numerous trends, and not just the progress of global GDP shifting back towards what would have been its trend level.
Some of these trends are clear. The evolution from a defensive, to a more cyclical bull market, has had a couple of false starts. What has stifled it so far is the ongoing damaging impact of the pandemic on activity – pushing the next leg of the cyclical recovery back. There is also the lack of conviction that inflation and rates will move higher and that cyclical earnings will experience an above-trend trajectory, even if these are necessary for a more broad-based bull market. As we are not convinced that inflation will move higher and await convincing signals from higher yields, support needs to come from earnings. The consensus for 2021 is for strong growth in earnings-per-share relative to the recession of 2020. Yet, now, the level of projected earnings for the end of next year is not much higher than it was at the end of 2019. As 2020 draws to a close, the news on the pandemic and the global economy – ahead of a vaccine next year – is worrying.
Investors need to be given reasons to be more confident that earnings will eventually rebound robustly next year and into 2022 – and we do generally expect that to occur. However, the story needs to include a recovery in earnings in cyclical sectors and those most impacted by the pandemic. The timeline of when sectors such as airline travel and hotel occupancy will return to normal levels remains unclear. Here is where deployment of vaccines is critical in putting the world on a recovery path to economic normality. The industrial cycle also needs to continue to strengthen to push up the general level of corporate earnings.
There are two other big themes for equities. One is the continued impact of digitalisation and automation across many walks of life. The pandemic has clearly identified this. Online communication, consumption, education and entertainment is replacing many traditional economic activities with implications for small and large businesses alike. The large providers of online services and the technology that supports them will, in all likelihood, continue to deliver superior growth. They will also continue to be a magnet for regulatory and political attention. However, the investment case remains strong.
The other theme is related to the energy transition. This year has seen increased awareness of the need to rapidly reduce carbon emissions. The private sector – corporates, banks, and asset owners and managers – are making big contributions and there will be intense focus on governments at the United Nations COP26 meeting in Glasgow, which is now set to take place in November 2021. In the field of investing, the proliferation of environmental, social and governance factors i.e. ESG, and impact funds, is unlikely to be halted. More interesting, however, is that the technologies being developed around the energy transition can give a boost to the earnings of traditional industrial companies. The biggest manufacturers and users of green hydrogen, for example, sit in the materials and industrials sectors.
Achieving carbon neutrality requires trillions of dollars of investment over the coming years. The key is to mitigate the cost of transition through technological progress and this provides plenty of investment opportunities. These include the ongoing development of renewable energy sources and identifying best-in-class companies across sectors that are developing credible strategic plans to lower their carbon footprint. But the world needs to follow science-based targets and focus on the technologies which will make the biggest impact on lowering the cost curve of the energy transition. Hydrogen as a green fuel, carbon capture and storage, and new ways of transporting and storing green energy are all areas that need investment but can also provide profitable opportunities for the key players.
Exhibit 1: Carbon price still too low
Source: Bloomberg and AXA IM Research, as of 19 November 2020
Public investment needs to sit alongside the marshalling of private capital. There are grounds for optimism here. The incoming Joe Biden-led Democrat Administration in the US will take a very different approach to climate relative to the outgoing government. Domestically this will include a focus on areas such as electronic vehicles and de-carbonising energy. In Europe, a significant amount of the European Union’s recovery fund and budget will be dedicated to green investments. There are interesting developments in countries like Saudi Arabia, and of course, China, which is aiming to become carbon neutral by 2060. Ideally, we might see more international cooperation on things like establishing a global price for carbon. While there are numerous carbon pricing schemes around the world, they are fragmented and mostly don’t reflect a carbon price that is high enough to accelerate the shift away from fossil fuels. The carbon price should rise quite substantially over time, and the existence of financial products based on exchange-traded futures for carbon now provide investors the opportunity to hedge or offset their hard-to-reduce carbon exposures (Exhibit 1).
A sustainable economy is one that can deliver wealth and growth. Reducing climate risks and lowering the cost of energy over time are essential for driving productivity and reducing inequality. As investors, we need to continue putting governments and companies to task by insisting on allocating capital on the grounds of sustainability. For markets, long-term growth is dependent on the continued shifting of the frontiers. Going forward, climate change mitigation could prove as powerful for corporate earnings and equity investors, as digitalisation has been over the last two decades.
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