Welcome to the upside scenario
- Led by a well-stimulated United States, global growth should surge by the most in decades this year as large developed economies sprint into the post-pandemic world.
- As we revise up our outlook for global growth, we must also consider the related risks, with inflation chief among them.
- Effective vaccines and enormous budget deficits notwithstanding, not all financial assets will benefit equally from an economic boom.
- The rotation into economically sensitive assets seems likely to endure in the context of strong balance sheets, surging economic growth and a sharp bounce in corporate profits.
- We see the best opportunities in emerging markets assets, as well as U.S. small cap stocks, leveraged loans and other floating-rate areas and across most real assets, including real estate.
Inflation could create risks, but we expect it to remain contained. At least for now.
Three months ago, the Nuveen Global Investment Committee offered an optimistic outlook for the global economy and financial markets in 2021. Evidence since then suggests we may not have been optimistic enough. Multiple COVID-19 vaccines are inoculating a rapidly growing share of the global population. New cases have fallen off a cliff in most of the worst-hit countries. And the world’s largest economy has added nearly $3 trillion of extra stimulus, creating an unprecedented amount of pent-up consumer demand ready to be unleashed when the coast is clear. Welcome to the upside scenario.
Brighter light, shorter tunnel
Economists and investors alike are busily revising up their already-high expectations for 2021. Fueled by a massive fiscal expansion and rapid vaccine deployment, the U.S. economy will set the pace this year, but the rest of the world won’t be far behind. Economic data continues to consistently surpass expectations around the world, and in virtually every sector of the economy, from housing to manufacturing to labor.
So how did we arrive at this upside scenario? Fast and effective vaccinations and aggressive fiscal stimulus. Daily COVID-19 cases are well off their highs (Figure 1), and mitigation strategies are being rolled back in most places. The U.S. Senate flipping to the Democrats in January — again, unexpectedly — created a political alignment far more conducive to passing stimulus, which Congress promptly did with the American Rescue Plan Act signed in early March. Even before the various aid provisions in that bill took effect, personal income had spiked thanks to the previous fiscal relief bill (Figure 2), allowing both spending and savings rates to remain historically high.
Forecasts for economic growth have been pulled forward into the first half of this year, and financial markets have rotated — at times violently — out of last year’s winners into more economically sensitive sectors, with energy the biggest winner so far. The highest global GDP growth in decades should translate into high corporate earnings growth, which will either ease equity market valuations, push stock prices higher or some combination of both (Figure 3). But we are also already seeing some of the downsides to the upside scenario. Improved growth expectations also mean rising interest rates and potentially higher inflation.
Volatility may remain elevated, but we see opportunities across asset classes.
“Upside risks” aren’t all good
2021 is shaping up to be a fascinating case study in the relationship between economic growth and economic policy. Running fiscal and monetary policy ultra-loose in what was already expected to be the best year for growth in decades has never been tried before in a large, developed economy. Understandably, many investors are concerned that this formula could lead to inflation. In developed economies like the U.S., it’s an unfamiliar phenomenon to those who didn’t own financial assets before 1990. Rising prices can devastate consumer confidence and wreak havoc on investment portfolios, putting simultaneous downward pressure on both stock valuations and bond prices.
Inflation is almost certain to rise in 2021, but we expect it will do so only temporarily. Starting this spring, as last year’s extremely weak months roll out of the 12-month observation period, year-on-year inflation will almost certainly increase (Figure 4). Investors can safely ignore this data quirk, especially if monthly increases remain modest, as we expect they will.
Inflation may also rise this summer for more economically relevant reasons. As more consumers shift their spending from goods to services — eschewing home theater upgrades for meals out and vacations — we’re likely to see a relative shift in price pressures that could cause overall inflation to rise. This is especially true if businesses encounter difficulty quickly expanding their operating capacity in the face of a sudden increase in demand. Small business surveys already show this becoming an issue. Employers are having trouble finding new workers to fill open slots, and a large number expect to raise prices in the next few months. Job openings in the U.S. are more numerous than they were at the end of 2019. Central banks are unlikely to view such a phenomenon as a reason to urgently tighten policy, however. The overall increase in inflation is likely to be modest, and it should pass as supply rises to meet demand.
A broad-based and durable rise in inflation can only happen when an economy is running at full capacity or slightly beyond it. That is still a long way away for the world’s largest economies. In early 2020, as the U.S. economy was creating close to 200,000 jobs per month and the unemployment rate was dropping to 3.5%, inflation remained quite tame. Today, despite considerable progress since last April, the unemployment rate is 6.2% and over four million people have dropped out of the workforce altogether. This gives the Fed and other central banks facing similar conditions plenty of room to keep monetary policy easy for a good while longer. We do not expect the Fed or the ECB to reduce their asset purchases until the first quarter of 2022, at the earliest.
The reason the GIC spent so much time discussing inflation at our last meeting, however, is because we think risks are skewed toward overheating in 2021. Unprecedented fiscal expansion, along with a once-in-a-century positive demand shock to large segments of the economy, presents somewhat unknowable risks to financial assets. Some assets are well positioned for an economic boom and a moderately higher inflation environment. Others seem to have already incorporated this scenario into their prices. More important than successfully predicting inflation is knowing what types of investments are likely to perform well in a variety of inflation scenarios.
Where to focus if markets struggle to keep pace with the economy?
This year has already brought welcome news regarding the pandemic and the subsequent economic recovery. The trouble for investors is that much of this good news has already been priced into markets.
Figure 5 shows that the so-called “reflation trade” has gained momentum since last November, following the U.S. election results and the first news about the efficacy of several COVID-19 vaccines.
Markets are anticipating a strong global economic recovery, as well as higher inflation. Investments tied to those trends can continue to perform well, assuming the news continues to come in better than expected as it has in recent months. Better-than-expected economic data and faster-than-expected drops in new COVID-19 cases have boosted commodity prices, long-term interest rates and inflation expectations. They’ve also helped U.S. small cap stocks handily outperform large cap stocks, with the technology sector taking a back seat to energy and financials. Emerging markets assets have also received support, which is typical during periods of synchronous global economic growth, as long as sharply higher interest rates and a rising U.S. dollar don’t derail things.
Broad diversification will be critical in this environment.
We think the reflation trade — in its various forms — still has legs, but we advise investors to be more discerning in how they invest for the global reopening and recovery given the run many of these assets have already had.
Real assets like real estate, farmland and timberland are among our favored asset classes in a reflationary environment, especially given their inflation-resistant yield. We are investing in renewable energy infrastructure and U.S. housing in light of the sharp increase in demand for new construction and shifting demographics.
Within equities, we are emphasizing near-term opportunities in the financials and consumer-related sectors, while also keeping an eye on industrials that could benefit from publicly funded infrastructure investments. We remain bullish on U.S. small caps, emerging markets and cyclicals for the longer term as the economy reopens, but think those areas could be subject to volatility over the coming months. We see tactical opportunities in some growth stocks that have experienced recent underperformance.
In fixed income, while TIPS have outperformed nominal Treasuries as inflation expectations have increased, we prefer to take more risk in credit-sensitive parts of the market, including emerging markets. Improving fundamentals can help spreads compress even further, and higher-yielding parts of the market should prove less susceptible to a further increase in interest rates. Leveraged loans and other floating rate products are another preferred area for this reason.
One unmistakable feature of the first quarter was the increased interest in speculative investing among individual investors (as well as a handful of institutions). Intense interest in online trading communities — in assets ranging from Bitcoin to Gamestop to silver — led to eye-popping rallies, some of which have proven to be more durable than others. With liquidity plentiful and average net worth at its highest level ever, many investors are willing to pay high prices — at times clearly divorced from fundamentals — for assets with no intrinsic value that generate no income as long as they believe they can sell them to the next buyer at a higher price.
Investments primarily, if not entirely, driven by speculation can be extremely volatile with inconsistent correlations to other asset classes. As such, they are difficult to incorporate into a diversified asset allocation and can be subject to sudden, severe losses. The bottom line: While we know it can be tempting to follow the latest trend or the hottest stock, we suggest remaining diversified and limiting exposure to any single asset or asset class.
A different type of uncertainty from here
If someone had told us six months ago that our primary focus in March 2021 would be on the risks surrounding inflation and rising interest rates, we would have been both surprised and delighted. But the truth is, as we exit a period of human and economic tragedy, we enter a new phase that will bring its own forms of uncertainty: rapid shifts in consumer behavior, unprecedented stimulus and a market less than a year removed from a recession already exhibiting some late-cycle tendencies.
We continue to see a range of opportunities for investors looking for yield and willing to diversify within their fixed income portfolios and into illiquid and alternative asset classes. Guarding that income stream against a rise in inflation — or inflation expectations — is moving up the list of necessities for all types of investors over the balance of 2021.
All market and economic data from Bloomberg, FactSet and Morningstar.
The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature.
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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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