Reflation theme back in play: Raising US 2021 economic growth forecast from 5% to 6%
Following the Georgia Senate elections, the Democratic Party now has control of the US Congress.
A unified government will catalyze a more aggressive path for US fiscal stimulus, and we believe that Biden would likely pass a substantial relief aid package in 1Q 2021 via the reconciliation process that is around USD1 trillion or more, and that later in his first term, Biden will successfully implement major spending initiatives on infrastructure, renewable energy, the environment and healthcare.
Some of this spending will likely be offset by Biden’s proposed tax increases, which may lead to some market nervousness.
But, on the whole, a Blue Wave scenario is likely to accelerate the US recovery and would be bullish for risk assets; bearish for the US dollar; and will also put upward pressure on Treasury yields.
In the aftermath of the Georgia elections, our macro team have raised our US GDP forecast for 2021 from 5.0% to 6.0%, and also lifted our one-year estimate for 10Y US Treasury yields from 1.20% to 1.50%.
History shows that US equity returns have been strongest when inflation is rising from low levels
Because of the prospects of more aggressive fiscal stimulus and stronger economic growth, US inflation expectations have broadly risen since the Georgia elections on 5 Jan, with US 10Y breakeven inflation rising 7 basis points from 2.00% to 2.07%.
Benchmarking today’s inflation levels against the levels in the aftermath of the last two crises in 2009 and 2001, we note that inflation expectations have risen to levels that are fairly normal at this early stage of a business expansion.
A study of the historical performance of the S&P 500 shows that its 12-month forward returns have been highest when inflation levels are at below average levels and rising.
The combination of an economic recovery and rising inflation from low levels forms a sweet spot for markets. Importantly, in this phase of the business cycle, there is sufficient leeway for the Federal Reserve to maintain a loose monetary policy stance.
Therefore, a key risk to watch in 2021 is a surge in inflation which will drive the Fed to turn hawkish and taper its quantitative easing. But we don’t see this as our base case scenario and expect the Fed to wait until 2022 to taper given its new strategy of aiming for 2% inflation on overage over the business cycle.
Negative real yields remain supportive of equities
Rising inflation and growth expectations are also driving US Treasury yields higher and resulting in a steeper yield curve.
Generally, a rise at the long end of the Treasury yield curve from low levels due to firmer growth prospects is a positive development for equities.
This is especially as real yields remain solidly in negative territory today, which is a key tailwind for risk assets.
In the last post-GFC business cycle, rising real yields only became a disruptive factor for risk assets when the 10Y US real yield rose above 0.50% in 1Q 2018. Currently, the 10Y US real yield is at -0.96%, which is quite a distance away.
Upgrading US equities to overweight; we expect 30% growth in 2021 S&P 500 earnings-per-share
Another key positive factor for US equities is the earnings outlook.
Our base case expectation is that earnings-per-share of the S&P500 will increase by a healthy 30% year-on-year in 2021.
Although the price-to-earnings levels of the S&P500 do not appear outright cheap, they are not excessive today given that real yields are at ultra-low levels.
Equity cash flows are valued against competing assets, such as long-term government bonds and cash.
Given very low real yields, and as the equity risk premium contracts during an economic recovery, it is consistent to see equities trading at higher price-to-earnings ratios.
Factors related to investor positioning also look supportive: The cumulative change in US money market fund holdings (both retail and institutional) pre and post the Covid-19 recession show that only half of the pandemic-driven inflow into cash has been reversed so far. This means there is dry powder for deployment into risk assets ahead.
During the 2008 Great Financial Crisis and the 2001 Tech Crisis, the inflows into US money market funds triggered by the respective recessions fully reversed over time, which helped fuel the post-recession bull markets in the last two cycles as investors redeployed cash into risk assets.
Given the multiple factors discussed above, we are upgrading our view of US equities to overweight, funding it from cash.
In addition to upgrading US equities to overweight, we remain overweight in Asia ex. Japan equities and Emerging Market High Yield bonds.
Expect reflation theme to benefit cyclical sectors, such as financials, industrials, energy, materials, and real estate
The earnings of cyclical sectors, such as financials, industrials, energy, materials and real estate, are more sensitive to economic growth and therefore will be greater beneficiaries of the reflation theme ahead.
Considering that the valuations of these cyclical sectors remain at relatively attractive levels and that the performance of cyclical sectors have significantly lagged growth sectors, such as technology, since March 2020, we expect cyclicals to outperform the broad market ahead as the reflation theme gains momentum.
“Risk-on” trend does not mean no risk of short-term volatility
Although the long-term outlook for risk assets has improved with the reflation theme, we cannot rule out the risk of some short-term volatility given the sharp V-shaped market rebound since March 2020 and that a few technical indicators suggest that the market is technically over-bought over the near-term.
Since the 1920s, the stock market has, on average, experienced a 10% correction every 1.5 years. Near-term gyrations of the market are impossible to predict with certainty, and it is often counter-productive for long term investors to attempt to time them.
Finally, the effectiveness of the global vaccine rollout is a primary determinant of the reflation theme and a key market driver in 1H 2021.
Over the last month, new strains of the Covid-19 virus have been found, including the B.1.1.7 strain which was first reported in the UK.
While there is still limited clarity about how these new strains will impact the effectiveness of the vaccine rollout, most scientists are also confident that existing vaccines would be effective or that future vaccines can be modified to be effective against these new virus strains.
The vaccine rollout is under way and is widely expected to help major economies reach the herd immunity threshold by 2H 2021, but currently only Israel, UAE and Bahrain have vaccinated more than 5% of their populations to date. This is an area that needs to be watched closely.
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