Economic Outlook 2021

"The weather is a great bluffer. I guess the same is true of our human society — things can look dark, then a break shows in the clouds, and all is changed, sometimes rather suddenly." - EB White

2020 will go down as an historic year for its unique economic trajectory. In the beginning, Australia was battling intense bushfires in a period of black summer with fires burning in many parts of the country. Economists described it as the costliest natural disaster in Australia. And then, COVID-19 struck and completely overshadowed the effects of bushfires.

We encountered the deepest global recession on record, which was followed by the sharpest rebound, as the world economy restarted off the policy support and easing of lockdown restrictions. There was a point when fear was widespread, toilet paper was scarce, and Americans were loading up on guns to prepare for an apocalypse. Thankfully, common sense has made it back.

As we turn the page and look ahead to 2021, we are likely moving from a period of hope to a period of growth. Scientists have delivered more than one successful vaccine in record time. The collective efforts of central banks, governments, and businesses to respond to the situation has made a strong case for the consensus to back the healing global economy with a ~5%-6% growth forecast in 2021.

How do we plan to navigate 2021?

I am borrowing a quote from Howard Marks to extrapolate how we are making sense of the world events.

“In the world of investing, perception often swings from flawless to hopeless. The pendulum careens from one extreme to the other, spending almost no time at the happy medium and rather little in the range of reasonableness.” - Howard Marks.

Our brains constantly simplify our choices by dividing things between two – good & bad, introvert & extrovert, optimism & pessimism; the list goes on and on. There is nothing wrong with this because we cannot function without generalisation. That is the reason we need experts in separate fields who act away from innate binary thinking because most of the time, answers lie in the middle of two extreme possibilities. Extreme optimism and incurable pessimism may seem to be complete opposites, but they both end in apathy.

The global economy is healing but not out of trouble. The situation is bad but getting better at the same time. It is more important to ensure survival during periods of extreme uncertainty than to guarantee maximum returns.

The traditional business cycle playbook is not applicable under current conditions. The COVID shock is more of a natural disaster, which is typically followed by a rapid economic restart. While the global healing process continues, there are forces that will determine the shape and pace of the recovery:

Vaccine, the game changer

The UK commenced rolling out of the Pfizer - BioNTech COVID-19 vaccine last week and, following FDA approval, US rollout will start this week. On vaccine expectations, markets have rebounded faster than the economy itself and share prices are reflecting the future benefits before they are realised.

Virus cases are still rising, and a mass vaccine distribution is not going to be a walk in the park. A major portion of the world’s population is not likely to get vaccinated next year due to supply & economic constraints, or personal choice; uncertainty will persist. We are holding on to our approach of focusing on the investments that can deliver with or without effective deployment of a vaccine.

Geopolitics – All about China

US China rivalry is accelerated and has moved the focus to resiliency in supply chains with less priority on efficiency. Both countries are working towards one goal, self-sufficiency. China has started investing in foundational technologies like semiconductors, an industry firmly rooted in Silicon Valley. The rivalry is here to stay even with lifetime diplomat, Joe Biden in the White House.

China’s share of world GDP has been steadily growing and is in a privileged position as one of the primary drivers of global growth and a gatekeeper to the world's biggest consumer market. Westpac forecasts China's economy will be 12% bigger at the end of 2021 compared to the end of 2019. China has already recovered lost output and has benefitted from the first in first out scenario.

Therefore, we utilise global managers that have an unbiased approach in sourcing international investments in both US and emerging markets, including China. For investors it is not a question of choosing between US and China, as both are key growth engines of the global economy and we should seek to benefit from both. Hence, we own investments in both jurisdictions.

What about Australia?

Heightened tensions throughout 2020 have strained the strategic relationship between Australia and China. China has imposed tariffs on Australian barley, meat, coal, and wine. Although the tariffs have generated plenty of negative news, these exports only make for a small portion of total Australian exports to China. Instead, iron ore is the major heavy lifter and China would not be able to replace these imports easily, given the high quality of Australia’s iron ore and supply constraints in Brazil.

Inflation; no longer a disease

Inflation has always dominated economic discussions. It has a direct impact on the purchasing power of cash. Famous economist, Milton Friedman defined inflation as a disease that can destroy an economy. The game of inflation has changed, and now central banks are willing to let economies run hot to achieve their inflation targets.

Simply put, a moderately rising inflation is consistent with a recovering global economy. Interest rates are likely to be on hold for few years and yield will be hard to find. We explore further opportunities in sectors that could benefit in a rising inflation regime like infrastructure, commodities, and real estate assets.

Dollar is not static

Investors who invest outside Australia do not have any choice but to think about currency volatility. On a relative basis, we expect the Australian dollar to strengthen against the US dollar. The fundamentals for the Australian dollar look supportive – resilient commodity prices, great fiscal capacity and a contained COVID environment.

The US dollar’s traditional status as a safe haven asset saw its value spike in March. It is quite usual for investors to hoard US dollars in highly uncertain times and to reverse the flow to high yielding currencies when the risk sentiment has improved. It means global economic recovery will likely weaken the US dollar. To protect our US denominated international holdings from a weakening US dollar, we continue to implement adequate hedging in clients portfolios.

Money supply like blood

Money supply in an economy is like blood in the body. Blood needs to keep flowing, else you die. Similarly, a well-functioning and healthy economy needs money to change hands and benefit from the multiplier effect. That is the reason governments injected unprecedented levels of liquidity into the economy to help businesses stay afloat, support households and preserve employment.

We saw in the world of low interest rates, monetary stimulus was not enough, and fiscal support had to come to the rescue. Some countries have more fiscal capacity than the others and the difference in the policy support is/will generate a different set of outcomes for these economies. We seek opportunities in jurisdictions with adequate policy support.

Are equities too expensive?

On traditional metrics, equities look expensive relative to their own historical prices. It is challenging to find good bargains in the current environment as investors are willing to pay a premium for the businesses with fortress balance sheets and steady growth prospects. Valuations are driven by the hunt for yield. The coupon payments on bonds are falling short of the dividends from equities. Low interest rates encourage risk taking in the markets and swell the time value of future cash flows.

We believe certain types of exposure offer better value than the majority investments. For instance, Microsoft, a stable compounder with low perceived risk of default; Microsoft flaunts a credit rating better than the US government. We are constantly watching the price action of the investments that sit on our watchlist to find opportune entry and exit points.

Bottom Line

Overall, we think the environment for 2021 is compelling for the investment strategies we are pursuing. In a fragile world, we aim to invest in companies that can sustainably compound high returns on capital. We enter 2021 confident and see more gains ahead for those who are willing to embrace our selective approach to quality and resilience.

May this holiday season make way for a fresh and bright New Year for you. Please get in touch for more insights.