Feature Stories | Apr 23 2021
As several economies regain pre-covid levels of activity and the world transitions to stimulus from support, this time may be different due to a more enlightened attitude towards fiscal and monetary policy.
-A globally coordinated economic upswing in 2021
-Equity preferences by sector, style and individual stocks
-Technology/Innovation investment opportunities
By Mark Woodruff.
A revival is essentially already underway on a global basis. World GDP has grown each quarter since the middle of 2020 and several economies will regain pre-covid levels of activity this year, including the US, while others should pass that mark early in 2022.
In the US, the federal government is providing a boost to economic growth via the passage of a $1.9 trillion support package to stimulate the economy and further plans for a huge infrastructure package.
Elsewhere, government support in the UK, the EU, Japan and China is also significant and will likely persist into the expansion phase in an attempt to avoid the austerity measures implemented in the wake of the GFC.
Simultaneously, central banks have made it clear that they won’t be raining on the cyclical recovery parade, given their commitment to achieve, or even temporarily overshoot, inflation targets. They now have a wider agenda which includes engineering employment gains that permeate through all parts of society.
This pro-cyclical shift of both fiscal and monetary policy has implications for the interplay between asset classes.
Before looking at how portfolio managers worldwide are adjusting their asset class exposures, let’s first examine expectations for world growth and inflation.
The manufacturing sector has rebounded rapidly and has continued to steadily expand through the more recent lockdowns. As a result, industrial production is already nearly back to pre-pandemic levels in many major economies. Also, spending on retail goods is well ahead of pre-pandemic levels in countries such as the US, where income support has been greatest.
Previously, Aviva Investors had an above consensus growth outlook for the world economy. In its latest assessment, the level of global activity at the end of the first quarter 2021 is roughly in-line with those prior expectations as weakness in Europe is offset by strength in the US and China.
As the investment manager looks further into 2021 and 2022, a somewhat faster pace of recovery is expected than previously. It’s now forecast that global activity will reach the pre-covid trend by the end of 2021 and growth will be around 7% in 2021 and 4.5% in 2022, with risks to the upside.
The key to delivering this rapid pace of recovery is both the success of vaccine roll-out and subsequent reopening of economies, alongside continued fiscal and monetary support.
Morgan Stanley sees inflation only modestly overshooting key central bank target levels. Also, rising inflation and interest rates are considered normal at this point in the economic cycle. Nonetheless, there is caution against a disorderly or rapid increase in interest rates caused by an inflation shock.
The output gap is an economic measure of the difference between the actual output of an economy and its potential output. A negative gap means that there is spare capacity, or slack, in the economy due to weak demand.
While spare capacity remains in most economies, underlying inflationary pressures are expected to be muted. However, Aviva Investors expects spare capacity to be eliminated much more quickly than in the recovery from the global financial crisis of 2008.
In the US it’s expected the output gap will turn positive by the end of 2021, with the eurozone to follow around a year later. That could put upward pressure on underlying inflation in 2022 and beyond, something that the investment manager thinks would be welcomed by central banks, so long as it is not excessive.
Thus, even with an economic recovery and upward pressure on inflation, Aviva expects monetary and fiscal policy to remain supportive. Central banks are expected to delay any tightening in policy until inflation has moved above 2% for a period. And looking beyond the pandemic, many governments are planning to increase spending on public infrastructure, as well as in other areas, to stimulate future growth.
Is it different this time?
The nature of the covid crisis has had a seismic effect on the way politicians and policymakers see their role in society, explains Aviva. The Washington Consensus that emerged in the 1990s has largely given way to highly interventionist demand management policies that have the potential to persist far beyond the crisis itself. If that turns out to be the case, then this time really is different.
The need for much of the direct fiscal support should diminish automatically. However, countries are using the covid reset, alongside the more enlightened attitudes towards fiscal policy, to rewrite the policy agenda. The US, for example, after passing the recent stimulus program, is quickly refocusing on a potentially huge and ambitious public spending package.
Everywhere traditional parameters and targets of fiscal policy are changing. In general, we seem to be evolving from support to stimulus. Some moves are reasonably conventional though overlooked for several decades. Infrastructure expenditure is an example, but even here there are important changes such as increased emphasis on the green agenda and the digital revolution.
However, some fiscal policy has an entirely new slant, notes Aviva. Countries are adopting or considering fiscal initiatives in new arenas, reflecting novel societal objectives in areas such as climate, diversity and inequality.
In general, fiscal tools seem to be reasserting themselves as key policy weapons, having been stuck in the doldrums for several decades.
Financial markets are starting to query the exact timing of an exit from the current extreme stimulus policy stance though have largely accepted that there will be minimal changes in the short run. The timing (and eventual degree) of any decisions that are made in coming years will also be fundamentally influenced by the adoption of a new monetary policy regime in many key geographies.
The Federal Reserve in the US has been at the forefront of these changes, unambiguously adopting an average inflation targeting (AIT) policy. Essentially, this will allow the Fed to balance inflation undershoots with intentional inflation overshoots. Other central banks have not yet been as bold, but are clearly moving in a similar direction.
This represents a major transformation in the way in which monetary policy is conducted, points out Aviva. It is perhaps the most important change since inflation targeting became the norm in the 1990s. While not yet certain, it could change the inflation and policy landscape fundamentally.
Equity allocations across styles and sectors
Given the above growth outlook, Aviva Investors prefers to be overweight global equities. There is a further leaning towards the both the US and UK markets, where domestic growth differentials, strong policy support and strengthening global trade should be supportive.
The most positive environment for equities, characterised by rising breakeven yields but falling real yields, is arguably behind us. Equity returns should slow from here but remain positive as real rate pressures on valuations are balanced by a bright outlook for earnings.
Having correctly predicted three months ago that value and cyclical stocks would outperform high-growth stocks, the asset manager expects that trend to continue. Steeper yield curves, in combination with a positive cyclical outlook, also leads to the maintenance of cyclical equity exposure to the Energy and Industrials sectors.
Brandywine Global are in full agreement with Aviva regarding value stocks. The US-based investment manager points out that while there has been a rally in recent months, the relative multiples of value stocks are still near all-time lows.
Higher interest rates are expected to help sectors with large exposure to value, like Financials, and hurt the high-flying momentum stocks where multiples have gone to extremes. There is also some evidence that “value” is becoming the “momentum” trade as well, which creates a powerful combination. Bank stocks, in particular, do well historically when short rates are stable and longer rates are rising.
Active management is as crucial as ever given many of the fastest growing/highest multiple stocks may be more challenged than in the recent past. According to Franklin Templeton, these companies now need to deliver on the promises implied by their rich valuations, and many simply won’t.
Despite this, there are still opportunities across many high-growth companies and the global investment firm believes the discounted cash flow methodology is the best way to determine a company’s intrinsic value, as it differs from standard multiples that do not incorporate growth.
Morgan Stanley reminds us that the Equity Risk Premium is at a decade low which, along with record high multiples, means the key driver for equity market returns from here will be corporate profits.
The investment bank believes sectors that should benefit from higher economic growth, inflation and interest rates are Materials, Financials and cyclical technologies like semiconductors and industrials. This rotation comes at the expense of interest-rate sensitive equities like those in defensive sectors (utilities and infrastructure) and large-cap secular growth names.
Looking even further out, while simultaneously calling upon the lessons of history, MFS expects that as policy normalises, investors will pivot back to cross-cycle earnings-compounders that make up many a portfolios’ core holdings. Cyclicals will have had their day, as they often do in the early phases of a market cycle and secular trends will win out in the long run, explains the American investment bank. This will reward patient investors as the cycle matures.
There has been stronger-than-anticipated activity during the fourth quarter 2020 and the start of 2021. In addition, the US has had a rapid vaccine roll-out and the passage of another very large fiscal support package. Consequently, Aviva Investors revises up growth expectations for 2021 to 6.5%, with risks tilted to the upside. This is with the conservative assumption that only around 15% of household excess savings are drawn down in 2021, with the possibility this could be materially higher.
The investment manager also revises the inflation outlook modestly higher, reflecting a more rapid elimination of spare capacity and a more positive outlook for the housing market. Despite these changes, it’s not expected the Federal Reserve will raise interest rates before 2023.
The Australian economy continues to be supported by high excess household savings which has supported consumption. Morgan Stanley estimates Australian households have around $200bn in excess saving which is equivalent to around 10% of Australia’s GDP. This has also been helped by a very strong labour market recovery, with employment returning to pre-covid levels in February 2021.
Housing related activities (construction and sales) remains bifurcated with detached houses leading activity. Apartment activity, on the other hand, continues to suffer from closed borders, which limits overseas student and tourist arrivals.
Policymakers remain growth-focused, with more government stimulus expected in the May Budget, and the Reserve Bank of Australia (RBA) committed to keeping interest rates at current low levels for several years.
Over the March quarter, Morgan Stanley has increased the allocation to growth assets based on expectations of higher equity markets in a year’s time. Specifically, the investment bank continued a preference for International Equities over Australian Equities on expected stronger cyclical upside and better relative policy support.
Within the International Equity allocation the overall hedged position was increased and a preference was expressed towards Japan and also to the Value style. Within the Australian Equity allocation the lean towards Value was maintained via Resources and a tilt toward Financials was introduced.
Westpac Bank expects the Australian economy to expand by a well-above-trend 4.5% in 2021 and increase by 3% in 2022. This will be a recovery from the covid-related -1.1% contraction during 2020.
Even on these upbeat forecasts, output at the end of 2021 will still be -1.5% below that expected in the absence of covid. The key dynamics shaping the outlook are a spending catch-up (the pent-up demand created by the temporary covid restrictions) and a strong tailwind from policy stimulus, which has led to a booming housing market.
The upcoming May 11 Federal budget will likely see another round of stimulus, suggests Westpac. With the 2020/21 Federal budget deficit tracking well ahead of forecast, there is believed to be flexibility for new measures.
Europe’s economic recovery has spluttered over the first three months of the year. The underwhelming vaccine rollout, an alarming third wave and an extension of lockdowns have combined to quash demand in the first quarter. This places Europe on the cusp of a second technical recession, according to strategists at Westpac Bank.
The most significant constraint upon demand has been lockdowns for the first three months of the year, which has delayed the reopening rebound that was set to follow the -0.7% contraction in the fourth quarter. Compounding this, Europe’s vaccine rollout has been lacklustre, crimped by supply constraints, a slow authorisation process and vaccine suspensions on health concerns. With little capacity to spend or invest since the start of the year, the Euro Area is poised for another contraction in the first quarter.
However, the activity outlook for the second half remains upbeat with Europe expecting a significant increase in vaccine deliveries in the June quarter. With furlough schemes and fiscal support continuing to cushion the consumer, a softer profile early in the year will be met by a brisk rebound in the second half. Westpac is looking for year-average growth of 4.2% in 2021 to be followed by 3.9% in 2022.
Fiscal and monetary policy is expected to remain supportive while underlying inflation is forecast to stay contained.
Aviva Investors largely agrees on the rebounding outlook. Despite lockdowns and slow progress on vaccination, encouragement can be taken from the experience in the fourth quarter when restrictions on activity did not have as large an impact on output and demand as had been feared.
The renewed national lockdown imposed in early January is likely to result in a small fall in GDP in the first quarter. However, the outstanding progress on vaccinations since December has boosted sentiment and should allow for reopening of the economy as scheduled and usher in a convincing rebound in activity in the second quarter and beyond.