Dan Chornous, Chief Investment Officer, provides his outlook for capital markets.
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What is your 2021 outlook for the global economy?
Dan Chornous:In a year of surprises, not all of them bad, one good one has been the resilience of the global economy. You know, there’s been massive support from fiscal authorities, special programs from monetary authorities, special programs to keep people at work or subsidize those that can’t work. And the result of this is an economy that we thought originally might shrink by as much as 7% on an annual basis in the United States is likely to shrink only by half that amount. And rolling into 2021, we now have a vaccine. We have confidence. A real chance that we can get back to a normal economy as the year progresses and a symmetric recovery. We’d look for something like 3.5% to 4% growth in the United States, a little stronger in Europe, and something between those two numbers in Canada.
Now longer term there are risks to the global economy. Of course, we’re just navigating Brexit as we speak. We still don’t know how that will turn out. There are, of course, tensions with China, global trade, and a variety of other problems. And as we look into the very long term, many of the things that we attribute to COVID-19 and the pressure in the economy are just reinforcing trends that were in place anyway: aging demographics in the industrialized world, the emergence of the emerging world, the convergence of the emerging world with developed world growth rates and smaller family size that results from that. All these things come together to lower the long term rate of growth that we can expect to see out of the global economy.
Still, looking into 2021 and a bit beyond, we should put this behind. The further we get into 2021, the more normal the economy should be and we should look for 3.5% to 5% growth in the developed world.
What is your outlook for interest rates and bond yields?
With the pandemic still in place, at least through part of 2021 and output gaps in existence pretty much everywhere on the planet, there’s absolutely no reason to raise short-term interest rates, at least through the forecast horizon. That would take us out until this time at the end of next year. Even looking beyond that, we don’t expect rates of growth or inflation to pick up to levels that will put much pressure onto the short end. So that’s a fairly stable and very low outlook for a long time. Move out the yield curve though and we would expect, as the economy normalizes, especially beyond the second half of or into the second half of 2021, that there’ll be some upward pressure on market interest rates or nominal interest rates, but perhaps by not as much as you might expect.
There’s both near-term and structural forces in place that should hold the pressure on long-term interest rates to a very low level. You know, real rates of interest form the basis of all rates. You know, the real rate is now negative numbers. It’s been around minus 1% for a long time, at least since COVID-19, but it’s been coming down for the last 40 years. This is because of structural change in the economy, which again has been reinforced by changes through the COVID-19 period. Now, if you remove that, you have aging demographics, you have an emerged emerging world, and you now have high government debt loads, all which will work to hold down the long-term sustainable growth of the global economy.
We think that even as real rates start to move higher in a more normal, sustainable, or self-sustaining global recovery, we’re unlikely to move much above zero percent and maybe not much above 1% over the next five to ten years. So that limits the near-term pressure on long-term interest rates which are now call it 80, 85 basis points, not even 1% in the United States, to perhaps lifting to 1% in a more normal environment by the end of 2021 and similar pressure on 10-year yield elsewhere.
What is your outlook for equities in 2021?
One of the great surprises of the COVID-19 period has been the strength of the stock market, and the U.S. stock market especially. Over the last 12 months, it’s up over 18%, and none of us would have believed that possible back in March or April of 2020. That’s moved valuations for the S&P 500 to levels that we haven’t seen since the tech bubble in 1999, 2000, and many forecasters are quite concerned. Obviously, that needs to be monitored but there’s some important context.
First, the rally has been very, very narrow until fairly recently. While the market expressed by the S&P 500 Index is up 18%, if you simply took the biggest stock out of it—Apple out of it—it’s up only 15.2%. And if you took the five largest winners out of it, the market’s only up 8.2% in the United States. Now, fortunately, that market is now broadening, which gives us an indication that investors are believing in the emergence of a self-sustaining recovery at some point, probably early in 2021.
We’re also seeing, you know, other measures of valuation not as acute. One of the problems with the current measurement of valuation is that the types of firms that have led and now dominate the S&P 500, the world’s largest market, are difficult to value in a traditional accounting sense. They’re high on IP, low on hard assets, and so GAAP accounting is less useful in establishing what the future wealth-creating capabilities of those firms are.
While we could look away from price-earnings ratios, which are GAAP accounting-based or heavily influenced by GAAP accounting, things like depreciation and amortization, use instead price to cash flow as the measure, and on that basis, the U.S. market, even the large-cap U.S. market, is essentially normally valued. We could look beyond the United States to European and emerging markets and see that while they’ve rallied strongly off the bottom, they’re not at all-time highs as the S&P 500 is and actually, their valuations are quite attractively placed.
So valuations by themselves present a greater hurdle to future gains in stock prices but not an insurmountable hurdle. In the United State especially, we look for something like 20% gains and earnings in 2021 as we hit the self-sustaining recovery. So we believe that even in the United States, but especially elsewhere, we could see high-single-digit returns in 2021 and perhaps a little higher in the more depressed markets the further away we get from the U.S.
What factors will drive equity performance in the New Year?
Way back in the summer of 2019, and doesn’t that seem like a long time ago, the market was consolidating gains it had put on the board in the late winter and spring. We put a list together that we felt the indicators that we would expect to see flashing if it was to be a sustainable move for the market. We thought that since it had been led by growth, and especially mega-cap growth at that point, that a big new move would need new leadership and that leadership was likely to come from more value-oriented stocks which had lagged for the better part of a decade at that point.
We thought also that mid- and small-cap stocks which had lagged mega- and large-cap stocks for so long would also start to move to the fore if this was to be a sustained move. In the economy, we expected to see a sustained move validated by a steepening yield curve, maybe a falling U.S. dollar, and around the world we expected better leadership, better performance out of non-U.S. markets than the domestic market. But this little tick list and actually, those things were starting to flash green around Christmas of 2019 and then, of course, came COVID-19 and the deep, deep decline in stocks prior to the recovery.
We took that tick list out a few weeks ago as the market was piling on gain after gain and what do you know, many of them are happening right now. We have seen a bit of return to more value-oriented stocks. There’s been a broadening out of the rally from the very narrow list of mega-cap, global tech stocks that have led the market to here. We’ve seen better performance out of international markets, including some of those that are troubled by Brexit, like Europe and the United Kingdom, and certainly better performance out of emerging market stocks lately. These typically come at the early stage of a sustainable rally.
While the yield curve is certainly not steep, it’s steeper and the U.S. dollar has been weak. So that tick list, well, it’s been pretty good. So we feel comfortable with our overweight in equities as we head into 2021. In fact, as we look at asset mix, for a long time now we’ve had underweights in fixed income and we’ve progressively pushed our overweight higher on stocks. And we’re comfortable with that as the economy hits a more normal and sustainable stride into next year.
What are some important lessons investors can learn from 2020?
There are many lessons that investors take away from the pandemic period of 2020. I’d like to focus on two. The first one is obviously the importance of establishing an investment plan before a crisis hits and then sticking to that plan, being responsible to it during the crisis period. Those that shuffled assets dramatically during March were not there to reap the benefits of the strong recovery that followed. So develop a plan when things are calm and stick to it when they’re not.
I think a second aspect as we move into 2021 is also worth considering, and that’s that there is long-term change, sustained change in the returns that we can expect from various asset markets and the way that those assets will work together going forward. You know, since at least 1980s, packaging bonds with stocks has been an ideal solution for many investors. Bonds gave you cash flow and they gave you protection against the volatility of stocks when stocks tumbled in a bear market. It’s been a really reliable solution through the last four decades.
We enter the next period with rates near 1% or even lower, and that has a variety of implications that I think we have to consider and respond to and we need to respond to those things now, right. It means that cash flows from bonds, the income portion of the portfolio, won’t be anywhere near what they were like over the last 40 years. And as interest rates sink to near zero, the duration of bonds increases so the volatility asset changes. It means that they won’t provide the calming influence on portfolios that they have. And most importantly, they’ll have a higher correlation to equities going forward they have in the past so they won’t cushion the portfolio as much as they have during decline phases in the stock market.
So what’s an investor to do? First, I think that lengthening time horizons to the extent that’s possible is a good idea. The longer we can look out into the future the more that we’ll be able to take advantage of the normal decline but followed by recoveries in risk assets. To the extent that one can, the first response to very low-interest rates may well be some type of increase in equity exposure along with a lengthening time horizon for the investment plan.
Within fixed income one could look to move out of sovereign bonds with at least some of the investment that sits there and move into investment-grade securities, perhaps some high yield in measured amounts, even emerging market debt.
And then there’s this white space that opens up between the traditional role of bonds and the go-forward and past role of equities. That white space is the ‘what can we recapture’ that sovereign bonds used to offer us and that being cash flows, low correlation to equities and drawdown protection.
Well, there’s things like mortgages perhaps. We’ve put commercial real estate into some of our funds offering higher cash flows than bonds and lower volatility than equities. Some absolute return investments may well serve investors well. The real point here is that for the last 40 years that bond/stock mix, sometimes an even mix, as I said, has served investors very well. That needs to be rethought right now because returns and correlations aren’t going to be what they have been since 1980.
Thank you.