The Monthly View – December 2020

Ending The Year Positively

In November global stock markets rallied strongly on the news that Biden’s election victory was convincing enough that it will be very hard for President Trump to overturn the results. Combined with a likely republican controlled senate this is seen as a positive for the markets as Biden will most likely provide more economic stimulus, but he won’t be able to raise taxes.

The second piece of good news was the announcements from several pharmaceutical firms that they have a vaccine ready for distribution and that these vaccines might be more than 90% effective.

While we remain positive on equities over a 12-month horizon, we would highlight three vaccine-related risks that investors should be aware of.

First, immunizing most of the world’s population could prove logistically challenging, especially considering widespread skepticism about the safety of the vaccine.

Second, the virus could mutate in a way that undercuts the efficacy of the vaccine, as recent unsettling news from Denmark demonstrates.

Third, is that someone prematurely dies after taking the vaccine, which would make people less willing to be vaccinated.

Vaccine Optimism

Vaccine optimism could, ironically, lead to weaker economic growth in the near term as it could reduce the urgency around extending fiscal support. Even if it does lead to stronger growth in the medium and longer term.

The macro outlook for the next six months is relatively clear as the pandemic will cause a renewed slowdown in global growth.

But the key for markets is what happens in the second half of next year, once the roll-out of vaccines allows the global economy to return to normality. The Fed is likely to stay dovish for a long time, which will be highly supportive for risk assets outperforming.

Fiscal and monetary stimulus typically take about 6-18 months to have a full impact on the economy. The stimulus in the second quarter of this year was more immediate in terms of preventing mass layoffs and bankruptcies, but it will continue impacting the broader economy in late 2020 and will continue throughout 2021. U.S. money supply and monetary base growth have not been higher since the 1940s.

Strong economic reflation is to be expected as money supply expansion like this without economic growth and inflation to match would be very unusual.

Inflation Outlook

Inflation is unlikely to rise much over the next two years. However, inflation could rise significantly later this decade as unemployment falls below pre-pandemic levels and policymakers keep both monetary and fiscal policy accommodative.

Many of the structural factors that have depressed inflation are going into reverse: Baby boomers are leaving the labor force, globalization is reversing, and social tensions are running high in many countries because of income inequality.

Monopoly power has grown, especially in the tech sector. This has had a deflationary effect in the past but could take a more inflationary tone in the future.

In the second half of this decade (5 years from now), inflation could potentially average as high as between 3% and 5%. However, we need to keep in mind that inflation is not a linear process. Once it starts to rise, it becomes very hard to control. In this regard, the experience of the late 1960s is instructive. Through the 1960s economic boom, inflation was well behaved, contained between 0.7% and 1.2%. Then it started to rise in 1966, and quickly hit 6.1% by 1970.

While the average-inflation target the Fed recently adopted is well intentioned, in an environment where governments are unlikely to curtail deficits, it could easily unleash a long-term inflationary trend. And this would have a significant impact on fixed income and equity markets.

Commodities Outlook

Commodities will profit in the medium to long term, first from the economic recovery and longer-term from inflationary pressures and potentially a weaker dollar.

The Fed is committed to maintaining an ultra-accommodative monetary policy indefinitely, which, along with the U.S. government’s ever-expanding budget deficits, will keep the supply of money and credit extremely high for years. This combination will also continue to support precious metal prices.

Other important trends for commodities are the global trend towards the more extensive use of electricity, for example electric cars but also the use of electricity for many other applications like for heating homes instead of using heating oil. The buildout and modernization of China’s electric grid as it embarks on its 14th Five-Year Plan in 2021 is also important. Similar efforts are arising globally. This could be very important for base metals prices, particularly copper and aluminum.

Investment Conclusions

The path to ending the pandemic is likely to be a bumpy one. Nevertheless, the balance between risk and reward still favors overweighting equities versus bonds over the next 12 months.

Within the equity portion of a portfolio, we expect non-U.S. international stock markets to catch up to the U.S. market. And it is also likely we will see a shift from high growth stocks to value stocks.

Growth stocks benefited from the pandemic and from falling bond yields but will suffer as yields rise, even modestly, from current levels and investors shift exposure to stocks that will benefit from the reopening of economies.

Equities have run up nicely since the start of November. Bullish sentiment has surged in the American Association of Individual Investors weekly bull-bear poll. Given the likelihood that economic growth could surprise on the downside in the near term, equities are vulnerable to a short-term correction. Market sentiment can sometimes change quickly, as we have seen before. This is often triggered something unexpected like Brexit turning ugly or that the Democrats win both senate seats in the Georgia run-off election. These are two events that the market currently isn’t expecting.

But if something like this would happen, it would not derail structural economic trends. Even if we would experience short-term volatility we would remain fully invested.

The approval of an effective vaccine and continued easy monetary policy keeps us bullish on stocks over a 12-month horizon.

We still think a diversification into commodity assets as a long-term play is something to consider going into 2021.