Will economic reopening roar past 2019 levels?

Manulife Investment Management’s top strategists assess the impact on equity markets, whether there is a real risk of overheating, and if this era is a case of history repeating

Will economic reopening roar past 2019 levels?

The global reopening is in full swing but concerns persist over the impact of the unprecedented amount of fiscal and monetary stimulus pumped into the system. How quickly will the global economy respond? Is there a danger of it overheating? Will inflation spiral out of control?

These were just some of the questions posed when Wealth Professional hosted a virtual roundtable with Manulife Investment Management’s Capital Markets Strategy team, consisting of Chief Investment Strategist and Head of Capital Markets Research, Philip Petursson, and Senior Investment Strategists Kevin Headland and Macan Nia. You can watch the full 2021 Mid-Year Outlook here.

Impact on equity markets

The ongoing question is how the global re-opening will affect equity markets as COVID immunization numbers continue to increase? Petursson believes there are reasons for optimism and that the recovery is on track to exceed where we were in 2019.

“We’re seeing solid evidence of a very, very strong reopening in the United Sates,” he said. “This is probably leading the rest of the world as far as the economic reopening goes. But, if you look at Canada and other countries, we’re not too far behind and the results are promising.

“We believe that the global economy will not only emerge out of these COVID lockdowns to where we were in 2019, but we may surpass it given all the monetary and fiscal stimulus that has been put into the system.”

Equity markets have responded to stronger sales and earnings growth, particularly in Q1 of 2021, and this trend is expected to continue through this year and into 2022. Bond markets, however, are bearing the brunt of the reopening with higher interest rates having put pressure on bond prices, generally leaving markets modestly negative year to date. 

Too hot to handle?

When asked whether the economy is in danger of overheating, Nia saw three potential risks for 2021: recession, inflation, and geopolitics. However, he believes none of these should weigh too heavily on investors’ minds.

Regarding recessionary risk, the metrics around manufacturing, employment, and financial conditions suggest the probability of a recession is low for the rest of 2021 and start of 2022. Meanwhile, the Capital Markets Strategy team does not anticipate a central bank policy mistake caused by inflation surging materially higher than 3% as spending resumes. Geopolitical activity is a perennial risk but one that tends to affect short-term prices only.

Nia explained: “We are medium to long-term investors. If you do get that [geopolitical] sell-off, that provides, historically, a great opportunity for investors to either use some cash or increase their equity weights to take advantage.”

Inflation rates and ramifications

The team expects inflation to potentially increase more than in the past decade, which has been “stubbornly low”, according to Headland. The U.S. Federal Reserve has been trying to get it above the 2% target for years and, pre-COVID, thought it would need federal policy support to generate economic growth. Instead, the world’s monetary and fiscal policy COVID support has been the stimulus to drive inflation higher.

While the word “transitory” has been thrown around recently, Headland said no one has really defined what it means. Is it one, three, six, or 12 months? Or does it mean pushing inflation from elevated levels of 5% to below 2%?

“While we do not believe that inflation will remain at these levels currently – near 5% – on a year-on-year basis, we do believe it will remain above the 2% level for quite some time,” he said, noting that the team expects the Fed to keep rates near zero bound for a while yet.

Petursson added that the Fed’s most recent statements indicated inflation might be slightly higher and more persistent than originally expected, so it revised expectations higher by 1% for headline inflation and 0.6% for core inflation for the rest of 2021.

“This is a good acknowledgment that inflation is less transitory, and a little bit more persistent,” he said. Now, he expects the central bank to keep short-term rates low through 2021 and most of 2022, but nudge them up in the back half of 2022 to return to a more normal level. This gives investors a runway of about a year of the Fed fund rate hovering around zero before rates are potentially hiked in Q4 of 2022.

What era does this remind you of?

With many pundits and analysts comparing this era to the 2000 precursor to the “tech wreck”, primarily because of tech valuations, Petursson argued that, while valuations are similar, the rest of the environment is completely different.

“In 2000, we were headed toward the recession of 2001,” he said. “We were headed toward the earnings collapse and we were headed toward economic stress and other exhaustion shocks, like 9/11. We think this environment is much more like 1993 or 1994, where we’re moving away from the recession. We just came through the recession in the bear market.”

While Petursson said valuation is more a function of the market’s attitude toward earnings this year and next, which is like 1991, the two periods looked very similar when valuations jumped.

During the 1992 to 1994 economic recovery, he explained, “earnings growth expanded at a very, very healthy pace. That allowed for valuation to moderate and yet still deliver positive returns for equity investors.” That seems likely now since there’s been a strong 2021 earnings rebound, expected to continue through 2022.  So, much like the early 1990s, valuation isn’t much of a concern in this rising earnings environment.

For more, including the outlook on asset classes, the loonie, and fixed income, watch the roundtable here.

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