We expect an accelerating economic rebound through 2021 and ongoing expansion in the years to follow. There may be more bumps along the way, but rapid development of vaccines in 2020 suggests re-opening and a rise in consumption and business investment ahead. With inflation likely to remain subdued, and central banks poised to remain easy even as the recovery accelerates, conditions are in place for further sustained equity market gains in our view. Valuations may be a drag on the outlook, but with global earnings growth projected to rise back to trend, we expect average global equity total returns of circa 8% annualised over 2021-25. We expect more convergence among regional returns with Europe and Asia favoured to outperform. With fixed income returns struggling to reach positive territory in our scenario, asset allocations are biased in favour of equities. But risk control and capital preservation objectives suggest there is still a clear role for fixed income in portfolios.
Big global rebound now in prospect
Following the economic catastrophe that was 2020, the prospects look good for a rapid rebound in global GDP in 2021 and beyond. Key to this assertion is the arrival and rapid distribution of a vaccine for COVID-19. Some countries can start this process by the end of the year, but it is now a realistic prospect that a substantial proportion of the most vulnerable in the developed world could be vaccinated by Q2 2021. If this mass vaccination proves successful, the widespread lockdowns of 2020 should become a thing of the past.
While the early period of 2021 will continue to be hampered by efforts to tackle the coronavirus, a rapid rebound could gain traction as the year progresses. The latest IMF forecast points to global growth of 5% in 2021, following a 4% fall in 2020, but this was before the series of positive vaccine announcements, suggesting there are upside risks to even this forecast.
Owing to a combination of fear, uncertainty and inability to spend, savings ratios rose to record highs in 2020. Some normalisation of these trends will boost consumer and investment spending in 2021. There is also the prospect that the stock of savings built up in 2020 could be utilised too, as households and businesses ‘catch-up’ on lost consumption and investment.
With a new US administration that is more open to conventional multilateral co-operation, the threat of trade wars and reversal of globalisation has eased. President elect Joe Biden will have to work with a tightly split Congress (to be determined in Senate election run-offs in early 2021) meaning risks from major changes in taxation and regulation are reduced, but fiscal expansion and a brighter international trade outlook are still very likely. The choice of Janet Yellen for Treasury Secretary also bodes well for Fed and Treasury co-operation and policy cohesion.
Scars from the COVID-19 recession will be visible for the foreseeable future. The most notable damage will be on the public finances, where governments were forced to step into the breach in 2020 by spending large amounts on healthcare, welfare and business supports through large-scale borrowing. This was facilitated by record low borrowing costs linked to extraordinary levels of asset purchases by central banks. These fiscal policy measures are unsustainable over the medium-term and will have to be rowed back, but monetary policy will remain highly accommodative and growth, not austerity, is likely to be pursued as the fiscal solution. The 2020 recession has widened output gaps that will take some time to close before inflation becomes a concern, so interest rates are set to stay low.
Global growth, inflation and interest rates
The table below shows a summary of our base case scenario for the world economy, inflation, and central bank interest rates. In line with International Monetary Fund forecasts, we see a highly synchronized rebound unfolding across all major economies in 2021-22, with strong rebounds coming where growth has been most deeply affected by the pandemic in 2020. As that upswing is associated with an assumption of full reopening and reduction in household and business savings, it is not without risk of bumps along the road. But the rapid and promising progress on vaccines, already rolling out in some countries by the end of 2020, suggests a clearly optimistic bias for the outlook and a resumption of trend growth over five years.
Inflation is likely to be a hot topic of debate, but in our view the lingering effects of the pandemic on the labour market, combined with structural factors such as demographics and technology, reduces the chances of lasting inflation upside risk into the medium term. Prices, especially of raw materials, may be highly volatile as the recovery accelerates, lifting consumer prices inflation from lows in 2020-21 towards central bank targets in following years, but risk of a persistent inflation surge appears unlikely until much later in this recovery cycle.
Central banks, given the experience of the recovery from the last crisis, will be even more cautious in re-tightening policy. The Federal Reserve has already moved to target average inflation suggesting that even if inflation rebounds significantly, policy will respond more slowly than in past cycles. Key interest rates are set to stay low through the five-year time horizon. US rates may not rise until 2024 in our view - and even then, only moderately. Liquidity is set to stay plentiful to tide credit markets through the post-pandemic refinancing cycle and yield curve control to cap government bond markets may see more widespread use.
A good backdrop for equities, but not for bonds
Our base case scenario, that we are still in the early stages of a synchronised global economic recovery, is a good backdrop for equity assets. We expect equity valuation multiples to decline, but this should be more than compensated by strong earnings growth. In addition, risk premia could fall if we get less international tension as a result of the new President in the US. An end to policy musings by ‘tweet’ should reduce policy uncertainty which would be good for risk assets in general.
The chart below shows we expect global equities to return about 8% annualised over the next five years. This is despite historically rich valuations when measured on past earnings. Indeed, while we are assuming an annual near -5% drag on global equities from a partial reversion to lower valuations, a projected average pace of earnings growth above 10% is forecast to more than offset this. Adding in dividend yields, global equities can still see healthy returns in 2021-25.
Regions outside the US are less likely to lag behind in coming years in our view, as the earnings recovery potential is greatest in more cyclical sectors, where there is also less risk from valuation. The tech-heavy US indices may still see strong earnings growth, but also face arguably the biggest drag from potential valuation adjustments. See the chart again for a snapshot of major market returns and their drivers.
Overall, the major theme should be one of convergence among regional performances in the recovery, and less about US exceptionalism. For the stronger economic recovery scenario, we would favour Europe and Asia as the best regions to position for this. The UK, where equity returns have been depressed (notably in euro terms) in recent years, is expected to stage a comeback from a particularly deep recession in 2020. Subject to both our favourable global growth scenario and a reasonable outcome to the Brexit talks, ongoing as we write, the UK may well have among the highest returns for 2021-25. It may also remain among the most volatile. Our preferred sectors are Industrials, which are well-positioned to benefit from re-opening and a durable economic recovery, and Healthcare which we expect to continue to deliver dependable growth.
Fixed income markets face a far more challenging environment in our recovery scenario. It is difficult to see interest rates declining as the more rapid recovery takes hold. On the positive side there is little inflationary pressure and central banks can provide continued support. But we would expect negative returns of circa 1% p.a. coming from most major sovereign bond indices. Corporate bonds should hold up relatively well compared to this grim outlook for sovereigns, as spreads are reasonable and defaults stay low thanks in no small part to central bank liquidity. To achieve returns above zero, investors may need to take more credit and illiquidity risk, and seek more novel sources of income in coming years.
Asset allocation and portfolio construction
Equity assets are strongly favoured in terms of expected return, so it should be no surprise that the asset allocation preferences for coming years tilt in favour of this asset class. At each and every risk profile, the drag from fixed income reduces expected returns.
To reach a given expected return, the solution must be to raise the risk level, either by increasing the proportion of corporate credit in the fixed income allocation (so a near- zero rather than negative fixed income return) or to raise the proportion of equity. In practice, a combination of both is preferable, as it offers better diversification. With any increase in equity allocation, it is also important to seek diversification among sectors and factors driving return. Our preferred sectors - Industrials for the recovery and Healthcare for dependable growth - already offer some clear diversification in this regard, but broader diversification within equities remains a key part of the implementation of strategy. This is particularly the case for the 2021-25 scenario, in which cyclical recovery can combine with structural trends and low interest rates, to underpin a wide variety of different sectors.
Why hold any bonds at all, and particularly government bonds? The primary role of core government bonds (for example, German) in a portfolio is capital preservation. They have a known, fixed terminal value at maturity. These assets would be considered the most secure and should retain their value and liquidity even in a deep and prolonged crisis. They may even appreciate in value during such a crisis, so they can have a very positive diversifying effect in a portfolio. Bonds can still play a critical role.
In applying our global outlook and expected returns to asset allocations and individual portfolios, we seek to balance these risks and rewards to give the best trade-off between the often-competing ends of capital preservation, income, and growth. A blended, diversified asset allocation, taking into account an investor’s overall objective and most importantly their identified risk profile, is likely to continue to prove the wisest approach in 2021-25.
We wish you the very best in the year ahead and much investment success through the years to follow.
NOTE: Nothing in this document constitutes investment advice and does not confirm that a strategy is suitable or appropriate to your individual circumstances or otherwise constitutes a personal recommendation to you. Recipients should always seek independent advice.
Dermot O’Leary, Chief Economist; Bernard Swords, Chief Investment Officer; Sarah Quirke, Co-head of Investment Solutions; Niamh O’Leary, Research Analyst and Joe Prendergast, Global Strategic Advisor.