After a year of chaos, the 2021 investment outlook is refreshingly normal: Trust the recovery and, for most assets, stick with the early-cycle playbook.
The social and economic uncertainties stemming from the COVID-19 pandemic won't suddenly subside with the end of the 2020 calendar year. However, from an investment perspective, 2021 could offer a welcome change in the narrative—a return to normal.
“Though challenges remain, we think this global recovery is sustainable, synchronous and supported by policy, following much of the 'normal' post-recession playbook,” says Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley Research.
A cornerstone of this outlook—which includes positive adjustments to several economic estimates—rests on sustaining the V-shaped recovery that began in May 2020, leading to 6.4% global GDP growth in 2021 and price appreciation for a wide range of asset classes.
Indeed, Morgan Stanley’s strategists expect 25% to 30% earnings growth across major equities markets and significant declines in corporate leverage—key factors in their call to overweight equities and credit vs. government bonds and cash, along with positioning for U.S. dollar weakness.
Despite the highly unusual circumstances surrounding 2020, this pattern has played out before. In 2010, for example, investors questioned the market rebound’s sustainability, but we now know that period marked the start of a long bull market.
“The lesson from 2010, which we think also applies to 2021, is that the cycle usually wins out," says Sheets. “In short, we think that 2021 will see above-average risk-adjusted returns in equities and credit, and support a modestly above-average weighting to both."
Forecast change in global GDP, U.S. GDP, earnings and U.S. leverage
(2020 vs. 2021 forecast)
One exception to the typical early-cycle playbook is timing. “Normally, uncertainty rises with time, but today, we have higher conviction in our 6-to-12-month view than our three-month view," says Sheets. He adds that near term, markets still need to grapple with uncertainties around COVID-19, fiscal stimulus and whether U.S. Senate runoff elections in early January lead to unified government or keep the status quo of divided government.
Here are six key takeaways from the 2021 investment outlook.
In their outlook a year ago, Morgan Stanley strategists expressed concerns about a late-cycle economic backdrop and elevated valuations both of which informed their expectations of below-consensus earnings and single-digit equity returns.
It's a very different picture today. “We’ve now transitioned to an early-cycle environment, which implies strong profit growth that we believe is not yet priced into markets, despite the market's recent rally," says Sheets.
The strategy team is forecasting 25% to 30% earnings per share growth across regions in 2021, though they see the greatest potential for double-digit returns in developed markets.
Among U.S. companies, Chief U.S. Equity Strategist Mike Wilson says earnings growth could initially come from top-line improvements, with better margins leading the way. “Add additional fiscal stimulus and business reopenings to the equation and we think earnings growth could be explosive and surprise to the upside," says Wilson, who forecasts that the S&P 500 could reach 3900 by the end of 2021.
Morgan Stanley strategists expect a strong recovery in earnings-per-share growth across all regions in 2021
In another parallel with 2010, the market will enter 2021 on the heels of a post-recession rally. This raises the eternal question of whether stock prices have already baked in earnings improvements, but the strategists note that global equity valuations look reasonable by many measures, including risk premium relative to historical volatility, and the MSCI World index relative to the Global Purchasing Managers' Index, a key indicator of manufacturing activity.
Additionally, COVID-19 cases and geopolitical uncertainty appear to be muting investor sentiment. “This suggests that the strong growth outlook we are forecasting is not fully priced into the equity markets," says Sheets.
Though earnings growth should be consistently elevated, valuations appear uneven. Stocks in Europe and Japan, for example, have treaded water for five years, while U.S. small-caps and emerging markets have done so for three years. Sheets highlights that, coming out of 2010, U.S. small-cap stocks nearly doubled the return of the S&P 500. In other words, starting valuation is key.
Risk-adjusted valuations may now be reasonable
Risk premium (bp)
Keeping with their view that this cycle will be relatively “normal," the strategists are inclined to trust the recovery and favour early-cycle outperformers. “Coming out of a recession, we think it pays to buy stocks with the lowest expectations," says Sheets.
That means owning small-caps over large-caps. Smaller companies typically lead coming out of recessions, and additional fiscal stimulus measures would likely be more supportive for smaller firms. The early-cycle playbook also favours high-quality cyclicals, such as U.S. and European financials, materials, and segments hard hit by COVID-19 lockdowns, such as travel and leisure.
Owning “Cyclicality” may now be cheap
“Cyclicality” valuation (15Y percentile)
In their outlook last year, strategists noted that Europe, long unloved and undervalued, was set to turn around. Then COVID-19 sent most of Europe into lockdown, resulting in what will likely be the worst year of European relative performance since the 1980s.
While Europe continues to grapple with the pandemic, last year's poor performance, coupled with strong fundamentals and policy support, could set Europe up for a strong “bounce back” next year— and even into 2022—says Chief European Equity Strategist Graham Secker, whose team forecasts European average earnings-per-share growth of 30% in 2021 and 20% in 2022.
Morgan Stanley strategists forecast solid equity returns across all developed markets over the next 12 months
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Over the course of 2020, already weak corporate fundamentals seemed to get weaker, with companies tapping the bond market at an unprecedented pace. However, this surge in issuance across both the U.S. and Europe reflected companies playing defense—they wanted plenty of liquidity in case things got worse.
As the economic backdrop and earnings outlook improve, however, many issuers could use this cash to pay down debt and improve their credit ratings. For this reason, strategists favour select high-yield over investment-grade corporates across all regions, based on the view that, as credit spreads tighten, excess returns will match or exceed historical averages.
In securitised credit, strategists call for going down in quality and up in risk, given expectations for a sustained V-shaped recovery and key U.S. interest rates holding near zero until 2023.
While the early-cycle playbook for equities and credit is fairly straightforward, the outlook for other major asset classes is nuanced. For example, commodity prices tend to rise in the early stages of recovery, but strategists think this strength will be back-loaded and with high dispersion.
Take oil, which tends to be a textbook early-cycle theme. This time around, many factors contribute to Morgan Stanley's current call to pass on the commodity and buy the options instead. On the other hand, copper is a different story and Morgan Stanley metal strategists see it "ticking all the boxes" for a bull market in 2021.
For more Morgan Stanley Research on global strategy, or to read the full Morgan Stanley Research report, “2021 Global Strategy Outlook: Keep Faith in the Recovery” (15 November 2020), speak to your Morgan Stanley financial adviser or representative. Plus, more Ideas from Morgan Stanley's thought leaders.