Brace for strong growth - 2021 rebound set to surprise
An increasingly successful vaccine roll-out, the passing of a massive US fiscal stimulus, and recently less hawkish China policy outlook all suggest that 2021 will deliver the strongest growth momentum in over two decades. With inflation set to spike near term on the back of rebounding oil prices—helping to encourage bond yields higher—the coming months could see an uplift in volatility. This may provide opportunities to strengthen portfolios ahead of likely moderating inflation in H2 2021 and better equity valuations, as macro growth drives earnings uplifts.
Global growth is set to rebound at a pace not seen for decades
Over the past couple of months, there has been increasing evidence that global growth will surprise positively in the year ahead. For many investors, this could be the fastest pace of economic activity they have ever experienced (noting 2020 was potentially the sharpest contraction since the early 1900s).
As shown in the first chart below, averaging forecasts for UBS, the Organisation for Economic Co-operation and Development (OECD) and the International Monetary Fund (IMF) delivers an estimate of 5.9% growth for 2021, which is the fastest growth in at least two decades. Highlighting the likely momentum, China’s Q1 output (due mid-April) is expected to show growth of around 20% relative to a year ago. Now, of course, China’s lockdowns were in Q1 2020. For most of the rest of the world, where lockdowns dominated in Q2, China’s data is a bellwether of the strength of the growth rebound expected for major economies, including Australia, when Q2 data is released later in the year.
“The outlook for growth has improved almost everywhere… indicat[ing] an unprecedented boom …the pre-crisis growth level is expected to be regained much sooner than had been expected”. - Societe Generale
What’s driving the improved growth prospects?
A quickening pace of inoculations globally. Vaccines are proving to be more effective in terms of new-case prevention than in their testing phases, while also leading to a dramatic fall in hospitalisations (see second chart below). As estimated by UBS, since late January, the share of the developed population projected to be vaccinated in 2021 has increased from 38% to 72%. In emerging markets, the share has only increased from 5% to 28%. Europe has also lagged in terms of its inoculations. Still, despite expectations for a Q1 contraction, forecasts continue to point to a strong rebound for 2021 growth in Europe (Credit Suisse is forecasting 4.4% and UBS 4.3%).
A much larger-than-expected US fiscal stimulus. At USD 1.9 trillion, the Biden administration’s COVID-19 relief package was larger than earlier estimates of around USD 1.0 trillion. Estimates suggest around 5% of this stimulus will be delivered to the economy before September this year. Not only will this drive faster US growth in 2021 (with Société Générale now forecasting 8% and UBS upgrading from last December’s 4.0% forecast to 6.6%), but strong demand growth in the US will also spill over to stronger export and production demand in Asia and Europe.
China delivers a less hawkish policy outlook. At the 14th National People’s Congress (NPC) in mid-March, China’s authorities delivered a less restrictive policy outlook for 2021. Any tightening of policy, including for the property sector and credit availability, were less significant than expected. Together with recently much stronger-than-expected January and February activity data, expectations for growth in China have been raised (UBS has lifted its 2021 forecast to 9.0%, joining CBA at 9.2%). Strong China growth will also be a positive for the rest of Asia and Australia.
“Over the course of my career, there have been a handful of times when I felt the logic for calling a top (or bottom) was compelling and the probability of success was high. This isn’t one of them”. - Howard Marks, Oaktree Capital Management
What’s the outlook for Australia?
Australia’s outlook also continues to improve, with stronger-than-expected growth and jobs data over recent months leading to forecast upgrades for 2021 and 2022. While sentiment has been supported during Q1 by easing mobility restrictions, the recent still minor outbreak in Brisbane could temper optimism. Still, Australia’s vaccination program is also now accelerating. As we noted last month in our property outlook, spending will also be supported by fast gains in home lending and house prices. A sharp drop in unemployment to 5.8% in February (from 6.3%), well below its 7.5% peak, has led both UBS and CBA to lower their end-2021 forecasts (to 5.5% and 5.75% respectively). Latest estimates point to growth of 4-5% for Australia in 2021 (UBS is targeting 5.0%, up from 4.3%, while CBA is forecasting 4.4%).
Challenges remain, including a near-term inflation spike
There are, however, several challenges to the global growth outlook. In particular, the recent resurgence of the COVID-19 virus in a number of emerging economies, namely, Brazil, India and South Africa, has the potential to dent H1 2021 growth for a large region of the world. However, an accelerating vaccine roll-out in H1 2021 should support better-emerging market growth in H2 (as will strong external demand from the US and China).
More broadly, there is also the residual risk that a mutation of the virus will delay the growth recovery, as variants of current vaccines are developed. This could impact global consumer confidence and the willingness of governments to open for international travel, expected late this year. The risk of a geopolitical event over the coming year also remains elevated.
Nearer term, the next few months are likely to be dominated by a significant spike in inflation. For Q2, inflation in Australia (see above chart) is forecast by UBS to jump from 0.9% in Q4 2020 to 3.2% (above the inflation target). For the US, UBS is forecasting headline inflation will rise from 1.7% in February to 2.5% in March (due 13 April) before peaking at 3.5% in May (before receding to 2.4% by end-year). Core measures of inflation are seen more contained.
“Oil prices will drive headline inflation to scary levels in the coming months”. - Societe General
In expectation of this, global bond yields have already moved higher in recent months (with the US 10-year Treasury yield rising from 0.92% to 1.74% at the end of March). Indeed, as Janus Henderson Investors notes, the Australian bond market (following US trends) had its worst month in February since 1983, returning -3.58%. There is significant uncertainty whether markets will react further if and when inflation appears. There is a risk bond yields could move above 2% in Australia and the US in the short term, having a potentially negative impact for risk assets, but also reinforcing the growth-to-value rotation that has already been material for equity markets.
“So far, the bond market turmoil hasn’t extended into risk assets (equities, high yield, investment grade credit, etc.), but the conditions are fast brewing for this to occur if central banks do not intervene in a coordinated fashion.” - Janus Henderson Investors
Central banks and most economists view this pick-up in inflation as ‘transitory’ —to use the US Federal Reserve’s (Fed) language. The Reserve Bank of Australia (RBA) also reiterated in March that it will not raise rates until “actual inflation is sustainability within their 2 to 3 per cent target range”.
So, why are central banks and economists relaxed?
- Oil prices fell to close to zero a year ago, and their rebound to USD 70 is driving much of the March/April spike in headline inflation.
- A re-opening of economies will only create passing price pressures, as consumer spending picks up faster than business production.
- Unemployment rates today are still above pre-pandemic levels, a time when central banks were failing to lift core inflation to their targets.
- The deflationary impacts of ageing and tech disruption remain in play and will continue to put downward pressure on core pricing.
Together, these factors suggest developed economy central banks will be able to continue to flag that hikes in policy rates remain many years away. For the Fed and RBA, they are targeting their first hikes in 2024. That said, it is likely that prior to lifting interest rates, central banks will begin by ‘tapering’ their bond purchases. When the Fed did this in 2013 it destabilised markets.
There is wide debate over when central banks may begin to withdraw liquidity and the impact this may have on equity markets. UBS continues to target Fed tapering in September this year (announced in June), while CBA believes no tapering will occur before end-2022.
Does the growth surprise point to further earnings upgrades?
While price/earnings (P/E) ratios can be a relatively poor guide to timing equity investments, their current elevated levels, well above historic averages, continue to challenge sentiment (see table below). However, given the strength of the economic recovery, as discussed, we believe it is likely there will be further upgrades to corporate earnings estimates in the period ahead. In particular, we expect earnings growth in 2022 to be revised higher during 2021. Key to this is our sense that current estimates do not fully capture the operating leverage many businesses will experience, given the significant cost-cutting that occurred during the pandemic and high levels of pent-up demand for many of the most COVID-affected sectors.
As an example, a few weeks ago, UBS upgraded its 2021 corporate earnings growth estimate to 50%, raised its year-end equity return target, while also lowering its P/E estimate to 16x (from 17x currently). We believe these types of upgrades are consistent with our moderately overweight equities positioning for portfolios for the year ahead.
In the short term, from a tactical perspective, we favour companies that are likely to grow at multiples of economic growth (here and offshore) and have a tailwind associated with economies re-opening post-COVID-19. Moreover, those that can perform in a rising interest rate environment over the next few years will also be a strong hedge in portfolios. In particular, financials and industrials are likely to continue to perform well near term. Somewhat counter-intuitively, we expect healthcare to perform well, given the very nature of the COVID-19 recession, which significantly impacted the hospital system (and healthcare budgets and elective surgeries). As both a long-term structural growth thematic and re-opening beneficiary, healthcare should perform better than we would typically expect coming out of a recession.
In the medium term, from a more strategic perspective, we also believe portfolios should still have exposure to structural growth themes. While there remains potential for further pull-back in the tech sector, we favour more cyclically sensitive, long-term growth exposures, as opposed to many of the recurring revenue-type business where the pandemic has pulled forward significant demand already. Sustainability and digital disruption, two of our key themes, are likely to continue to outperform in the longer term. Regionally, over time, emerging markets, particularly Asia, will continue to benefit from structural growth.
We expect a recovery in economic growth to surprise positively in the year ahead (led by stimulatory fiscal policy, low central bank policy rates and a successful rapid roll-out of vaccines globally). We expect current forecasts for around 6% global growth to move higher to 6-7% for this year. We expect this to drive further upgrades to corporate earnings, supporting both moderate gains in equity indexes and better valuations over the coming year. As usual, risks are ever-present—from virus mutations, earlier-than-expected central bank tightening and difficult-to-predict geopolitical developments.
Volatility is unlikely to dissipate any time soon and may intensify in the coming months as a burst of short-term inflation arrives on the back of higher oil prices and cyclical growth pressures. This will present opportunities to strengthen portfolios. While inflation is likely to trend higher in the years ahead, we still expect central banks to remain accommodative until at least mid-2022. Commodity prices are also likely to remain elevated through the growth acceleration, supporting the Australian dollar, though we doubt we are on the cusp of a commodities super-cycle.
Holding excess cash, unfortunately, will continue to lead to real capital loss for some years to come, supporting our moderate risk-on stance. For equities, two of our key themes, tech disruption and sustainability, are also expected to continue to outperform. Regionally, emerging markets (Asia) should continue to benefit from structural growth and the UK from post-Brexit recovery.
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Scott has more than 20 years’ experience in global financial markets and investment banking, providing extensive economics research and investment strategy across equity and fixed income markets.