One Step Ahead of What’s “Next”: 2021 Themes and Investment Implications
December 16, 2020
“One who, fully prepared, awaits the unprepared will be victorious.” – Sun Tzu, The Art of War
Following a tumultuous 2020, we look to the year ahead, not to produce overly precise forecasts for the economy or the markets as many attempt to do, but to understand the backdrop and driving factors underlying the path forward for the economy and markets. Such an approach prepares us for the year, helps us think ahead, and gives focus to our monitoring efforts. This backdrop, from our perspective, centers on the transition of government in the U.S., the COVID-19 pandemic, and eventually an evaluation of what the next “normal” will hold for the economy and markets.
Exhibit 1: 2021 themes – one step ahead of what’s next
With status quo in Washington and vaccine approval/distribution plans, the return to some semblance of “normal” will perhaps justify and reinforce the rally in risk assets into 2021. This writing seeks to identify and detail the economic and market drivers we are monitoring, and the potential shifts from our base case that could impact our outlook.
Theme 1: The next administration
With each new administration, there is potential for modest to more substantial shifts in policy. While the presidential race seems resolved, we won’t know for certain the scope of change expected in the composition of government until the runoff elections in Georgia determine control of the Senate in early January.
Exhibit 2: Gridlock and compromise in 2021 should be a new positive
The table shows key potential economic policy shifts that are likely to result under various potential outcomes from the 2020 presidential and congressional elections.
Presuming betting markets and polls are accurate (aren’t they always?), the Senate should remain under Republican control, challenging President-elect Joe Biden’s ability to pass the more ambitious pieces of his agenda (Exhibit 2). This scenario won’t render Biden’s administration ineffective, as there are numerous tools with which to govern, including executive orders, implementation oversight and legislative compromise. Further, Biden is regarded as a deal maker; both he and Senate Majority Leader Mitch McConnell have previously worked effectively together. However, the legislative agenda with a divided government is likely far more modest in magnitude. As a result, we should expect some stimulus or infrastructure spending, but without significant corporate tax increases or big boosts in minimum wages. This combination is likely to be a net positive for the economy and corporations.
Theme 2: Next for COVID-19
After a year spent in fear of rising case counts, hospitalizations and worse, the coming year will likely see the widespread distribution and administration of a COVID-19 vaccine. As of this writing, three vaccines have announced Phase 3 results which appear to meet the efficacy threshold the U.S. Food and Drug Administration (FDA) has communicated as necessary for emergency use authorization (Exhibit 3). One vaccine has already been approved in both the U.S. and U.K. and distribution has begun, with manufacturers ramping up production.
Exhibit 3: Vaccine approvals and distribution should enable a more complete recovery
Source: Glenmede, World Health Organization (WHO), U.S. National Institutes of Health (NIH) Data through 11/30/2020
Information is based on clinical trial data submitted by each vaccine candidate’s organization through ClinicalTrials.gov. Vaccines highlighted are from developed markets only. Production estimates are based on those disclosed by Pfizer & BioNTech and Moderna. Actual production of COVID-19 vaccine doses may differ from the data shown.
It will be critical that enough of the population ultimately gains immunity to COVID-19, either through vaccination or previous exposure. Medical theory suggests that, based on COVID-19’s reproduction rate of ~3.0, roughly 60%–70% of the population will need to be immune in order to slow the spread of the disease enough to generally protect communities from additional widespread surges in infection. Once herd immunity is reached, economic lockdowns and restrictions will become far less necessary to contain the disease, and many previously restricted activities should resume.
Theme 3: The “next” normal
Presuming vaccine approvals and administrations play out as scheduled, investors’ attention during 2021 will begin to turn to what the “next” normal will look like. The reopening of the economy that started amid the pandemic and occurred mostly in the back half of 2020 will likely continue in 2021, recovering the remainder of the way back to more normal levels. Those businesses most impacted by COVID-19, such as restaurants, in-person entertainment and travel, will likely experience a rebound in activity like what we have seen in the other parts of the economy, and lead overall earnings back to more normal levels by the end of the year (Exhibit 4).
Exhibit 4: Corporate earnings should return to normal in 2021
Source: Glenmede, FactSet Estimates as of 12/09/2020
Data shown are Glenmede’s proprietary estimates for S&P 500 EPS under various scenarios. Prior refers to estimates of S&P 500 EPS before the out-break of the virus and the oil price shock. Upside Case refers to Glenmede’s estimate of S&P 500 EPS assuming a 2-month shutdown and quick return to full economic activity. Base Case refers to Glenmede’s base case estimate of S&P 500 EPS assuming a 4-month shutdown and a slower return to a level 1% below the prior trend. Downside Case (Long “U”) refers to Glenmede’s estimate of S&P 500 EPS assuming a 6-month shutdown and a slow return to a level 2% below the prior trend. Downside Case (“W”) refers to Glenmede’s estimate of S&P 500 EPS assuming relatively quick re-opening of the economy, followed by a second wave of infections, a second shutdown and a slower return to a level 4% below the prior trend. All scenari-os account for the effects of depressed oil prices. These figures are projections which, though arrived at in good faith, are not guaranteed. Actual results may differ materially from projections.
However, it may be harder to see what differences may remain. Our government will have committed great sums to support the economy, and the result will be hefty additional debt. The cost of that debt should be manageable given current relatively low interest rates, but will likely weigh on longer-term growth at some point in the future. It is also possible that some practices or behaviors will outlast the pandemic, such as working from home; however, the impact of this may be more positive as it appears to have made the average worker more productive through the more efficient use of time and technology.
Investment strategy: Maintain neutral equity and risk exposure
Equity markets have largely grown to reflect the coming vaccine-induced recovery in the economy and corporate profits. In fact, one could argue that equity market valuations have even reached premium levels that may warrant some caution (Exhibit 5).
Exhibit 5: Combined equity market valuations are high, but not unreasonable
Source: Glenmede, MSCI Data through 12/09/2020
*Total Equity is a mix of 60% U.S. Large-Cap, 10% U.S. Small-Cap, 22.5% Int’l Developed and 7.5% Int’l Emerging Markets. Glenmede’s estimate of long-term fair value is based on normalized earnings, dividend yield and book value using a weighted mix of the representative indexes for these markets. Valuations for periods prior to 2010 were determined via a retroactive application of Glenmede’s Global Expected Returns Model. These figures are projections which, though arrived at in good faith, are not guaranteed. One cannot invest directly in an index. Past performance may not be indicative of future results.
However, overvaluation alone need not portend poor performance in the coming year, particularly if high valuations are not materially outside historical bounds. Current levels are not yet above the 90th percentile of valuations for overall equities. Such valuations can persist for longer periods of time, permitting equities to continue to rise alongside corporate earnings, which serve as the basis for those valuations. Further, equity valuations must be viewed in concert with historically low interest rates. Of the two largest asset classes — bonds and equities — equities appear far more capable of generating longer-term expected returns that exceed the rate of inflation, justifying a full weighting within portfolios. In contrast, the interest rate on 10-year Treasuries currently sits below the expected rate of inflation for the next 10 years (Exhibit 6).
Exhibit 6: Interest rates have been pushed to historically low levels
Source: Glenmede, FactSet Data through 12/09/2020
Inflation expectations are based on the Federal Reserve’s Survey of Professional Forecasters since 1993, and a 10-year trendline average inflation rate prior to 1993.
Digging deeper into valuations uncovers some disparities. U.S. large-capitalization stocks sit clearly over the 90th percentile of valuations, while other portions of the broad equity market — U.S. small-cap and international markets — remain closer to fair valuation. We continue to believe valuation disparities within equities provide opportunities for investors through the more nuanced approach of shifting within the asset class instead of the more blunt approach of reducing the overall equity allocation.
Exhibit 7: U.S. large-cap overvalued, fair valuations elsewhere
Source: Glenmede, MSCI Data through 12/09/2020
Glenmede’s estimate of long-term fair value for equities is based on normalized earnings, dividend yield and book value using MSCI Indexes (MSCI USA Index, MSCI USA Small-Cap Index and MSCI All Country World ex-U.S.), which are unmanaged total return indexes with dividends reinvested. Past performance may not be indicative of future results.One cannot invest directly in an index.
2021 themes to watch
Overall, the 2021 themes outlined may seem overly optimistic given today’s rising COVID-19 cases and the severity of the pandemic. However, this path is far from certain and deserves ongoing monitoring for the many potential triggers for reassessment. For example, an unexpected two-seat Democratic win in Georgia could shift the balance of power in Congress just enough to make bigger legislative shifts more likely. Further, while we can envision a broad economic recovery, with corporate earnings returning to previous highs (Exhibit 4), it is harder to see the differences that may linger or remain permanent.
Exhibit 8: What could potentially cause a reassessment?
The majority of uncertainty in our expectations for 2021, however, relates to the timing of the COVID-19 vaccine rollout and public acceptance rate. Embedded in our expectations is the assumption that more than one vaccine wins FDA approval, manufacturers meet production targets and enough of the public is vaccinated to establish herd immunity. Admittedly, while this progression is our base case, the required string of outcomes that needs to occur leaves little room for error and warrants ongoing monitoring.
Presuming our expectations for U.S. policy and the path forward for the pandemic are correct, there remain additional factors that bear watching. Corporate bankruptcies appear contained, but a beginning-of-year surge of COVID-19 cases amid a shutdown could create a hangover effect just as a vaccine is rolling out. Also, the massive fiscal and monetary stimulus could cause a faster-than-expected rise in inflation, forcing the Federal Reserve to raise rates sooner than expected.
In closing, each of these extenuating risks has a relatively low likelihood of occurrence, but deserves monitoring from a risk management perspective. By establishing expectations based on the most important drivers, we prepare ourselves not just for the environment that includes our base case, but also accounts for the drivers that could lead us to adjust portfolio recommendations as the year progresses.
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This article is intended to be an unconstrained review of matters of possible interest to Glenmede clients and friends and is not intended as personalized investment advice. Advice is provided in light of a client’s applicable circumstances and may differ substantially from this presentation. Any opinions, expectations or projections expressed herein are based on information available at the time of publication and may change thereafter, and actual future developments or outcomes (including performance) may differ materially from any opinions, expectations or projections expressed herein due to various risks and uncertainties. Information obtained from third parties, including any source identified herein, is assumed to be reliable, but accuracy cannot be assured. In particular, information obtained from third parties relating to “ESG” and other terms referenced in this article vary as each party may define these terms, and what types of companies or strategies are included within them, differently. Glenmede attempts to normalize these differences based on its own taxonomy, but those efforts are limited by the extent of information shared by each information provider. Definitional variation may therefore limit the applicability of the analysis herein. Any reference herein to any data provider or other third party should not be construed as a recommendation or endorsement of such third party or any products or services offered by such third party. Any reference to risk management or risk control does not imply that risk can be eliminated. All investments have risk. Clients are encouraged to discuss the applicability of any matter discussed herein with their Glenmede representative.