Why the recovery has only just begun
Economic and investment outlooks often have short shelf lives. In 2020, however, year-ahead outlooks were rendered useless by the end of February. At the start of last year, few market participants took the potential for a global pandemic as seriously as perhaps they should have, nor did anyone anticipate the robust and coordinated policy response that followed. Fiscal and monetary policies seem to have built a bridge to the other side of this pandemic, and with effective vaccines now in distribution, it appears that better times lie ahead.
That said, we are not yet out of the woods. Although the U.S. economy finished 2020 with a decent amount of momentum, that was not the case for the global economy. The European economy contracted during the final quarter of the year as a second wave of COVID-19 spread rapidly and lockdowns were put in place. In emerging markets, China has rebounded strongly, but elsewhere the picture is more mixed. Still, we believe that 2021 will be a year of recovery. In other words, the current business cycle has only just begun.
In early 2021, the global economy will likely pause to catch its breath, with the duration of the pause determined by the path of the virus and subsequent policy response. We expect that policy will continue to help the economy heal during, and through, the pandemic: In Europe, austerity seems to be off the table, and in the U.S. additional fiscal stimulus was delivered in December. These policy supports will help bolster economic activity in the short term. Critically, too, they will prevent more permanent economic damage.
As populations around the world are vaccinated gradually during the first half of the year, economic activity should begin to accelerate. Goods and manufacturing bounced back strongly in 2020, but services remained under pressure due to social distancing (EXHIBIT 1). As the threat of the virus fades, we expect a material acceleration in the pace of services sector activity amid pent-up demand for restaurant dining, entertainment, travel and other services impacted by the pandemic. This suggests a surge in economic activity during the second half of 2021 and into the beginning of 2022. We expect it will be accompanied by a strong increase in corporate profits, particularly for the hardest-hit sectors.
Inflation and policy
Against this backdrop, inflation should remain fairly tame. In the near term, a combination of elevated unemployment rates and output gaps should keep a lid on inflation. In the long term, high levels of corporate and government debt, coupled with structural trends like income inequality, continued technology adoption and aging demographics, will likely constrain price growth. However, inflation could surprise to the upside as economic growth picks up into the end of the year. If demand were to come roaring back when liquidity was still plentiful, we could well see an environment in which too much money was chasing too few goods.
In the near term, however, low rates of inflation should allow central banks to maintain an accommodative stance. The Federal Reserve (Fed) made a shift to average inflation targeting, suggesting that inflation above 2% will be tolerated for some time. Although the Fed may signal a tapering of its asset purchase program toward the end of the year, interest rates look set to remain at the zero bound for the foreseeable future. The European Central Bank (ECB) has extended its window for net asset purchases through March 2022, and for reinvesting maturing securities through the end of 2023. The bottom line: Until inflation picks up, monetary policy will remain easy.
In general, 2021 should be a solid year for the global economy. As always, investors should understand the risks, particularly when everyone seems to be singing from the same song sheet. Any lack of fiscal support or abrupt change in the tone of monetary policy could undermine the recovery and cause capital markets to stumble. Challenges relating to the distribution of the vaccine and/or inoculation would almost certainly delay a complete economic recovery. And there is still a risk that the virus mutates in such a way that current vaccines become ineffective.
While these risks do not represent our base case, they need to be considered. At the same time, last year’s policy response pulled forward a great deal of return – particularly in the public markets – which will make investing increasingly difficult during the early stages of this expansion. We expect that investors will continue to shift their focus from public to private markets as they increasingly search for businesses that have experienced temporary disruption due to the pandemic but avoided long-term demand destruction for the goods and services they provide. This leads us to favor more cyclical assets in the short term even as we continue to recognize the need for growth, income and diversification over the long run. The pandemic may soon come to an end, but this economic cycle has only just begun.
Goods and manufacturing bounced back strongly in 2020, but services remained under pressure
EXHIBIT 1: GLOBAL PMI FOR MANUFACTURING AND SERVICES