Net exports. The viral crisis has worsened the U.S. net trade balance. While both exports and imports have started to recover, imports have recovered more. As the U.S. economy recovers, this trend is likely to continue, suggesting net exports will be a drag on the economy into and through 2021.
Government spending. Now we get to the wildcard—government spending. It is the final component of the economy and is usually a consistent data point. In 2020, however, government spending was one of the dominant features of the economy. The multitrillion-dollar complex of stimulus programs (monetary and fiscal) has kept large sections of the consumer and business economies alive.
With the election moving behind us, more stimulus is likely at the start of next year. Low interest rates will remain effective, and expanded unemployment insurance will likely be renewed. But this federal-level stimulus may be offset by cuts in government spending at the state and municipal levels. So, net stimulus is likely to be close to even, leaving government spending as a neutral factor through 2021.
On the whole, the slow healing process of 2020 will likely segue into renewed growth in early to mid-2021. The first and second quarters will show slow growth, similar to the second half of 2020. Then, the economy should normalize, federal stimulus measures will wind down to zero, and state and municipal spending should move back to normalized levels. Given this, we could see faster growth in the second half of the year. If the virus is controlled, through a mix of policy and vaccines (again, our base case), and the economic recovery continues at its current rate, a recovery to January 2020 levels by the end of 2021 looks quite possible.
The Financial Markets: Constrained Through 2021?
Next, let’s turn to the financial markets. There are a few areas we should focus on for the rest of the year: interest rates, which are influenced by inflation, as well as the stock markets here in the U.S. and globally.
Inflation. Inflation is likely to remain low through 2021. The tremendous demand shock of the first half of 2020 has driven inflation rates down significantly. Even with a recovery in 2021, it will take time to normalize them. Supply shocks have also raised inflation in certain areas. They are likely to subside as well, further mitigating any inflationary pressure.
Interest rates. So, we know that inflation should remain low and the Fed is committed to continued low rates as support for the economy. As such, interest rates may increase a bit but should remain low across the curve. In turn, fixed income returns will continue to be constrained given low coupon rates and the possibility of rate increases.
U.S. markets. Stock market returns are also likely to be constrained through 2021. Stock valuations depend on two things: earnings and interest rates. Interest rates, as noted above, are likely to remain low but may increase somewhat as the economy recovers. That creates a headwind for stocks through the end of the year.
Earnings are also likely to remain constrained, even with an ongoing recovery. According to Yardeni Research (as of November 11, 2020), earnings for the S&P 500 for 2021 are estimated to be $168.22. This number is only about 3 percent greater than the 2019 total of $162.97. In other words, markets are expecting a recovery through 2021, with earnings up substantially from 2020. But valuations on a forward basis are still quite high, which could constrain further gains.
This valuation is actually a bit misleading. In fact, 2020 earnings are still on the recovery path from the pandemic. If we look at 2022 expectations (i.e., $195.58), we see much greater appreciation potential. With ongoing economic recovery and the possibility of one or more vaccines, that valuation seems very achievable. So, with a year-end multiple of 20 on forward earnings (which is at the lower end of recent valuations), a potential target for the S&P 500 is 3,900—or about 10 percent above current levels.
International markets. When we look at international markets, we see much the same story on a gross value basis (see Figure 6). Current valuations are well above 10-year averages, based on 2021 earnings. These valuations suggest that markets are not cheap and, on a relative basis, are even more expensive than comparable U.S. stocks. In that difference may lie a risk. Given the dependence of many of these markets on global trade and the likelihood of slower pandemic recoveries, they may continue to lag U.S. stocks—even before considering the higher valuations.
High valuations, greater exposure to global trade risks, and continued growth of the pandemic (in many cases) are likely to constrain international markets. As with U.S. markets, expect year-end levels to be constrained and depend largely on whether countries bring the pandemic under control. This would set the stage for faster growth in 2022.
The Risks: What Could Go Wrong?
As of this writing, the medical risks have risen, with the third wave of infections well underway. Nonetheless, the base case remains that those outbreaks will be contained into 2021 through policy actions and that vaccines will become available through 2021. As of now, the economic news continues to improve despite the rising medical risks. Even with some setbacks expected, the recovery is on track to something approaching normal by the end of 2021. Indeed, stock markets have largely already priced in this recovery through 2021—although further growth in 2022 provides for future appreciation above current levels.
Upside risks. The upside risks are primarily medical in nature. An effective treatment regimen for the virus would be helpful, while a vaccine would be even more so. We can reasonably expect one of the two in 2021, possibly even both. The need to massively scale both production and delivery of a treatment or vaccine would likely take us well into the year. Still, by year-end, we should be able to have the pandemic under control.
The economic upside risks include consumer and business spending recovering faster than expected. Current expectations are that we get back to 2019 conditions sometime in the next 6 to 12 months. For there to be meaningful upside, we would need to see growth beyond 2019 levels, which were, after all, something approaching boom times. Even with the recovery going well, that outcome is not guaranteed for 2021.
Downside risks. The risks to this outlook are primarily on the downside, which appear very possible. The base case—vaccines and treatments bringing the virus under something approaching full control in 2021—is by no means assured, especially as the third wave continues to accelerate worldwide. If the vaccines and treatments do not pan out and if we do not see enough policy and behavioral changes to slow infection growth back to prior levels? The base case would be at risk.
Further, although the economic recovery has been steady and much faster than expected, that could pause or even reverse. First, a renewal of shutdowns could shake confidence. Second, other factors (e.g., a slowdown in the rehirings underway) could also do damage. With so many factors (medical, employment, trade) in play, the potential for something to go wrong remains very real. And that is before we even consider political factors, such as continued deadlock in the U.S. government and failure to enact supportive policies. The risks are real.
Let the Healing Continue
Even with all the risks discussed here, the base case is this: the virus will be brought to heel in 2021, the economic recovery will continue and approach something like the pre-pandemic normal, and political concerns will not disrupt the economy in a significant way. As of late 2020, the prospects for 2021 remain positive.
In 2021, we will likely see a continued healing process, with progress and setbacks. This story is not what we expected at the start of this year. But it is much better than it might have been—and much better than what we could have expected a month or two ago. Healing is underway, but healing takes time. And that will be the story of 2021.
Brad McMillan is the chief investment officer at Commonwealth Financial Network.