When it comes to closing the book on 2020, many around the world may want to slam the thing shut. This is understandable following a global pandemic and the many challenges it brought, not the least of which was significant loss of life. Though not as important as the human cost, the economic costs of COVID-19 have been high as well. Looking back, the virus rendered many 2020 forecasts obsolete within the first few months of the year. Even so, we made some key correct calls. We expected accommodative monetary and fiscal policy to continue and posited that a contentious U.S. political season would end without major disruptions to markets. Though 2020 was a year of many challenges, we are optimistic for 2021 and expect improved economic conditions and better times ahead.
2020 closes on an optimistic note as countries around the world begin to administer COVID-19 vaccines. The vaccine-development timelines have been nothing short of extraordinary, as multiple companies were able to develop a vaccine, run trials, receive regulatory approval and begin distribution, all within a year’s timeframe. We expect rapid vaccination in the first half of the year, setting the stage for a vigorous growth recovery to take hold in 2021. The beaten-down services sector should be the principal beneficiary of this return to normal as the in-person economy roars back to life in the post-pandemic world.
By mid-year, we expect certain sectors such as travel and tourism to bump against capacity constraints as long-delayed holidays and other spending finally materializes. The return to normalcy and shift in consumer spending will also lead to greater demand for labour, matching currently unemployed workers with businesses in need of help and drawing more workers off the sidelines. While the Canadian and U.S. unemployment rate may not match their respective pre-pandemic level of 5.4% and 3.5% by the end of 2021, we do expect it to be meaningfully lower than their current rate of 8.5% and 6.7%, with strong momentum. The explosion in debt, which helped economies endure lockdowns, will linger for years, but we believe strong economic growth and low interest rates should minimize its long-term effects.
In response to the pandemic, 2020 saw unprecedented fiscal and monetary actions globally. Global central banks launched multiple initiatives: axing interest rates, developing new policy tools and boosting asset purchases. In parallel, fiscal authorities aggressively supported their domestic economies. The combined fiscal and monetary support proved crucial to global economies and financial markets.
As we move into 2021, these levers of support will remain in place, and in some instances, expanded upon. In the U.S., for example, we expect further financial support from the federal government, with additional stimulus of nearly $1 trillion (5% of GDP); in Canada, further federal stimulus worth 6% of GDP has been passed. While we expect the global economy to recover from its recessionary levels of 2020, we anticipate central banks across the world remaining accommodative for the coming year and beyond. With unemployment still elevated, economic growth potentially being uneven and inflation muted (albeit moving higher), central banks will likely keep accommodation in place to allow for economic growth to take full hold. Despite interest rates remaining at or near their lower bound, central banks still have tools available to further accommodate the recovery.
With continued fiscal and monetary accommodation, we expect a modest increase in long-term global interest rates, as economic slack is absorbed and inflation modestly increases. At the same time, short-term interest rates should remain anchored at their current levels amidst global central banks remaining on pause for the coming year. Global yield curves should thus steepen modestly in 2021. However, with absolute rates remaining historically low, this environment should be supportive for equities and broader risk markets globally.
We continue to have a favorable medium-term view on equities due to our expectations for a vaccine-driven economic recovery and revitalized global corporate earnings in 2021. While earnings in the U.S. were negative throughout 2020, momentum turned sharply positive in the third quarter as a record high percentage of S&P 500 companies reported earnings above expectations.
The fourth quarter of 2020 saw a recovery in Value stocks and Small-Caps, which had lagged their Growth and Large-Cap counterparts significantly over the past several years. Despite this short-term reversal, we recognize that long-term secular trends are at work here and we remain relatively neutral on Value versus Growth, but we overweighted Small-Caps versus Low-Vol stocks as a reflation play.
We moved to an overweight stance on emerging-market equities early in 2020 in light of China’s handling of COVID-19. In the coming years, we expect trade policy to turn gradually less restrictive and the U.S. dollar to weaken, providing further support to emerging markets. Emerging-market central banks will likely be able to stimulate economies if necessary by reducing interest rates given the muted inflation outlook, especially if their currencies continue to strengthen against the U.S. dollar.
We expect the U.S. economy and financial markets to perform well on the fiscal, monetary and vaccine developments discussed above. In past expansions, headwinds often built up as the Fed lifted interest rates to head off inflation pressures. In August 2020, however, the Fed announced a new “average inflation targeting” approach that not only backs away from pre-emptive tightening to contain inflation pressures but actually permits inflation to be above target “for some time.” This policy could play a prominent role in 2021 and beyond as an accommodative Fed provides support to risk assets. For now, the question of whether equity market valuations are “too high” is front and center. It’s important to understand that comparing PE ratios across time excludes many important variables — growth, interest rates, inflation, risk appetite and structural shifts in the market that may have occurred. Our long-term valuation modeling, which includes these considerations, indicates that equities are reasonably priced at current levels.
Despite some recovery following vaccine announcements, oil prices remain one of the worst performing assets this year, down about 25% as demand collapsed while inventories swelled. COVID-induced lockdowns have been a major headwind, but the world was already in excess supply of oil and OPEC+ countries were rationing crude supply to keep prices from falling further. As life and economic activity normalizes into 2022, oil demand should rebound, but at a slower pace than the broader pace of the economy. This will likely leave demand to fully recover only by 2022 or later.
However, COVID-19 will also leave permanent imprints on behaviour, from business travel and work-from-home schemes to green preferences for greater fossil fuel regulation and electric vehicles. Notably, concerns over peak oil being reached within the next decade have only grown, with more and more companies and analysts pulling forward their estimates on timing. This will have negative implications for business capex and growth in the traditional energy sector, whereas less carbon heavy energy initiatives are likely to accelerate.
The Canadian economy has recovered swiftly in recent months, but some of this strength is largely because of an epic debt surge, leaving Canada with the most aggressive fiscal response compared to other countries when measured as a share of GDP. At nearly $400bn (or near 20% of GDP) for fiscal-year 2020/21, with provinces adding about $100bn, it’s no wonder the recession has felt relatively mild for the broad economy. The mirage of free money in Ottawa means the federal deficit will easily run north of $150bn for FY-2021/22 as the economy remains on aggressive health support along with substantial wage and income support programs.
Another reason behind our thesis for expecting Canada’s economic performance to lag the U.S. and global rebound is due to the longer-term scarring from depressed oil prices. For Canada, investments in traditional energy, which peaked in 2014 will likely fall further. While infrastructure and green-energy projects will accelerate in the years to come as Canada focuses on promoting less carbon-heavy industries, we don’t think it will suffice to replace the lost investments from traditional energy as green projects are less likely to attract foreign capital than the oil boom did.
Our third concern is the over-reliance on housing investment in the economy. At 9% of GDP, housing investment has surpassed business investment (8% of GDP) for the first time. Although we think the housing market will get additional tailwinds when immigration resumes in 2021, we think the lack of breadth in the drivers of growth poses some challenges to sustained growth going forward. Our positioning in 2020 as reflected our macro concerns and we have been underweighting Canadian equities during most of 2020 with a small overweight to interest rate duration.
As we expect a great normalization in 2021, those regions and sectors that have suffered the most from the pandemic could have the most to gain. On this basis, Europe should have a strong upside: it has suffered a much greater loss in terms of GDP and corporate earnings than either China or the U.S. However, Europe has been a serial disappointer for growth and this is the main reason why we’ve been underweight EAFE equities. Overweighting Europe also involves a sectoral bet since it has a much smaller tech sector and a large financial sector. Therefore, our strategy is to be ready to overweight Europe but only after we see clear evidence of economic and earnings outperformance
EM countries look poised to benefit from a global economic recovery in 2021, with rates of growth again superior to those of developed markets. Debt-fueled fiscal expenditure and accommodative monetary policy should help to achieve this growth, albeit indirectly, as developed economies have more flexibility in both forms of stimulus. Macro improvements are already seen in trade and manufacturing — especially in East Asia — and we expect them to continue, notably in markets that were not as harmed by COVID-19 in 2020 and have a strong tech focus (e.g., China, South Korea, Taiwan).
While COVID-19 dominated the financial news throughout the year, we also note that responsible investing continued to gain traction in the industry, with a focus on environmental, social and governance (ESG) criteria and the development of strategies that can positively impact the world. We are highly confident these trends will flourish, and we are committed to expanding our set of ESG solutions for BMO clients.
After a challenging 2020, we are optimistic 2021 will be much better although it may take a few months to get the pieces in place for a pronounced recovery. In terms of positioning, we expect accommodative policy and a vaccine-driven recovery to support risk assets. As a result, we are currently overweight equities and underweight fixed income, and continue to prefer U.S. and EM equities vs Canadian and EAFE markets.
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This report has been prepared by the BMO GAM Multi-Asset Solutions Team (MAST) and is intended for informational purposes only. This report represents their assessment of the markets at the time of publication. Those views are subject to change without notice as markets change over time. The information contained herein is not, and should not be construed as, investment, tax or legal advice to any party. Investments should be evaluated relative to the individual’s investment objectives and professional advice should be obtained with respect to any circumstance. Past performance is no guarantee of future results.
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