It may look like an unusually bleak Christmas for many investors, but there is some source for cheer ahead.
RBC Wealth Management is predicting that the economic damage resulting from the pandemic should diminish through 2021, while confidence in a return to a recognisable social and business landscape will likely grow.
As GDP regains its pre-pandemic peak and corporate earnings recover further, the firm expects equities could provide attractive all-in returns in 2021 and probably for 2022 as well.
Frédérique Carrier, Head of Investment Strategy at RBC Wealth Management, said: “Equity investment attitudes in 2020 were mostly shaped by the pandemic and by scepticism that life and the economy would ever be the same. We believe the V-shaped recovery that began in May for most economies will give way to a less dynamic, possibly bumpier phase of growth, and expect equity prices will appreciate further from today’s levels through 2021, although not by as much as earnings advance, bringing price-to-earnings ratios down modestly.”
RBC Wealth Management believes that the U.S. and Canadian economies should regain their pre-pandemic high ground by late 2021/early 2022. For Europe, the UK, and Japan, it will likely take a couple of quarters longer. China’s economy has already recovered all the ground lost to the first half’s COVID-19 shutdown. Earnings, already in recovery, could surprise to the upside in 2021 and 2022 as some sectors and groups, crippled by the pandemic, return to life.
RBC Wealth Management recently changed its recommended exposure to equities in a global balanced portfolio from a benchmark weight to overweight, or above-benchmark. Rather than a big tactical shift, it is a recognition that the driving force behind earnings growth and equity valuations is rapidly shifting away from the outsized volatility risks presented by the pandemic and back toward the long-term expectations for sustainable economic growth.
Carrier reckons that for 12–18 months following the end of a recession there is usually very rapid catch-up growth for both GDP and corporate profits. Thereafter, the GDP expansion settles into a trajectory more closely aligned to the economy’s longer-term potential growth rate. “In terms of long-term positioning, we think portfolios should be populated to the greatest extent possible with the shares of those businesses for which there is high conviction that sales, earnings, and dividends can grow faster than the economy,” he says. “Those companies will almost always be trading more expensively than the average. That would be even more the case if, as we expect, the corporate concentration that is likely to come with slow GDP growth and more intense competition winnows down the number of sustainable dominant leaders in each sector.”
But what about inflation?
Inflation which, in the U.S., has increased a little in response to the government turning the economy back on, will likely bounce rather sharply in mid-2021 to 2.5 percent, according to RBC, because of weak year-before readings, but the wealth manager believes that it will linger into the second half of next year.
“We are not arguing for rampant or pernicious inflation, rather just enough to get the market wondering when the Fed will respond to it,” says Carrier. “In our view, the only way to see a strong resurgence of inflation is if the economy were to be fully opened. It is not and won’t be for a while. The U.S. economy was still three percent below potential as of November – that is before any additional shutdowns.”
Public debt has ballooned since the COVID-19 pandemic began, with that of advanced economies jumping almost 27 percent as a group since January 2020, according to the International Monetary Fund (IMF), and there are no signs that borrowing will let up anytime soon. This debt level now sits beyond what was reached after World War II, at greater than 120 percent of GDP. All seems justified as the COVID-19 economic shutdowns earlier this year were imposed by governments themselves, and created an enormous vacuum for many households and businesses, with the output loss, at the worst moment in the spring, approaching that experienced during the Great Depression.
In the U.S., household debt obligations fell from nearly 100 percent of GDP to around 75 percent in the decade that followed the 2008–09 global financial crisis, largely driven by a reduction in mortgage-related debt. Over the same period, publicly held federal debt rose from around 50 percent to about 80 percent.
Debt servicing costs will remain manageable
RBC Wealth Management asserts that while some may harbour reservations and fears about rising debt levels, that shift should be a net-positive in terms of systemic risks, as the federal government obviously has greater capacity and more avenues to address debt service than the U.S. consumer, not least of which is the ability to print its own money.
“We believe that deficits and overall levels of publicly held U.S. federal debt are not a material concern for investors over the near and intermediate term,” Carrier observes. “Higher Treasury supply alone is not sufficient to send yields higher, based on historical correlations. Factors such as the path of Fed policy rates, GDP growth, and inflation expectations matter to a much greater degree.”
RBC Wealth Management also expects debt servicing costs will remain manageable even in the medium term, though they will likely restrict governments’ budgetary choices, and warns that policymakers lack the incentive to address the issue of debt accumulation given borrowing costs in the market have remained low despite debt levels spiking.
In all likelihood, debt loads will be forced ever higher as further stimulus measures for the COVID-19 crisis are implemented and other crises inevitably hit. The U.S. may find it easy to turn a blind eye to its growing debt because of the U.S. dollar’s status as the world’s reserve currency means there is underlying demand from institutional investors and governments globally for the debt America issues.
The temptation of further debt accumulation
Given this ease to finance itself and to print money, the U.S. may be even less inclined to reduce debt levels or meaningfully lower its rate of debt accumulation. In Europe, recent moves toward some form of debt mutualisation could further unify member countries, binding them not just by joint monetary policy, but by fiscal policy as well. This could make higher debt levels more sustainable in the eyes of investors.
“Within advanced democracies, we think it will be difficult for elected and appointed officials as well as voters to resist the temptation of further debt accumulation,” Carrier says. “The path of least resistance seems to be pointing toward increasing fiscal spending, not restraint. Persistent debt accumulation will likely be one more factor that will keep central banks suppressing interest rates over the medium and longer term, further burdening savers and fixed income investors.”
High debt loads will likely also be a powerful incentive for policymakers to further suppress interest rates. This is a key reason why RBC Wealth Management recommends that investors consider strategies for a low interest rate environment that may linger for much longer than one might think is reasonable.
There seems to be greater acceptance of high debt loads in the financial community and among government officials in the wake of the pandemic crisis. From a pure balance sheet perspective, RBC Wealth Management believes higher debt loads are manageable in the near and intermediate term. However, at a minimum, high debt levels, while sustainable for the time being in most advanced economies, will eventually restrict governments’ budgetary flexibility and are likely to result in higher tax rates.
The more that debt and debt-to-GDP mount over the longer term, the more governments and taxpayers will enter uncharted territory. “It’s unclear to us where the tipping point is between manageable and unmanageable debt loads,” Carrier says. “So far, markets are behaving as though any tipping point is a long way from here.”