What Might Be the Biggest Investment Risk in 2021? | Lord Abbett
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Economic Insights

Some observations on the economic and investment climate as the year gets underway

Read time: 4 minutes

In the early weeks of 2021, the average person sees a world of hurt around them, as the human and economic misery caused by the worst pandemic in over 100 years continues. It seems counterintuitive that financial markets have been able to deliver such strong returns in that environment and that makes many investors infer that we must be in some kind of “bubble.” Based on sentiment surveys and levels of holdings in U.S. government-only money market funds,1 many investors appear to be looking for reasons to avoid risk and preserve wealth.

But such a mindset may prevent them from taking advantage of some investment themes that may potentially influence markets in 2021:

  • Strong market returns potentially can continue
  • Inflation likely will remain low
  • Listed company earnings have held up extraordinarily well
  • Economic recovery in China continues to be a large positive for the global economy

We think 2021 could potentially see the depressing and enervating stories of sadness and failure of the preceding year replaced by narratives of success. Public health authorities are poised to get better at distributing vaccines. And the discovery of so many vaccines with extremely high efficacy in so short a time is a miracle of modern genomics and data analytics. By the third quarter of 2021, we have the potential to achieve “herd immunity,” and life may start to go back to something resembling normal.

Markets and risk asset prices likely will, as always, react to this scenario before it happens. If the successful public/private partnership that ultimately delivers victory over the pandemic provides a model to start dealing with the world’s other big problems–global warming and the establishment of stable, peaceful relations between liberal democracies and China (with India in the wings)–then investors will find themselves in a climate of optimism that seems at odds with the drumbeat of negative news that characterized 2020.

High and seemingly inexplicable past returns make many people hesitant to take on risk with their investments. But that’s a mistake, in our view; historically, there is virtually no correlation between past returns for stocks and future returns. And whatever negative correlation there is has reflected a good outcome—that is, a tendency for very bad years to be followed by above-average ones.

The Inflation Equation

Many investors are also concerned that the policy measures to mitigate the economic and market impact of COVID-19 have led to debt creation that sharply increases the risk of accelerating inflation. Much higher inflation would be a real negative, since it would tend to force bond yields to rise sharply, both through rising short-term rate expectations and an increase in risk premiums.

Worries that inflation will tick higher due to excessive debt creation are nothing new. The same concerns arose as the economy recovered from the 2008–09 recession, aided by aggressive monetary and fiscal stimulus. History shows that the idea that increasing debt inevitably causes currency debasement through high inflation has things exactly backwards.2 Increasing debt, by itself, depresses aggregate demand in the economy because the initial stimulus to capital spending and consumer demand is replaced in short order by the depressive effect of having to service the debt. Moreover, short-term fiscal stimulus is usually followed by medium-term fiscal drag. Only if government behaves irresponsibly—by doing things like pretending that deficits don’t matter and that any amount of government spending can be financed with increasing debt—would inflation be potentially unleashed, and that is the historical exception, not the normal case.

Instead, a rising debt burden and a shift back towards a sustainable budgetary regime, once the economy recovers fully, is likely to cause another disappointingly slow economic expansion. This, in turn, likely would keep inflation capped at less than 2% for at least the next several years, prolonging the current regime of near-zero short-term interest rates.

Earnings Surprises

In the meantime, investors should recognize fully the extraordinary earnings that listed companies have delivered, despite the pandemic and all the associated disruptions. The second and third quarters of 2020 were the two best quarters for positive earnings surprises on record, based on FactSet data, and early indications are that the fourth quarter could be almost as good.

This reflects tremendous resilience as managements have acted quickly to cut working capital, implement productivity enhancements, and reduce headcount. High margins have been preserved in an environment when they normally would have fallen sharply. The only real damage has come in high fixed-cost industries directly affected by the pandemic—energy, airlines, leisure and entertainment—and banks that provisioned aggressively for an increase in anticipated

losses. And we believe these companies should stage substantial recoveries, given the prospect of economic activity returning to near-normal levels later this year.

The significance of this extraordinary earnings performance is that there is no reason to believe that listed companies suffered permanent damage as a result of COVID-19. When the problems caused by the virus are overcome by reaching herd immunity, long-term earnings power will be restored.

Meanwhile, positive earnings surprises are likely to provide a strong foundation for additional gains in stock prices in 2021, as high multiples are maintained for a while longer.

China Didn’t Crack

Lastly, the global economy has been buoyed by a V-shaped economic recovery in China, which, as we have noted before, has been responsible for 30–50% of global economic growth in the last decade (per data from the International Monetary Fund). China’s growth engine has underpinned demand for commodities-driven global trade in capital goods. This is particularly positive for emerging-market economies, but China’s historically strong growth has also provided the spark necessary for above-trend economic growth in Europe and Japan.

If trade conflict were to diminish, as the U.S. and its allies seek a more multilateral approach to confronting the frictions caused by China’s economic growth, the benefits for the global economy would be vast.

What’s the Biggest Risk?

Our assessment of the biggest risk for investors in 2021 is that they continue to anchor themselves too much in the present—and not enough in what is very likely to be a much better future. As we learned throughout the record-long U.S. economic expansion from mid-2009 through the end of 2019, an environment of low inflation and moderate economic growth is a very good one for financial markets. Given the prospect of a successful rollout of COVID vaccines, and the resultant boost to public health and economic vitality around the globe, investors may wish to reconsider their cash-hoarding caution as 2021 unfolds.

 

1Based on data from State Street (sentiment) and Bloomberg Index Services Limited and ICI (money market fund holdings), as cited in the October 19, 2020 Market View.

2This concept is explored fully in a January 2013 paper from the Organisation for Economic Co-operation and Development (OECD).

 

The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Debasement refers to the historical process of lowering a currency's actual value.

An earnings surprise occurs when a company's reported quarterly or annual profits are above or below analysts' expectations.

Fiscal drag happens when a government's net fiscal position (spending minus taxation) fails to cover the net savings desires of the private economy, also called the private economy's spending gap (earnings minus spending and private investment). The resulting lack of aggregate demand leads to deflationary pressure, or drag, on the economy, essentially due to lack of state spending or to excess taxation.

Herd immunity occurs when a large portion of a community (the herd) becomes immune to a disease, making the spread of disease from person to person less likely. As a result, the whole community becomes protected, not just those who are immune.

V-shaped economic recovery involves a sharp rise back to a previous peak in economic activity after a sharp decline; when charted, such a trajectory forms a “V” shaped line.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education. No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein. If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

The opinions in the preceding commentary are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research, or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.

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