Morgan Stanley
  • Thoughts on the Market
  • Nov 20, 2020

Special Episode: 2021 Global Outlook

Andrew Sheets and Chetan Ahya


Ahya: Welcome to Thoughts on the Market. I'm Chetan Ahya Chief Economist for Morgan Stanley.


Sheets: And I'm Andrew Sheets, Chief Cross-Asset Strategist. And on this special extended episode of Thoughts on the Market, we'll be sharing our year ahead economic outlook for 2021 and how that outlook could affect markets worldwide. It's Friday, November 20th, at 11:30 a.m. in New York City.


Sheets: So Chetan great to talk with you. And, you know, I'd like to start by discussing our outlook for the global economy. I think if people take one thing away from this is that we at Morgan Stanley expect global growth to be better than expected next year. But I'd like to dig into that a little bit more and kind of what's driving that, you know, what is the assumption that we think we're making on the global economy that will turn out better than what other people currently assume.


Ahya: That's right, Andrew. We're expecting 6.4% global growth next year versus consensus at 5.4, so a full one percentage point higher than consensus. And what we are forecasting is that there will be a synchronous global recovery with the developed world, as well as the emerging world growing together. And the key reason why we are different from consensus is not because we have a different assumption for the path of virus, but rather the reaction of the economy to the virus. And what we have been highlighting on this point is that the equation between virus and economy is changing. We are actually expecting a much stronger return of private sector risk attitude towards spending. So we are expecting both private consumption and CapEx to pick up meaningfully in 2021. And that's what is really the at the heart of our forecast being different from consensus, Andrew.


Sheets: Hmm. And I think that is a great point on the different sensitivity to the economy, because you can see that that happening kind of in real time, right? You know, we're dealing with far more cases today in the U.S. than we were in July. And yet overall, U.S. economic output is well above where it was in July. So this issue that there's kind of a one to one relationship between the amount of cases and economic activity. Clearly, there seems to be a more complicated story than just that.


Ahya: That's right, Andrew. And I think we have now reached a point where both the consumers as well as the corporate sector have learned how to adjust and manage the situation around the virus.


Sheets: So stepping back for a global perspective, how do we think emerging market economies fare in the year ahead? And importantly, you know, how do you think that that compares to the pattern that we've seen between developed markets and emerging market growth over the last several years?


Ahya: What we have seen in emerging markets is they've had almost a lost decade and going forward, we're expecting the EM story to come back because of several reasons. First is that emerging markets have got their house in order with inflation and current account deficit being in a good position. And from an external environment perspective, we expect low real rates in the U.S., weak dollar and a wider current account deficit that will support the EM external demand. At the same time, we expect China's real GDP growth to be at 9% in 2021, which will also provide an reflationary impulse to emerging markets outside China.


Sheets: So I think that's also a story that has gotten a lot of investors attention because, emerging market equities are almost at the same level they were in the middle of 2011. So, you know, you mentioned a lost decade for emerging market growth and you've had something of a lost decade for emerging market asset returns. And so I do think a scenario where you have that growth becoming resynchronized is a pretty interesting and exciting story.


Sheets: Another one of our key views on the economic side has been around inflation. We're forecasting inflation to rise. But my sense is a lot of investors are still very skeptical about that idea. You know, they point to still high unemployment rates and the fact that you still have a lot of technological disruption as reasons why inflation is going to stay stubbornly low. So why do we think differently and how high do we think inflation could rise to over the next several years?


Ahya: So, look, I think what we are seeing is that the output for the U.S. economy, for example, would be getting to pre-COVID levels in the second quarter of 2021. But the policy backdrop when we are at that pre-COVID levels of output will still be extremely reflationary. So in the fourth quarter of 2019, before the corporate shock occurred, the Fed was having policy rates much higher than zero. And it was not really taking up any kind of balance sheet expansion. In fact, it was shrinking the balance sheet before that. But now when we are at pre-COVID levels of output in the second quarter, the policy backdrop is going to be significantly different. You have the Fed taking out big asset purchases, as you were highlighting earlier, and at the same time, the fiscal deficit for the U.S. in 2021 will still be very high relative to where we were pre-COVID. So I think is that reflationary policy backdrop that makes us think about the inflation outlook being much different from where the consensus is.


Sheets: So Chetan I'm glad you mentioned government spending because that's, I think, been another real key debate in the market and something I've honestly been a little bit worried about when it's when it come to the economic outlook. You know, you look back at 2011 when there was a Democrat in the White House, divided power in Congress and the economy was still recovering from the Great Recession, it was almost impossible to pass legislation. And in the middle of 2011, Congress almost failed to approve paying interest on the U.S. debt. And what followed from that was very weak economic growth, very poor market performance. So, what do you think is going to be the fiscal drivers of the economy next year? How much fiscal support will the market get? How much does it need? And, you know, how worried would you be if there is no further fiscal action approved in either the U.S. or Europe next year?


Ahya: So when we are thinking about the U.S. macro outlook, just look at the final demand in the U.S., which is including consumption and investment, taken together, that final demand is already at 98% of pre-COVID level in the month of October. And we are expecting some moderation in the next two, three months. But it's not going to be big enough that it kind of dents the overall recovery path. And we are forecasting that, you know, when you get to March, April, the consumer spending as well as the investment spending recovers back much more quickly. And to just highlight the state of the U.S. consumer health, the U.S. consumers have already seen personal income, 4% above pre-COVID levels in the month of September. And they are also holding $1.2T of excess saving in their balance sheet. So we think that this will provide the comfort for the U.S. consumer to keep going on in terms of the spending trend driving that recovery that we are forecasting.


Ahya: So, Andrew, let me turn this over to you now. What does our economic outlook mean for major asset classes? And how are you recommending investors position for 2021?


Sheets: Yeah, so let me pick up on that last point you made actually on the unusually high savings rate, because, you know, I do think a really important way that we're looking at this market is that as abnormal of a year as 2020 was, you know, global pandemic, huge swings in economic activity, huge intervention by central banks and policy. We think that markets in the months that have followed are actually following a lot of very normal post recessionary patterns. And that as kind of unusual as things seem that investors can apply a lot of that usual post recessionary playbook to investing. And those post recessionary periods often involve low consumer confidence rising, high savings rates coming down, business investment picking up, low inventory levels picking up, you know, a lot of the fear and the disruption of the recession going away and moving from that more distressed place to a better place is the shift in direction that ultimately drives both economic growth and better market performance.


Sheets: And so I think we'll see those things again. I think we're looking at a better growth and better earnings growth backdrop for next year. I think we're still looking at a pretty healthy liquidity environment for next year where central banks are still providing support for markets and I do think investors have a lot of cash that they've built up, given all the uncertainty that things have been facing and that cash can come back into the market. And finally, while valuations have become more expensive than they were a couple of months ago, we still think those valuations are closer to average than extreme across a lot of markets. And thus, I don't think they're going to be an impediment to an above average year for returns in stock and credit markets.


Ahya: And Andrew where do our asset market, views differ the most from the market consensus?


Sheets: So I think that's a very good question. I think, you know, last year we had a more differentiated outlook for 2020. Then I think we were much more concerned about late cycle dynamics in the market. Now, I think we're more consensus in the sense that I do think many investors are expecting 2021 to be a decent year for markets to see solid gains. So but I think the difference seems to come more from how you get there. So I still think there are a lot of investors who think this is going to be a market that's powered not by better growth, but by simply lots of central banks supports in markets. And that would mean a different pattern of performance. We think cyclical stocks would outperform. But if you think that growth will disappoint and rather it's all about central banks, then it would be quality stocks that outperform. So that's one difference.


Sheets: I think we're a little bit more downbeat about the performance for commodity markets in the sense that, this backdrop would seem a really good one for commodities. So you have better global growth, higher inflation. We think the dollar also will weaken. All of those are usually great backdrops for commodity investing. But in the next three to six months, we think a number of key commodities actually still suffer from high oversupply, a lack of demand. And that means that they'll lag. So I think we're a little bit more downbeat on commodities relative to others. And I think we see yields rising a little bit more than other people do. We see the U.S. 10-year Treasury yield rising to about 1.5% by the end of next year. And that's more than the market expects. I think that's more than many investors expect. And some of that's related directly to the above consensus growth outlook that we at Morgan Stanley have.


Ahya: And Andrew, from near-term perspective, we are seeing some downside, but then we are expecting a strong recovery from March, April onwards. How do markets look at this development in the near-term? Where there will be some downside in the economic activities.


Sheets: Yes. So I actually thought our colleague Michael Wilson put this brilliantly in his episode on Monday, which is that in investing, I think sometimes it can be easier to have confidence about the long run outlook for markets than the short run outlook. And the short run outlook is very murky. You know, you have aggressively rising case counts in the U.S. As you mentioned, growth should decelerate in part because of that. You have a little bit maybe a leadership gap politically as you transition into a new administration, into a Biden administration. And that that potentially also means that you could have a little bit of a little bit of volatility. And so, you know, I do think that markets are maybe facing their toughest, most uncertain period of the next 12 months over the next two.


Sheets: That being said, I think, you know, the weakness in markets will be limited because I think investors might see it as their last best chance to kind of transition portfolios towards a more optimistic 2021. And, you know, I think it's important markets are discounting machines. They should be forward looking machines. And as much as it can seem like markets are simply overlooking all of the terrible headlines, maybe a more accurate way of saying it is that they are simply trying to look ahead and look further out into a brighter 2021. So I do think we're set for some volatility. You know, we wouldn't be rushing into the market today or tomorrow. But I do think of, you know, having a plan to increase exposure over the next several months makes sense to us. And especially if we do see near-term data weakness leading into market weakness we'll be kind of further taking up our allocations.


Ahya: And Andrew, as we discussed, one of our major out of consensus call has been the return of inflation over the course of this year and into 2022. How should investors play this theme in the market? And what are the what are your favorite expressions on this one?


Sheets: You know, the rise of inflation we're expecting would actually be a very normal early cycle phenomenon, a very normal post recession phenomenon. You know, we saw inflation rise in 2010 and 2011, even though the unemployment rate was still high, even though the economy was not fully healed. Inflation, inflation can rise before those things. We've seen it, you know, very recently. And so I think, you know, a lot of these ideas that we like, a lot of the strategies we like are things that that do work in those post recessionary periods. One is U.S. small cap stocks. You've heard our colleague Michael Wilson talk about why he likes those. They're historically inexpensive relative to large cap stocks. They usually do well post recessions. They usually do well when inflation is a little bit higher. That's something we like. We like copper, the commodity. We think it benefits well from the stronger global growth that that you and your team are calling for. And again, you know, historically does well in in inflationary environments. We think that copper will outperform gold if we if we compare it to another metal a little bit further down the periodic table. And, you know, we do think financial equities will do well in this environment in so much as better global growth and rising inflation, we think will lead to steeper yield curves. And financials should get a benefit from that, as well as just generally an uplift from a better economic environment and thus lower loan losses. So those are three ideas that we think are not just, I think, historical beneficiaries of a higher inflation environment, but also all trade at kind of reasonable valuations relative to the market.


Ahya: Right. And when you're thinking about the valuations in the markets, Andrew, even investors who would agree with our bullish view on the economy may question that the valuations are rich. What is your response to that?


Sheets: Look, I think this is a really important debate in the market and, you know, stocks on an outright basis are very expensive relative to bonds. They're more reasonably priced. And then bonds are very expensive, but they've been very expensive for a while and have only gotten more so. One is I do think this is why are strong global growth environment is really important. You know, if I if I think about our forecasts for the S&P 500, you know, we think that next year the price to earnings ratio for the S&P will fall maybe about 10%. The S&P could go from trading at about 22x earnings to 20x earnings. So the valuations come down.


Sheets: But then we think earnings go up even more. Much more. Earnings could go up next year, you know, 20% or more. And thus the overall market could see gains of around 10%. And so, you know, I think, yes, you know, expecting some decline in valuations next year is probably the right way to think about it. But, you know, we're hopeful that that the earnings will be able to grow enough in excess of that to mean that that slightly lower valuations next year are fine. They can be absorbed. And I also think it means that, you know, one always has to be a little bit picky about price. Again, you know, a reason why we prefer small caps as we think they traded at cheaper historical valuations than large caps. You know, we think that, as I mentioned with financials, that's a sector that also trades at historically cheaper valuations. We think European stocks are effectively at similar levels that they were five years ago. So, again, a market that we do not think is particularly overextended. Japanese stocks are at a similar level to where they were three years ago. So, you know, we do think that that overall for markets, you know, there are enough places where we think the valuations are acceptable, that that we think the overall investment environment will ultimately be a constructive one. But investors do need to be mindful of that, that, you know, it is a market where some parts of the market have become a lot more expensive and that that obviously creates some dangers.


Sheets: Chetan, thanks for taking the time to talk.


Ahya: Great speaking with you, Andrew.


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