Capital Market Outlook (December 14, 2020)


  • Macro Strategy—The global economy is expected to rebound in 2021, with the U.S. economy poised for its fastest rate of growth in decades. Below we summarize our key macro views heading into the new year, including risks to our outlook. In short: aggressive monetary and fiscal stimulus, faster economic growth, a pickup in inflation, higher long-dated Treasury yields, a neutral-to-slightly weaker U.S. dollar, and strong profits growth with supportive margins. This is a positive backdrop for equities.
  • Global Market View—Globalization is alive and well for a number of reasons, ranging from the rebound in global trade to the "sticky" nature of global supply chains. For Corporate America, this entails more foreign trade and investment, rising overseas earnings, lower costs, and greater operating efficiencies—all of which are bullish for U.S. equities.
  • Thought of the Week—The outlook for small-caps has gotten more constructive given attractive relative valuations, rising earnings revisions, potential for a global synchronized growth environment, and favorable central bank liquidity and financial conditions.
  • Portfolio Considerations—Headline risk is likely to keep investor risk aversion and cash allocations high, and we expect this to lead to a "seesaw" investment environment well into November. We would use major weakness in equity markets as a buying opportunity for those who have at least a six-month-or-longer time horizon.

Macro Views for 2021

Global economic growth: Aggressive monetary and fiscal stimulus continue to support a positive, self-reinforcing growth dynamic that is expected to receive an additional boost from vaccinations, unleashing pent-up demand all over the world next year. Global leading economic indicators reflect this confluence of factors (Exhibit 1). Strong growth in the U.S. and China, the two largest economies in the world, should lead the way, in our view. The U.S. economy could be poised for its fastest rate of growth since the early 1980s.

Exhibit 1: V-Shaped Recovery in Global Leading Economic Indicator Signals Solid Growth Recovery in 2021.

U.S. Consumer Spending: The U.S. consumer will likely be a solid pillar of support in 2021. With the help of fiscal stimulus, the personal savings rate is relatively high, while at the same time, wealth is rising (rising home and equity prices are helping), and financial obligations are low, a powerful setup for consumer spending in 2021. Consumers have room to lever up. Pent-up demand for high-contact leisure activities is expected to provide a significant spark if vaccinations are effective in gradually reducing the associated risk. Jobs are expected to also rebound rapidly in these industries. Like overall real gross domestic product (GDP) growth, real consumer spending growth could set up for a multidecade record.

Labor Market: Job and wage growth should be supportive of consumer spending in the year ahead, and we expect the unemployment rate to drop below 5.0% by year end. Vaccinations will play a key role in opening up hiring in contact services industries where millions of workers remain out of work. While job growth may slow until vaccination picks up, small business survey data like the National Federation of Independent Business (NFIB) survey and Job Openings and Labor Turnover Survey (JOLTS) data from the Bureau of Labor Statistics point to still-high job openings at the same time that some industries struggle to find qualified workers. Leading indicators of employment like the Conference Board Employment Trends Index™ continue to move higher. Vaccination setbacks and structural unemployment are considered risks.

U.S. Housing: Residential construction is estimated for another strong year in 2021 even if existing home sales slow and home price growth normalizes. Favorable demographics, high liquid consumer savings, low financial obligations relative to disposable income, decent job growth, record-low mortgage rates, and incredibly lean inventories for both new and existing homes should give the housing boom legs. Homebuilder confidence is at an all-time high, well above the high reached during the housing expansion in the mid2000s. Key risks may include affordability, loose lending practices from nonbank lenders, structural unemployment, or a cyclical labor market shock.

Inflation: Inflation growth should pick up in the first half of the year and eventually will run above the Federal Reserve's (Fed's) 2.0% target, in our view. After years of missing its 2.0% inflation target, the combination of the Fed's new monetary framework and massive fiscal stimulus could be a game changer. Technical factors should also play a role for the calendar-year outlook. Core Personal Consumption Expenditures (PCE) inflation bottomed in April 2020, likely setting up positive year-over-year base effects for April 2021. About this time, vaccines should be reaching the most vulnerable and gaining traction more broadly, unleashing pent-up consumer spending. This pent-up demand should combine with capacity constraints in many industries that would keep upward pressure on prices. Under the Fed's new framework, though, it will hold the line on accommodative monetary policy, reinforcing inflation expectations. For the year, core PCE inflation should average near or above the Fed's 2.0% target.

Profits: The profits rebound already underway will help to reinforce the broader economic cycle in 2021. Companies would use profits to invest in productivity-enhancing technology and people. Corporate profits at the economywide level reached a record high in the third quarter. The profits cycle will be supported, in our view, by elevated margins, which also surged in the third quarter with after-tax profit margins for nonfinancial companies near a record high. Low interest costs should support margins even as labor costs pick up. Importantly, a pickup in productivity will likely serve to ease these labor cost pressures and support margins.

U.S. Equities: The economic growth and profits outlook for 2021 and 2022 is encouraging for U.S. equity performance next year. The Organisation for Economic Co-operation and Development (OECD) is forecasting faster economic growth in the U.S. in 2022 than in 2021 (3.5% versus 3.2%). The BofA Global Research Global Wave is showing a cyclical upswing in the global manufacturing cycle and earnings revisions. While historical valuations are a longer-term headwind, equity valuations relative to fixed income remain attractive. Monetary and fiscal stimulus remains on standby next year in the event of a coronavirus resurgence or an unexpected deflationary shock.

Fixed Income: The Fed is expected to keep short yields anchored near zero, but rising growth and inflation expectations will likely continue to push longer-dated Treasury yields higher, steepening the yield curve. BofA Global Research expects the 10-year Treasury yield to reach 1.5% by the end of 2021. The profits backdrop, including the likelihood for margins to remain elevated, should be supportive of corporate credit, but rising nonfinancial corporate leverage is worth watching and favors high-quality corporates.

Dollar: The broad, trade-weighted U.S. dollar remains slightly overvalued even after the greater-than-10% depreciation since the March highs. Valuations have mostly normalized for the dollar versus the euro, the largest component of trade- and liquidity-weighted indexes. A pickup in global growth outside the U.S., positive risk sentiment and the likely path of the Fed monetary policy will keep downward pressure on the dollar, but the pace of depreciation could slow from here. The dollar should continue to be the preferred currency if bouts of risk-off sentiment occur in the new year.

Risks: Election risk around the Georgia Senate runoffs are an early risk. Other risks include: Premature monetary or fiscal tightening; disappointing vaccine results (in effectiveness or uptake, for example); structural economic scarring; U.S.-China relations (Taiwan is a notable flashpoint); the buildup of nonfinancial corporate leverage; and a bubble-watch from massive global liquidity injections.

Bullish Indicator: Globalization Is Far from Dead

There is no arguing the fact that over the near term the rise in populism, the spread of protectionism, and the decimating economic effects of the pandemic have dealt a blow to a more integrated global economy. Yet despite these headwinds, the demise of globalization—or the unfettered flow of crossborder movement of goods, services, capital, data and people—has been greatly exaggerated. As we discuss below, many factors suggest that globalization's obituary be placed on hold.

First, a more multilaterally minded Biden administration may yet reboot globalization and opt to strengthen the pillars of global integration. President-elect Biden's Cabinet appears to be full of globally minded policymakers who are more welcoming of greater global integration, not less. Reflecting this DNA, the Biden administration looks to be intent on working with U.S. allies in promoting smoother trade and investment agreements (think the European Union, Japan, and a host of Asian states); is more amendable to working within multilateral constructs like the Paris Climate Agreement and World Trade Organization; and even hopes to reset U.S.-Sino trade relations after four tumultuous years of tit-for-tat trade and investment restrictions. We don't expect the administration to rewind the clock on U.S.-China trade, but we do think the bilateral rancor of the past will likely be dialed back and become less unpredictable and uncertain. All of the above suggests more globalization, not less, over the next four years.

Second, for all the chatter about "onshoring" and "reshoring", and firms decamping en masse China, there is little evidence thus far to suggest a whole scale change in this direction. Indeed, according to a survey conducted by the U.S.-China Business Council, very few U.S. firms have moved or plan to move out of China.2 The reason: China's market is just too large and lucrative for U.S. firms not to be there; to this point, Exhibit 2, which shows a more-than-six-fold increase in U.S. foreign affiliate income in China since the start of the century. Meanwhile, foreign direct investment inflows to China totaled $76 billion in the first half of 2020, a 4% year-over-year decline, which was much lower than expected and counter to the-everyone-is-bolting–China narrative. In contrast, foreign direct investment (FDI) inflows to the U.S. declined a stunning 61% over the same period, and were some one-third less ($51 billion) than inflows to China (Exhibit 3).

Exhibit 2: U.S. Affiliate Income Earned in China.


Exhibit 3: Change In First-Half 2020 FDI Inflows For The Top 2019 Recipient Economies.

Third, and related to the above, global supply chains are rather "sticky' in nature given the high fixed costs that come with offshoring or setting up foreign operations.3 "Reshoring," meanwhile, is expensive and costly, and entails significant additional fixed costs most firms are unwilling to undertake. As a case in point, Philips, one of the largest manufacturers of ventilators, identified that in one machine there are 621 crucial components that were designed, produced and assembled all over the world. The upshot: Replicating the entire supply chain would be expensive, inefficient, and a drag on future earnings, and hence inertia around "reshoring."

Fourth, U.S. multinationals are not about to give up on being "multinational" any time soon because they simply can't afford to. The future earnings growth of many firms depends on accessing foreign markets and overseas resources given that the U.S. economy accounts for only one-quarter of world GDP and less than 5% of the world population. In other words, when it comes to global supply and demand, there is a great deal of both beyond U.S. shores. The activities of multinationals (i.e., crossborder investment, technology transfers, employment, trade, etc.) will likely remain the glue of globalization.

Fifth, while export restrictions have soared over the past year—the International Monetary Fund (IMF) counted 120 such restrictions last year—the pandemic-induced decline in global trade has not been as bad as first predicted by the World Trade Organization (WTO). To wit, when the pandemic started, the WTO forecast global trade to decline by 13% to 32%; in October, however, the organization upgraded its forecast, anticipating a drop in global trade of just 9.2% in 2020, followed by a solid rebound in 2021 (7.2%). As Exhibit 4 highlights, global trade has experienced a sharp V-shaped recovery—much to the surprise of the globalization-is-dead camp.

Exhibit 4: World Trade Volumes.

Sixth, investors need to reframe how they think about globalization—think less about trade and investment in goods, and think more about trade in services, as well as more digital and virtual crossborder activities. The next phase of globalization is about software, not hardware; experiences, not physical assets; clouds and codes, not colas; and intangibles as opposed to tangibles. As noted by Erik van der Marel of the European Center for International Political Economy, a new type of globalization is emerging, one based on "digital services, research and development, data, ideas and other intangibles." These activities are setting the tone for the global economy—indeed, services trade now represents 20% to 25% of total trade and is growing faster than crossborder trade in goods.

The world was already going digital before coronavirus, but the pandemic, like many other shocks in history, has hastened the pace of change. Despite disputes over crossborder data flows, the greater the digitalization of the global economy, the greater the level of crossborder digital trade in a host of sectors, including insurance and pension services, financial services, and telecommunications, computer and information services. The future of globalization includes more trade in so-called "other business services" which runs the gamut from research and development services, legal and accounting services, management consulting, and public relations services. It also includes more service exports of architectural, engineering, scientific and other technical services as well as waste treatment services, operating leases services, and exports of personal, cultural and recreational services.

Adding momentum to all of the above is the switch from physical retail toward e-commerce, the explosion in remote working and remote learning, and soaring demand for remote/online healthcare services. Most of these activities take place at the local level but will gradually go global as the world economy comes online. Keep in mind that over 2 billion people, or more than 40% of the world's population, have never logged on to the internet; that's another way of saying that there is still tremendous upside for the growth of the global digital economy and the continuation of globalization.

Finally, there is no better example of globalization being alive and well than the Pfizer/BioNTech vaccine—the world's first coronavirus vaccine recently approved for mass use. As the Financial Times recently noted: "The vaccine was developed in Germany by the children of Turkish immigrants; tested in Germany, the U.S., Turkey, South Africa, Brazil and Argentina; manufactured in Belgium and first approved in the UK."

The bottom line: Globalization is changing, adjusting and mutating. It is far from dead—a bullish prospect for U.S. and global equities.

A Constructive Outlook for Small-Cap Equities

Coming into 2020, over the previous 10 years, small-cap equity performance has broadly underwhelmed, as it trailed its larger brethren by 50%.8 This can be attributed to a relatively lower earnings growth profile, lower quality given a rising proportion of nonearners and less representation of secular growth industries like technology, whose dominant performance has been more beneficial for large-caps.

However, small-cap stocks have accelerated higher recently. Since the end of October, they have risen 25% and outperformed large-caps by 11%, as election uncertainty has declined and with positive vaccine developments raising the potential for faster economic normalization in 2021. Despite this rally, small-caps remain historically undervalued compared to large-caps. On a forward Price/Earnings basis, small-caps trade at a 21% discount to where they have historically been versus large-caps, and on a Price/Sales metric, it's at a 27% discount.9 And within small-caps, the Value segment remains significantly undervalued compared to Growth, suggesting perhaps more upside for the small-cap Value asset class going forward. In addition, the earnings recovery for smallcaps is estimated to be stronger than large-caps in 2021, even when comparing growth rates to 2019 earnings levels rather than 2020 troughs (Exhibit 5). A synchronized global growth environment with additional fiscal stimulus and easier financial conditions via rising central bank liquidity and tighter credit spreads are tailwinds for equities, especially for small-caps.

Exhibit 5: The Earnings Recovery For Small Caps Is Estimated To Be Stronger Than For Large Caps In 2021 Compared To 2019 Levels.

The outlook for small-caps has gotten more constructive, and they should be considered in multi-asset portfolios that may be significantly underweight this asset class, in our view. Attractive relative valuations, rising earnings revisions, and positive macro-economic forces led us to this conclusion. The recent strong momentum in small-caps and slightly extended investor sentiment create near-term risks of a pullback or consolidation, especially within the context of rising coronavirus cases and potential for further economic shutdowns. However, investors with a longer time horizon and those looking to include more cyclicality into portfolios should opportunistically add on weakness.