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Dark tunnel. Bright light.
- After sustaining an unprecedented shock from COVID-19 early in 2020, the global economy is ready to get back to normal in 2021 … with the help of one or more vaccines.
- While the promise of a better 2021 is at least partially priced in, accommodative policy and a snap back to normal in distressed service industries can help investors earn solid returns in the coming year.
- For the first time in a while, we see more upside than downside risks to our moderately constructive outlook for next year, but very near-term risks skew to the downside.
- Our key takeaway for 2021: A bright light lies ahead for investors, but only at the end of a very dark tunnel.
Returning to a more normal environment
The year 2020 delivered a massive global health crisis and an economic calamity, but 2021 promises to offer an end to both. Save for a few very nervous weeks in the first quarter of 2020, investors saw excellent returns across nearly every asset class as policy stimulus boosted the economy and vaccine breakthroughs permitted greater optimism about the coming year. As we head into the new year, our investment outlook remains constructive. But, perhaps more importantly, the range of uncertainty around that outlook has been reduced by the U.S. election results and positive news on a number of COVID-19 vaccine candidates. Upside risks may outnumber downside risks as conditions return to normal. But the most immediate concern: How much more lasting damage will the virus do to the global population and its economy before vaccines bring it to a close?
Global economy still in the tunnelIt’s impossible to develop an outlook for the year ahead without first acknowledging the ongoing human and economic tragedy resulting from the pandemic. As we write this, COVID-19 cases, hospitalizations and fatalities are rising globally on a daily basis, even as multiple vaccines could be only weeks away from becoming publicly available. Figure 1 shows the recent parabolic growth of new cases in the fourth quarter across both Europe and the United States.
Mandatory business closures in Europe and the U.S. are less sweeping than during the initial wave last spring. However, for many businesses and whole industries, activity never returned to anywhere near normal even when the virus’ severity temporarily subsided. The global economy will not be able to fully rebound until the pandemic has subsided for good.
At the same time, the parts of the global economy that can function during a pandemic are doing so. In fact, many are thriving. Global manufacturing has staged a V-shaped recovery, as has the U.S. housing market, thanks to shifting demographics, low interest rates and consumer preferences migrating toward the suburbs. China’s recovery has already turned into a durable expansion, while Europe’s post-lockdown bounce in the third quarter provides hope that it can recover swiftly from the current wave.
Most importantly, consumers are exhibiting considerable resilience. With limited spending options and financial aid from the federal government, household balance sheets have strengthened, on average. Savings rates remain unusually high and incomes have risen with the help of global fiscal policy stimulus, even in the U.S., where consumers tend to spend more of what they make each month (Figure 2).
It’s worth emphasizing how unusual it is to see higher savings rates, higher income growth and stronger spending growth, all happening at the same time, just six months removed from a deep recession. The pattern is similar in other large economies, implying that global growth is well positioned for a dramatic acceleration once the virus is contained.
To ensure that the economy emerges from the pandemic intact, policymakers have enacted aggressive fiscal stimulus to support individual incomes and prevent businesses from going under due to lack of revenue. Government relief remains in place in most countries except the United States, where more fiscal aid may not be forthcoming until the new administration is in place in late January.
The better-than-expected cumulative economic recovery has been extremely supportive of global equity and credit markets. But that progress may not continue in a straight line, especially if the current wave of COVID-19 causes businesses to close and workers to lose their jobs. The global economy remains in a dark tunnel, but we expect it to emerge by the second half of 2021. If we’re right, good things are in store for global growth, even if the virus and the lack of policy support provide setbacks along the way.
Markets are already seeing the lightAn effective vaccine will eventually supply a much-needed boost to global GDP, but markets can react to tomorrow’s good news today and have, in fact, already done so. While it’s not unusual for equity valuations to rise just after a recession, it’s rare for them to surge past their pre-recession levels so soon after the recovery begins. A combination of aggressive fiscal and monetary policy and progress on COVID-19 vaccines allowed investors to pull sunny expectations about 2021 into 2020’s markets.
The next few quarters may be bumpy, but we think 2021 will look more “normal” than 2020.
Two major events at the end of 2020 — the U.S. election and the success of multiple COVID-19 vaccine candidates — have greatly reduced uncertainty about the outlook for 2021. The U.S. election appears to have produced divided government, a welcome surprise to markets that prefer incremental — if any — change to public policy. And while investors were counting on vaccines to arrive eventually, the ones we know about so far are apparently more effective than expected and may be delivered ahead of schedule on a large scale. Lower uncertainty about U.S. public policy and the coming solution to the health crisis has contributed to lower volatility and high valuations for both global stocks and credit markets.
Investors will welcome lower volatility but not higher valuations. Readers of our 2020 outlook will recognize Figure 3. We’re including it again this year because, remarkably, the pandemic, the recession and all of the other unprecedented happenings have left valuations barely changed, if not somewhat more expensive. Current yields on municipal bonds and high yield corporate credit remain historically low, while the earnings yield on global stocks — the inverse of their P/E ratio — likewise points to lower returns in the years ahead, even if 2021 delivers beyond our hopeful expectations.
How can investors navigate through this challenging return environment, one that is likely to last at least to the middle of this decade? Our best ideas follow in the coming section, but broadly speaking, the most obvious opportunities lie where normalization still hasn’t been priced in. Cyclical parts of the global equity market performed better in the fourth quarter of 2020, but have not recovered their underperformance against defensive sectors. With the significant shift to online commerce likely to persist beyond the end of the pandemic, industrial real estate should continue to benefit from demand for storage, shipping and logistics and greater localization of majority industries. And the weaker U.S. dollar, which we expect to fall further as the U.S. passes more stimulus and the Biden trade policy comes into focus, should support emerging markets fixed income, including both U.S. dollar and local-currency bonds.
What if we’re wrong?The Nuveen GIC spent time at our last meeting debating what could go wrong in 2021, both for the global investing environment, broadly, and for our specific portfolio positioning. For the first time in a long time, we spent more time talking about upside risks to the outlook, which include an overheating economy that brings about higher inflation and an abrupt rise in interest rates. Even in a year that included a pandemic and the most closely followed U.S. election in history, investors’ most common questions still center on government deficits and the sustainability of growing debt loads. This also plays into concerns about inflation in 2021 and beyond.
Part of our “upside” scenario involves a rise in inflation that effectively wipes out positive real returns — those left after inflation is netted out — on a wide swath of investments, including cash and many types of bonds. Negative real returns are already a way of life in the global markets for inflation-linked bonds, which protect against changes in inflation expectations but not always against inflation itself (Figure 4).
While a roaring economy by the second half of 2021 wouldn’t leave too many investors complaining, it could potentially put the Fed and other central banks in a bind given their strong commitments to maintaining very low levels of interest rates. Even a hint that this commitment was wavering could cause interest rates to rise and the yield curve to steepen. But this risk would have less to do with concerns about debt sustainability and more to do with the core driver of inflation: too much demand met with too little supply. When both growth and inflation are accelerating from low levels, equities have traditionally performed well, as have real assets.
The main downside risk to our outlook — a failure to end the health crisis — looks less likely by the day as more vaccine candidates speed toward approval, production and mass distribution. But the global economy may sustain more damage before those doses arrive. In particular, unsupported U.S. small businesses are at greater risk of failure as states lock down or customers simply stay away. School closures are also affecting the labor market (Figure 5), with parents forced to choose between working and supervising at-home students. While headlines often focus on unemployment rates, the number of people, particularly women, leaving the labor force is alarming and could lead to a sluggish recovery as it did following the last recession. An economy too scarred to quickly recover following the end of the pandemic would produce flat yield curves and favor the shrinking number of higher growth assets in portfolios, particularly technology and consumer discretionary sectors.
Investing in 2021The lesson of 2020 for investors is that staying invested and rebalancing is more often than not the right move, even when it seems like madness in the face of a hopeless outlook. That approach does not change simply because headwinds seem likely to turn into tailwinds in 2021. While the next few quarters may be bumpy, the probable end to the health crisis by summer should help distressed parts of the economy — and distressed assets — stage a strong recovery bolstered by unusually good household fundamentals. But as the twists of a dark tunnel give way to a brightening exit from COVID-19’s dominance of daily life, investors confront a new risk: building portfolios that deliver durable income and total returns for the balance of the decade.
All market and economic data from Bloomberg, FactSet and Morningstar.
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A word on risk
All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Equity investing involves risk. Investments are also subject to political, currency and regulatory risks. These risks may be magnified in emerging markets. Diversification is a technique to help reduce risk. There is no guarantee that diversification will protect against a loss of income. Investing in municipal bonds involves risks such as interest rate risk, credit risk and market risk, including the possible loss of principal. The value of the portfolio will fluctuate based on the value of the underlying securities. There are special risks associated with investments in high yield bonds, hedging activities and the potential use of leverage. Portfolios that include lower rated municipal bonds, commonly referred to as “high yield” or “junk” bonds, which are considered to be speculative, the credit and investment risk is heightened for the portfolio. Credit ratings are subject to change. AAA, AA, A, and BBB are investment grade ratings; BB, B, CCC/CC/C and D are below-investment grade ratings. As an asset class, real assets are less developed, more illiquid, and less transparent compared to traditional asset classes. Investments will be subject to risks generally associated with the ownership of real estate-related assets and foreign investing, including changes in economic conditions, currency values, environmental risks, the cost of and ability to obtain insurance, and risks related to leasing of properties. Socially Responsible Investments are subject to Social Criteria Risk, namely the risk that because social criteria exclude securities of certain issuers for non-financial reasons, investors may forgo some market opportunities available to those that don’t use these criteria. Investors should be aware that alternative investments including private equity and private debt are speculative, subject to substantial risks including the risks associated with limited liquidity, the use of leverage, short sales and concentrated investments and may involve complex tax structures and investment strategies. Alternative investments may be illiquid, there may be no liquid secondary market or ready purchasers for such securities, they may not be required to provide periodic pricing or valuation information to investors, there may be delays in distributing tax information to investors, they are not subject to the same regulatory requirements as other types of pooled investment vehicles, and they may be subject to high fees and expenses, which will reduce profits. Alternative investments are not appropriate for all investors and should not constitute an entire investment program. Investors may lose all or substantially all of the capital invested. The historical returns achieved by alternative asset vehicles is not a prediction of future performance or a guarantee of future results, and there can be no assurance that comparable returns will be achieved by any strategy.
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