With COVID-19 fading as a cyclical driver, global output is likely to rebound strongly. Consequently, we have revised our expectations for global growth from 4.8% to 5.9% in 2021—roughly twice the pre-pandemic norm. Coupled with the new US administration’s sizable fiscal stimulus, we have also lifted our expectations for US growth in 2021 from 4.9% to 6.5%.
Vaccine rollout and fiscal stimulus will help set the pace of the global recovery. The US is well placed on both; Europe less so. China has already made a full recovery, with stability now the watchword.
We think the world is on the cusp of a new, higher, inflation regime. But large output gaps and anchored inflation expectations are important hurdles to a sustained near-term increase—notwithstanding a temporary spike in coming months.
Monetary policy rates in developed markets should be on hold until at least the end of 2022. But bond yields are now the battleground. We expect central banks to push back against a further rise, but that won’t prevent markets from testing their resolve. We believe investors should expect more volatility.
Equities are experiencing a pro-cyclical rotation to value, following a long period of growth outperformance. For the past two years at least, P/Es dominated as the driver for S&P 500 returns. But since the start of 2021, earnings have taken the lead. The potential for a rising-rate and inflationary environment should benefit risk assets, like stocks. During such periods over the past 50 years, the S&P 500 has generated an annualized average of 16% returns. But with so many unresolved pieces of the economic puzzle, we believe investors should be selective, focusing on companies with high and stable profits, positive EPS revisions and strong free cash flow. Quality is a durable and universal characteristic, so it can be rewarding to look beyond style and US stocks. In fact, over the past decade, among the top 50 performing stocks around the world, three-fourths were non-US.
Concerning bond yields, the Fed has been surprisingly relaxed about rising yields. But the Fed may be approaching the limits of its tolerance, especially if equities come under pressure. European and Japanese yields, however, are anchored. As the US yield curve steepens, credit sectors should perform well. High-yield spreads are tight and may remain so for some time, but tight spreads (below 400 basis points) have been more typical over the past 25 years than wider spreads. High quality and shorter duration high yield may likely offer better relative value and downside protection. Still, we see a blended credit portfolio—including emerging markets and securitized credit—offering a better income-to-risk profile than just US high yield. For municipal bond investors, the first quarter brought strong inflows on the back of massive stimulus aid to cities and states. Muni credit in particular offers investors attractive levels of income and benefits from the stimulus, and we continue to find that a credit barbell strategy appears favorable over a portfolio of AA Intermediate munis.
COVID-19 remains a key risk if mutations multiply and override current vaccine potencies. Another concern is the potential for central banks’ failure to control the reflation narrative, making the rise in yields disruptive. Investors need to keep a close watch on the historical warning signs of inflation: rapid demand growth when supply is impaired; explosive money-supply growth; and fiscal stimulus.
Despite the many factors that could trigger disruptive volatility, the improving economic trajectory offers opportunities for investors who are discerning and selective.