We expect a near-term economic double-dip for the global economy gives way to a vaccine-led broad recovery in 2021.
Key signs on the path to recovery: the second wave of lockdowns ending successfully this winter, mass immunization beginning in the spring, followed by a sharp rebound in economic activity in virus-depressed sectors over the summer. Deviation from the path may mean bad news for global stocks.
The new cycle comes with new leadership as international economic and earnings growth are likely to exceed the U.S. for the first time in years, supporting relative outperformance by international stocks.
As 2020 draws to a close, economic momentum is fading with infection rates on the rise, governments responding with more lockdowns, and few prospects for any major near-term fiscal stimulus. However, the global economy has the potential to make a full recovery in 2021, rebounding from the -4.4% decline in 2020 with growth of +5.2% in 2021, according to current estimates from the International Monetary Fund (IMF). Next year we expect very easy monetary and fiscal policy combined with a vaccine rollout beginning in the first half of 2021 to lead to a strong rise in economic and earnings growth. This 2021 backdrop may see the U.S. pass the baton of global growth leadership to Europe, favoring international stocks and a broader overall market advance compared to 2020.
Revisiting last year’s chart of the OECD composite leading indicator, we can see 2020’s sharp V-shaped recession and accompanying recovery. In our Outlook last year, we noted how the global economy had slowed and was on the threshold of a recession, indexed at the 99 level on the chart. Pre-pandemic, in the fourth quarter of 2019, six of the Group of Seven (G7) economies (Canada, UK, Japan, Germany, France and Italy) had reported close to zero or negative GDP growth. 2020 was vulnerable to becoming a year of global recession with even the smallest catalyst. Of course, the COVID-19 pandemic was a big catalyst, causing a deep global recession in 2020, and we believe the path of the pandemic will define the recovery in 2021.
Deep V-shaped recession in 2020
Source: Charles Schwab, Bloomberg data as of 11/10/2020.
According to the chart of high frequency data, this year’s economic plunge and rebound was largely synchronous around the world, with the low point in April corresponding to the spread of COVID-19 infections worldwide and governments’ response of strict lockdown measures. Since midsummer, economic momentum in nearly every major economy has stalled after climbing 60-90% of the way back to pre-COVID-19 levels. Now, a second wave of restrictions in response to a resurgence of the virus is again weighing on economic growth.
High-frequency economic indicators
Source: Charles Schwab, Bloomberg data as of 11/19/2020. The activity indexes are estimated using a dynamic factor model with a methodology that extracts an unobservable latent common factor of the underlying high-frequency data—where a reading of 100 means activity has returned to pre-pandemic levels, and thus indicates strength. The axis’ scale indicates the percentage of activity that is back to normal. The sources of the underlying data used in the model are: Bloomberg Economics, Google, Moovitapp.com, German Statistical Office, BNEF.com, Indeed.com, Shoppertrak.com, Opportunity Insight.
New COVID-19 cases are on the rise to varying degrees in Asia, the Americas, and Europe. Asia has not suffered a second round of widespread lockdowns, although targeted restrictions have been used to respond to localized eruptions of viral infection. In the U.S., selective lockdowns in some states are being implemented as case counts climb a second time and health care systems risk becoming overwhelmed. Europe’s secondary outbreak is ahead of the U.S. with some countries’ economies already experiencing the effect of lockdowns.
Although the term lockdown is being used, compared with the restrictions imposed last spring, it’s really “lockdown-lite.” For instance, France imposed new restrictions on October 30, including a curfew and closure of non-essential retailers, but kept schools, churches, manufacturing businesses and construction sites open. This stands in contrast to the first lockdown, when all these areas of the economy were closed. While reinstated restrictions are driving a double-dip in the economic data, they may not be stringent enough to trigger another recession and bear market.
November’s “lockdown-lite” in France
Source: Charles Schwab, French government guidelines as of 10/30/2020.
Current restrictions are mainly targeted at services: travel, restaurants, entertainment—rather than manufacturing. As a result, consumers have shifted spending toward goods from experiences, resulting in a boom in manufacturing. However, because it makes up only 17% of the global economy, manufacturing is not enough to fully offset the weakness in GDP. But there is a greater impact for stocks; manufacturing businesses make up about 50% of global market capitalization. As a result, profits and the stock market may rebound much more quickly than jobs and the overall global economy.
Source: Charles Schwab, World Bank and Bloomberg data as of 11/2/2020.
Global Stock Market = MSCI World Index
We expect current economic weakness to yield to much stronger growth when lockdowns are relaxed, the weather gets warmer, and a COVID-19 vaccine becomes widely available. In addition to the economic and geopolitical risks that accompany any new year, there are heightened risks tied to COVID-19. It is unclear how quickly vaccines can be produced and distributed. We don’t know to what degree the second wave of coronavirus cases and the reinstitution of lockdowns will weigh on the global economy in the near-term. Additionally, health care systems in some areas may be at risk of being overwhelmed as they respond to an uptick in cases of the virus.
Key signs that let us know we are on the path to recovery that we are hoping to see in the year ahead include:
- The second wave of lockdowns end this winter, having successfully contained infections with less economic impact than the first wave in March and April.
- Approval of at least one vaccine by early 2021 with mass immunization to begin by spring.
- A sharp rebound in economic activity in virus-depressed sectors as immunity builds up over the summer.
We will be on watch of any deviation from this path since it may mean bad news for the markets. But if we see these signs, the economy and market may remain on the path to recovery despite some negative data points. For example, business failures and unemployment may be elevated for some time, as is often the case early in recoveries. In fact, business failures may surge in 2021. Again, using France as an example, the country has averaged 4,500 bankruptcies per month in recent years. Due to assistance and rule changes they fell to 1,500 this summer. Zombie companies that would have failed regardless of COVID-19 have piled up. Now that rules are flipping back, we may see the spike in failures continue well into 2021.
Business failures on the rise
Source: Charles Schwab, Bloomberg data as of 11/13/2020.
Risks to the Recovery
Every year the global economy and markets face risks that range from financial crises to natural disasters. In 2021 there are additional risks that are heightened beyond the path of the pandemic, including those posed by: debt, politics, and trade.
- Debt borrows growth from the future; and we’ve borrowed a lot this year. If rates continue to rise, the interest burden could become a factor that slows growth.
- The new U.S. administration could face a geopolitical test as political leadership changes in 2021.
- A post-Brexit UK-EU trade deal has not been finalized.
- U.S.-China trade tensions remain.
Passing the baton
After years of economic and earnings growth in the United States exceeding the rest of the world, this is expected to change in 2021. The blue chart shows the most recent forecast for GDP for each country from the World Economic Outlook published by the IMF in October 2020. Below it, the orange chart shows the current consensus earnings per share growth forecast by Wall Street analysts for companies headquartered in each country. Both charts imply a change from the last cycle, when the U.S. led global economic and earnings growth, with the start of this new economic cycle.
Faster economic growth outside the U.S. expected in 2021
Source: Charles Schwab, IMF WEO as of October 2020.
EM = Emerging Markets
Faster earnings growth outside the U.S. expected in 2021
Source: Charles Schwab, Factset data as of 11/16/2020.
MSCI Indexes used for each country or region.
EM = Emerging Markets
A strong rebound in earnings per share growth can help ease concerns about stock market valuations, which have climbed this year as stock prices rebounded and earnings suffered. A strong recovery in earnings growth would mean that price-to-earnings ratios can move lower even if stocks continue to post solid gains.
We believe the strong vaccine-led recovery in global growth aided by accommodative policy expected for 2021 should favor stocks in general, especially economically sensitive stocks. Although global equity indices are on track for gains in 2020, these gains have been narrowly concentrated in a relatively small group of stocks that have benefitted from COVID-19 and subsequent government restrictions. The huge gap can be seen in the chart below, with the strong performance of the top 20% of stocks this year in sharp contrast to the other 80% of the stock market, which suffered losses. While improving in November, cyclical stocks have generally moved sideways since early June, leading us to believe that markets have not yet priced a broad recovery.
Source: Charles Schwab, Factset data as of 11/20/2020. Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly. Past performance is no guarantee of future results.
This disconnect within the stock market is hiding what we believe could be a long-term shift favoring international stocks. We can look at what the average stock has done this year by using equal-weighted indexes, instead of using capitalization-weighted indexes that have been driven by a small number of stocks this year. In 2020, the average international stock has kept pace with and even slightly outperformed the average U.S. stock for the first time in years, as you can see in the chart below, signaling a potential change in leadership from the last cycle.
Average international stock outperforming average U.S. stock in 2020
Source: Charles Schwab, Bloomberg data as of 11/13/2020. Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly. Past performance is no guarantee of future results.
New economic cycles come with new leadership. Market leadership tends to last for many years, even a decade before reversing at the start of a new cycle. For example, after international stocks outperformed in the 1980s, the 1990 recession saw a shift to U.S. stock outperformance. The 2001 recession saw a switch back to international outperformance, before the 2008 recession flipped the switch again to U.S. outperformance. And now, the start of a new cycle may once again signal a switch to international stocks.
Annualized performance by economic cycle
Dates reflect economic peaks defined by the National Bureau of Economic Research. Annualized total return between cycle peaks measured by MSCI USA Index and MSCI EAFE Index.
Source: Charles Schwab, Bloomberg data as of 10/31/20. Past performance is no guarantee of future results.
These changes in leadership result from both behavioral as well as fundamental factors. After a full cycle of outperformance, relative valuations and earnings expectations often get stretched and begin to reverse with the catalyst of a new cycle. These factors have aligned once again favoring international stocks as we wrote about in more detail here. History tells us that valuation extremes alone are rarely the trigger for changes in market direction or leadership, but they do help to support a shift during new market cycles.
As we look to relative stock performance in 2021, emerging markets require a special mention. History has shown us that emerging market stocks usually outperform developed market stocks in the first year of an economic recovery. Now we know that emerging markets were ground zero for the COVID-19 crisis, which started in China. However, most major emerging market economies came into this recession with fewer fiscal and monetary imbalances compared to the prior two recessions, having more manageable debt and deficits and even trade surpluses in some cases. Additionally, central banks acted swiftly to alleviate financial stress in global markets, allowing for emerging market policymakers to quickly enact stimulus without concern of a weakening currency. This healthier backdrop for emerging markets, combined with the global economic rebound and weaker dollar may propel the performance of emerging market stocks during the new cycle.
We expect that a near-term economic double-dip for the global economy gives way to a vaccine-led broad recovery in 2021. Key signs to watch to stay on the path to recovery include: the second wave of lockdowns ending successfully this winter, mass immunization beginning in the spring, a sharp rebound in economic activity in virus-depressed sectors unfolding over the summer. The new cycle may come with new leadership as non-U.S. GDP and EPS growth are likely to exceed the U.S. for the first time in years supporting relative outperformance by international stocks.
Last year, we talked about the coming end of the cycle shift in leadership in the 2020 Global Outlook. As the new cycle gets underway in 2021, rebalancing portfolios, a component of which rebalances exposures to international stocks relative to U.S. capitalization-weighted benchmarks, is important to staying on the path to long-term financial goals, regardless of the short-term path of the market.
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