Via Morgan Stanley:
November is the month when our macro team gets together to discuss its year-ahead outlooks across all asset classes. It’s a rigorous two-week process that allows us to collaborate and think about the next 12 months rather than the next 12 hours. As a strategist, I’m always torn between trying to forecast the next year versus the next week, and quite frankly I look forward to thinking about the longer term. However, with a US election this month and an ongoing global pandemic, this year’s process presented some unique challenges.
The 12-month view is often easier to map out than the very short-term outlook because it comes down to things that can be analyzed and forecast – namely, earnings and interest rates. While flows, sentiment or positioning may dominate stock prices in the short term, the value of a stock is ultimately determined by earnings and valuation, which is heavily dependent on interest rates. On both counts, our calls this year have been highly consistent. We’ve been well ahead of the consensus on the recovery story and specifically on earnings. We have also been more bearish than consensus on bonds, especially long-dated ones, where we think rates are likely to head meaningfully higher next year.
Last week, we got more good news that supports these views. Moderna announced that its COVID-19 vaccine was 94.5% effective in trials, and the final analysis showed Pfizer’s vaccine to be 95% effective. The initial reaction in equity markets to Moderna’s release was bullish, but more muted than after the initial Pfizer announcement of 90% efficacy. Interestingly, none of the major large-cap US averages are currently trading above their levels immediately after Pfizer’s first announcement on November 9. Yet, the small-cap Russell 2000 is higher.
Effective vaccines are exactly what the doctor ordered to get the economy fully reopened next year. Furthermore, they’re also what’s needed for greater participation in the economy from citizens who remain wary of contracting the disease. That’s the good news. The bad news is that the vaccine won’t be ready for mass distribution for another 3-4 months as case counts and deaths increase. This juxtaposition feeds directly into our short- versus long-term dilemma when thinking about our 2021 outlook.
With US equity markets a bit exhausted at the moment, I see the risk of one more drawdown before year-end. Nevertheless, I remain a steadfast bull on a 12-month view in terms of both the earnings outlook and the market. New bull markets that coincide with a new economic cycle last for years, and the business cycle trumps the political one. In S&P 500 terms, we forecast 10% upside over the next 12 months as earnings continue to surprise on the upside, thanks to better top-line growth next year combined with extraordinary operating leverage – a typical feature of the first year coming out of a recession. While 10% upside is attractive, the real opportunity is in small-caps and stocks that can deliver the operating leverage we expect.
With our economists forecasting 7.5% nominal US GDP growth next year, a 1% 10-year Treasury bond looks awfully mispriced on a 12-month view. This has implications for equity valuations, especially longer-duration ones like the Nasdaq and S&P 500. Conversely, shorter-duration cyclical stocks should get a boost from better growth and higher interest rates – hence the rotation we have been witnessing in the equity markets from the Nasdaq to the small-cap Russell 2000 over the past few months as markets contemplate a full reopening of the economy. We think this rotation has further to go if we are right about the economy and rates (Exhibit 1).
Bottom line, as we look forward to a more normal year in 2021, we expect US equities to remain firmly in a bull market. In the near term, stocks are elevated and may have to contemplate a second wave in the absence of a fiscal deal and before the vaccines can be widely distributed. The real opportunity next year for investors is likely to take place below the surface in smaller-cap stocks that have greater sensitivity to what is likely to be a very strong economic recovery. Along these same lines, financials, consumer services, materials, industrials and cyclical technology stocks should do best.
In short, value-rotation. I think that that is right for 2021 but only briefly before secular stagnation and lowflation return, reboosting growth (unless we do get an MMT breakthrough).