Equity investment attitudes in 2020 were mostly shaped by the pandemic and by scepticism that life and the economy would ever be the same. In our view, the COVID-19 economic damage will diminish greatly through 2021, while confidence in a return to a recognisable social and business landscape will grow.
We believe the V-shaped recovery that began in May for most economies will give way to a less dynamic, possibly bumpier phase of growth. The U.S. and Canadian economies should regain their pre-pandemic high ground by late 2021/early 2022. For Europe, the UK, and Japan, it will likely take a couple of quarters longer. China’s economy has already recovered all the ground lost to the first half’s COVID-19 shutdown.
Earnings, already in recovery, could surprise to the upside in 2021 and 2022 as some sectors and groups, crippled by the pandemic, return to life. The strong rebound off the deep March lows suggests to us that investors have already paid in advance for some of that expected return to “normal.” However, that still leaves the S&P 500 only modestly above where it was in Feb. 2020 before the pandemic, with all the other major averages in Canada, Europe, the UK, and Japan lingering below their pre-pandemic peaks.
We expect equity prices will appreciate further from today’s levels through 2021, although not by as much as earnings advance, bringing price-to-earnings ratios down modestly.
Beyond next year
For 12–18 months following the end of a recession there is usually very rapid catch-up growth for both GDP and corporate profits. Thereafter, the GDP expansion settles into a trajectory more closely aligned to the economy’s longer-term potential growth rate. Following are some observations on factors bearing on this long-term outlook.
In the decade following the global financial crisis, the U.S. economy and most other developed economies grew more slowly than they had in the post-World War II era up to 2007. U.S. nominal GDP growth (i.e., growth without taking out the effect of inflation) averaged 6.9 percent per annum from 1945 to 2007. Following the end of the financial crisis and associated deep recession, U.S. GDP grew for an uninterrupted 10 years but at a rate of just 4.1 percent. The slowdown was attributed to the combination of slower growth of the labor force as the baby boomers hit retirement age and the drag that resulted from the deleveraging of U.S. households.
There has been an implicit expectation that growth would pick up once the household deleveraging was over, but that has proven not to be the case. Now, the Congressional Budget Office, a nonpartisan federal agency that prepares long-term forecasts of the U.S. economy for Congress, projects nominal GDP growth will average just 4.3 percent from 2020 to 2030.
Slow/declining growth in the working-age population will likely continue to be the chief culprit aided and abetted by the drag stemming from the large buildup in government COVID-19-related debt, which RBC Global Asset Management estimates will shave about 0.1 percent to 0.2 percent from the per annum growth rate over the decade. All the developed economies are faced with these same two issues.
Birth rates per woman
World Bank replacement birth rate = 2.1
Source - World Bank
Immigration could be an offset to declining birth rates, but U.S. immigration policy has become steadily more restrictive over the last 20 years; the migrant crisis has diminished the appetite for newcomers in much of Europe; Brexit was in large part a reaction to unrestricted immigrant inflows from the EU; while Japan has never encouraged immigration nor has China. Canada still has an appetite for immigrants on its terms, but the doors are shut until the pandemic abates.
In broad terms, economic growth is the combination of growth in the workforce and the increase in the productivity of all workers. With workforces slowing or declining across the developed world, productivity is left to do the heavy lifting. Productivity is not easy to measure and notoriously difficult to forecast.
When the pie is growing quickly, as it was in the 65 years following World War II, it can nurture a great many businesses, from large established firms, to the up-and-coming, to start-ups. When that growth rate slows by a third, as it has done since 2008, competition intensifies, the weakest may get driven to the sidelines more quickly or absorbed, and corporate concentration becomes more apparent. A handful of dominant leaders emerges in many sectors, acquiring middle-level players along the way. These dynamics have played out over the past decade and are likely to do so again in the coming one.
Fierce competition for market share tends to drive up companies’ capital spending. Increasingly that spending has become technology-focused. Firms need diverse capabilities if they intend to stay ahead or catch up: to reach customers and anticipate their needs; to rapidly develop new products and get them to market; to manage inventories, replenish, and reprice; to manage supply chains and working capital; etc.
The digital economy is now thought to be approaching 10 percent of U.S. GDP, and growing. That would make it larger than the financial sector. The pandemic has revealed that businesses without a viable, functioning digital presence are at an enormous competitive disadvantage. The race is on to acquire that capability.
Tech-related capital expenditure is soaring
Source - U.S. Federal Reserve, U.S. Bureau of Economic Analysis; private fixed investment in information processing equipment and software, billions of dollars, seasonally adjusted annual rate, quarterly data through July 2020
This growth in capital spending is good for profits, employment, and productivity when looked at across the total economy. But within an individual sector or industry group, the willingness and capability to spend what it takes—maybe more than it takes—becomes a differentiating factor that can separate dominant industry leaders from the rest.
China slows, but still leads the pack
China’s rate of GDP growth has been gradually slowing over the past decade. It will slow further over the next. But it is still likely to outpace all the developed economies, including the U.S.
It’s clear that China is also experiencing the same demographic slowdown that the developed economies are faced with.
However, China enjoys several advantages on the productivity front. Among them are the ability to keep bringing underemployed agricultural workers (25 percent of total employment, down from 60 percent in 1993) into the urban industrial workforce—a powerful source of GDP and productivity growth by itself—and the continuing availability of higher-return infrastructure projects than are typically available in the developed economies. These tailwinds will continue to add to growth for at least another decade, in our opinion.
Bringing farm workers into urban employment can only happen if there is sufficient demand for what they produce. With more than half the workforce employed in agriculture until 2003 there was never enough domestic demand. That left exports as the prime driver of modernisation.
Between the late 1990s and 2008, China’s exports grew almost tenfold, and over the next seven years to 2015 by another 60 percent. Since then, they have stagnated, not growing at all, falling from 21 percent of GDP to 17 percent. In the process China’s economy has become more balanced, driven more by domestic demand than foreign.
With the urgent need to export behind it, China has shifted its priorities to becoming globally competitive, then dominant, in the production of high-value goods and services, particularly in technology and production equipment. It already has a growing presence in several strategically important fields. This thrust by the fastest-growing and second-largest economy in the world will just add to the intense competitive pressures already evident in the developed economies.
Protectionism: “Everybody’s doing it”
So too will protectionism, which looks set to be a prominent and growing policy feature globally. President-elect Joe Biden’s “buy American” proposals, if implemented, will further encourage a trend already in evidence for several years—the building of new manufacturing facilities in the U.S., whether by foreign companies wanting to ensure access to the U.S. market or by domestic companies who have watched the cost gap between U.S. and China-based production narrow dramatically over the past decade.
Unsurprisingly, as the past several years have evidenced, trade barriers erected by one party have usually produced a tit-for-tat response from the other. Whatever a country might stand to gain from keeping imports out, it loses some or all of it from the export account. The long-term benefits of “comparative advantage” are a tough sell to voters and politicians tempted to take the short-term gain, justified by perceived grievances of “unfair” treatment.
Whatever the concerns about potential long-term misallocation of capital or the undercutting of free markets, in this case, at least for a few years, the “buy American” policy tilt will likely provide a welcome boost to capital spending, to employment, and to productivity. So too might the responses of trading partners for their respective economies.
Implications for equity markets
Over the long term, equity values have appreciated in line with earnings. And earnings have grown at a pace somewhat faster than, but close to, that set by economic growth—in this case, nominal GDP growth (i.e., growth before any adjustment for inflation). If, as we expect, a slower-paced economy is acting to restrain the overall growth of earnings and business values over the coming couple of decades, then we would expect the resulting intensely competitive business environment will make the differences between the winners and also-rans more sharply defined.
Share prices have risen with earnings …
Source - Standard & Poor’s, Thomson Reuters, RBC Capital Markets; annual data 1945–2019, normalised to 1945 = 100
… and earnings have risen somewhat faster than the economy has grown
Source - Standard & Poor’s, Thomson Reuters, U.S. Federal Reserve, RBC Capital Markets; annual data 1945–2019, normalised to 1945 = 100
That sets a useful hurdle rate for stock selection. In terms of long-term positioning, we think portfolios should be populated to the greatest extent possible with the shares of those businesses for which there is high conviction that sales, earnings, and dividends can grow faster than the economy.
Those companies will almost always be trading more expensively than the average. That would be even more the case if, as we expect, the corporate concentration that is likely to come with slow GDP growth and more intense competition winnows down the number of sustainable dominant leaders in each sector. If it turns out these companies are able to deliver that superior, sustainable growth, then they will likely go on being more expensive than average.
Positioning for today
We recently changed our recommended exposure to equities in a global balanced portfolio from a benchmark weight to Overweight, or above-benchmark. This is not a big tactical shift. Rather, it is a recognition that the driving force behind earnings growth and equity valuations is rapidly shifting away from the outsized volatility risks presented by the pandemic and back toward the long-term expectations for sustainable economic growth.
The COVID-19 economic damage should diminish greatly through 2021, while confidence in a return to a recognisable social and business landscape will likely grow. As GDP climbs back toward its pre-pandemic peak, corporate earnings, already recovering, could perform better than expected through 2021 and 2022. Stocks in the major markets have priced in some of this better earnings trajectory but not all. We expect equities could provide attractive all-in returns in 2021, and probably for 2022 as well.