Month: December 2020

We all know economies will experience a burst of growth with the introduction of a COVID vaccine that will hopefully lead to an end of the current pandemic. Part of the growth will come from pent-up demand, part from increased productivity (gained during the pandemic), and lastly growth due to the return of sectors like hospitality, which are almost non-existent today. However, with 93% of economies around the world locked down and struggling from the pandemic, it’s hard to make a case for a return to pre-COVID normality anytime soon. 

Assessing economic growth and trying to predict what markets will do in 2021 is a great challenge, because many of the implications of the 2020 crisis have yet to manifest themselves. Not only are the long-term health repercussions of the pandemic still unknow, but there are many questions pertaining to the state of small businesses, hospitality, and a host of other sectors that have been affected by the pandemic.  

Furthermore, unemployment is still a concern. The outlook for the labor market in Europe is of particular concern. Increased unemployment and increased long term unemployment are issues central bank liquidity cannot address.  

We have all noticed the divergence between economic activity and market performance. Many (myself included) have wondered why. One explanation is that the liquidity created by central banks has increased the multiple in equity markets. Also, the low interest rate environment is another reason that should not be underestimated.  

Please note central banks will provide accommodation for a considerable for the foreseeable future. In fact, the Fed has said that the economy needs accommodation for a considerable period, even with inflation above 2%. This is something the Fed has repeated many times, and thus we find it difficult to see a scenario where markets crash or correct considerably as they did in the beginning of the pandemic.  

Irrespective of inflation, interest rates should remain low because central banks have unlimited firepower to keep them close to zero.  As such our base case for interest rates is that they will remain at current levels for many years. In fact, this has been my base case for over a decade. 

But market participants are conditioned to react to higher inflation. Their reaction, is usually, to sell equities preparing to move into bonds thinking rates will go up. But since interest rates will remain low, it is doubtful is if we see an exodos from equities to hide in bonds. Not only is there no yield anywhere to be found, but you can get a better yield in equities. So, it is difficult to fathom any kind of exit from equities, no matter what the inflation outcome is in the future.  

So, while inflation is possible, central banks have the tools to keep interest rates at bay. A byproduct of such a policy is more liquidity in the economy and markets. 

Will 2021 turn out to be a sell the news event? 

So, will 2021 be a correction? Will market participants sell the COVID19 vaccine? We don’t know, but even if the market tries to correct, the additional liquidity from central banks will probably prevent such an outcome. However, the truth is that we don’t know what will happen, especially since valuations are so rich.  

As you can see in the table above, the trailing PE ratio of the S&P is 42. Granted this is a high number because of depressed earnings due to the pandemic, however if we look at forward 12-month estimates, they are higher than the multiple pre-COVID. In the case of the Russel 2000, the multiple is almost double that of last year.  

These valuations are very hard to swallow, even for those who justify a higher multiple because of the liquidity created by central banks. So, earnings have to increase by a lot in 2021 to reach last year’s multiples. But there are many uncertainties to such a scenario. 

So, our base case for 2021 is that markets at best, will remain flat. And even if markets do go up, it will most likely be in the single digits at best. Valuation headwinds will probably prevent markets from continuing to expand the multiple, as has been the case over the past several years.   

The Dollar is losing ground against most currencies, which is a good thing  

As we have noted in the past, a weak dollar is good for the global economy and is supportive for global growth, especially for EM economies. A lower dollar helps companies and countries service their dollar debts, but also helps consumers around the world purchase iPhones. Historically, a lower dollar has been associated with a risk-on trade and better market returns. So, to the extent the dollar continues to drift lower, this should help support the global economy. 

While we have no target for the EURUSD pair or the dollar Index, we are modeling a lower dollar for 2021. However, we do not expect the kind of moves we witnessed in 2020. The move from 1.08 to 1.22 in the EURUSD pair has not happened for over a decade. If the dollar continues to drift lower as we think, the rate of decline will be at a much slower pace than in 2020.  

Will the rotation trade continue? Anecdotal evidence suggest it should. 

As you have probably noticed, there is a lot of talk about an ongoing rotation trade. In other words, selling high momentum growth stocks and buying stocks that have a lower multiple or cyclical plays.  

The chart above depicts the ISHARES 1000 value ETF (IWD) vs the ISHARES 1000 growth ETF (IWF). As you can see, growth did not always outpace value. After the crash in 2000, value was a far better choice than growth. And while after 2007 growth has done better, that will not always be the case.  

The main reason why we are currently favoring value, is because of the extreme valuation of growth stocks. Simply put, most stocks that I come across are simply not investable due to valuation concerns. So, if we assume a rotation trade is happening (or will happen), this can last for years, not days or weeks.  

Economies will continue to struggle despite a vaccine rollout  

A double-dip recession is possible despite a vaccine rollout. Things are not great at the moment, and we do not anticipate a return to normality for at least 18 more months.  

We are expecting many companies to become insolvent, despite fiscal help. Unfortunately, all the liquidity in the world cannot make up for lost business, especially if a company is leveraged.  

Small businesses in many countries are in very bad shape, and it is doubtful most will make a comeback.  

While everyone agrees that banks in this crisis are better off than during the 2008 crisis, nevertheless, there are still many unknows insofar the future quality of bank balance sheets, especially in Europe.  

Solvency is still a problem  

Remember, liquidity is not a substitute for a problematic balance sheet. This applies to both corporates and sovereigns, but also to individuals. While the solvency problem of the average consumer has been well managed in the US with the PPP program, the same cannot be said about Europe or the EM space.   

In addition, many sectors like hospitality are permanently damaged. Many companies like airlines still need massive capital increases to stay solvent. Many other companies in the hospitality space will probably stay closed forever.  

Central banks all over the world are pushing for fiscal help from governments. The US government alone will probably spend over $1 trillion in 2021. While the US government has the means to provide this assistance, most governments around the world can’t. This is especially true of countries in Africa.  

What to expect in 2021 

We do not expect equity markets to rally like they did in 2020. At best we think equities will be up in the single digits (if at all). The main reason being valuation headwinds. 

Inflation should continue to remain low, and interest rates should remain at current levels or lower.  

We do not think the dollar will be a safe haven in 2021. On the one hand the Euro is currently in style, and if inflation does resurface in the US, ultra-low interest rates will probably deter dollar investment flows, even in a risk off scenario.  

While volatility is off its high, it is still stubbornly high and refuses to fall. The resurgence of COVID cases in many countries and the fear of a double dip recession is likely to keep volatility elevated during 2021. 

While the popularity of passive ETF investing has been popular for many years, investors will actually have to do the work and pick individual names in 2021 if they want to make money. 

The EM space will outperform western markets, and Europe will probably outperform the US.  

About one third of sovereign bonds are in negative territory. This will likely increase in 2021.  

As we are leaving behind a volatile year in the financial markets, we expect that the current uptrend price momentum in the commodity sector will continue throughout most of 2021. 

We remain optimistic about the overall commodity market picture for the next year and we see another 10%-20% upside from the current price levels as the global economy comes back online, and “cyclical” sectors will benefit from a post-pandemic reopening.

The broader rally in the growth-led commodity sectors such as energies and industrial metals could be supported from the global economic growth after the pandemic, driven by an effective rollout of Covid-19 vaccines around the world, the continued fiscal and monetary relief stimulus to help stem market collapse, and the rebound in the global manufacturing and construction activity. 

The vaccination of at least 50% of the global population until May 2021, could help bring a conclusion to the deadly pandemic and reopen the global economy, increasing the demand for commodity products not only in Asia but also in Europe and North America for manufacturing and construction usage.

China, as the world’s biggest commodity consumer (50% of the global demand), was the first country that exited from the Covid-19 crisis and this helped them recover quicker than the rest of the world. The country will see its economic growth rates rebounding above pre-pandemic levels in 2021 amid the low rate of virus cases in the country and the unprecedented infrastructure stimulus from the Chinese government, benefiting the commodity sectors.  

The commodity market witnessed a roller-coaster ride in 2020

What goes up must come down and then usually goes back up again, at least in the case of the commodity prices in 2020. 

The COVID-19 pandemic has plunged the global economy into its deepest recession since World War II, causing huge losses (more than 50%) in the prices of the commodities. The sector experienced the worst demand shock (-30% y-y) in their history amid the impact on their demand from the social lockdowns to contain the spread of the virus. 

However, the commodity prices have since rebounded with surprising strength, recovering all the pandemic-led damages, even as Covid-19 cases continue to soar in Europe and the USA.

Industrial Metals: Bullish outlook for 2021

Forecasts: 

1. 12-month forecast for Copper prices to average near $4 per pound, up 10% from the current levels. 
2. It is highly probable that the prices of Copper will retest the existing record highs of $4.60 in the period Q4 2021-Q1 2022. In the case of a stronger-than-expected global economic recovery, it may rise 30% from its current levels.

We believe that the industrial metals will continue their reopening-led rally into 2021 amid the hopes for a vaccine-related global economic recovery, the robust industrial demand from China, and the massive “green” investments.  

The prices of the base metals showed impressive resilience to the pandemic, outperforming everybody’s expectations during the second half of 2020, and rising above their pre-pandemic levels. Copper prices climbed at $3.60 per pound at mid-December, hitting their highest since 2013, the Aluminium prices surpassed the psychological level of $2.000 per tonne, while Iron ore has been on a stellar run amid robust Chinese demand and supply concerns over the recent trade tension between China and Australia (possible tariffs on iron ore exports).  

“Doctor” Copper is widely traded as a proxy for global economic health since its demand depends on the global growth rates and the construction-industrial activity. The usage of Copper and Aluminium in automobiles and constructions has taken off in the last decade, thanks to their good conduct of electricity, recyclability, and lightweight. 

Industrial metals could also benefit from climate technology developments in 2021. Politicians including the European Union leaders and the new President of the USA Joe Baiden have promised massive “green” investments to expand the renewable energy capacity and to reduce carbon emissions. Copper and Aluminium will see their demand skyrocket since they are key elements to some climate technologies such as electric vehicles and their batteries, wind turbines, and solar panels.

Finally, the growing supply risks could act as a major bullish price driver in 2021, as a structural underinvestment in copper mines is seen in the last decade, caused by the low prices and lack of cheap liquidity amid the financial recession. The supply risk could deteriorate if we combine the low Copper stockpiles around the world and the frequent supply disruptions from major mines in Chile and South America amid labor strikes.

Crude oil: Bullish outlook for 2021

Forecasts: 

1. 12-month forecast for WTI and Brent crude oil prices to trade between $50-$55 and $55-$60 per barrel respectively, up by 10%-15% from the current levels. 
2. It is highly probable the WTI and Brent crude oil prices to retest the pre-pandemic levels of $60 and $70 per barrel respectively at the Q4 2021-Q1 2022 in case of geopolitical risk premium, up 25% from the current levels.

We believe that the crude oil prices will continue their upward momentum into 2021. Brent crude oil price moved back above $50 per barrel in mid-December 2020, for the first time since the start of the pandemic, while the WTI crude climbed at $48 per barrel, recovering most of their pandemic-led losses in Q2.

The demand and supply dynamics in the energy markets will play a significant role for the crude oil prices next year. The bullish price outlook will be supported by a limited increase in crude oil supply from OPEC and its allies led by Russia, and by the growing optimism that the start of the COVID-19 vaccine rollout will drive a recovery in the global fuel demand in 2021. 

Energy prices will also benefit from the rebound in the economic activity in China and other Asian industrial countries after the pandemic, which consumes in total more than 30% of the global oil supply.

The progress with the mass Covid-19 vaccinations in 2021 will be a bullish event for oil prices as it will put the global economy on a path to sustained recovery, affecting the oil demand in the second half of next year.

With vaccines on the horizon, we expect a significant rebound in the travel and transportation activity around the world which has been restricted due the virus outbreak. People will resume traveling with planes, ships, cars, and trains for business and entertainment in the second half of 2021 propelling a robust recovery in the demand for jet, maritime, and gasoline fuels.

A weaker US dollar will be another positive catalyst for oil prices in 2021, as it is the de-facto currency accepted for global trade (most contracts priced in US dollars). The greenback has slipped to 2.5-year lows against most currencies (DXY-dollar index fell below 90), making the dollar-denominated petroleum products more attractive to energy importers with foreign currencies.

OPEC and its de-facto leader Saudi Arabia are major influencers for oil prices as they always manage to avoid large surpluses or deficits in the oil market. Therefore, the willingness of Saudi Arabia and its non-OPEC allies (led by Russia) to keep their crude production at low levels amid the higher supply from Libya and US shale producers and until the full recovery of the global demand in 2021-2022, will be another bullish catalyst for the oil prices in the long term. 

The coronavirus-driven oil price crash combined with the market shift towards renewable energy investments, had forced the shale oil drilling companies to cut production and delay investments in offshore projects, creating the risk for a supply deficit in the long run, which is certainly bullish for energy prices.

On the negative side, we expect that the current rise of Covid-19 infections will continue damaging global demand growth. With virus cases surging to record highs across Europe and the USA, they have announced new lockdowns and travel restrictions to curb the spread, weighing on near-term gasoline and jet fuel consumption. 

Bottom Line:

We believe that the current vaccine-led rally in the commodity sector will be the first leg of a structural bull market amid their improved fundamentals. Therefore, we expect the prices of the energies and industrial metals to go higher by another 10%-20% in 2021 from their current levels, while every price correction will become a buying opportunity for the investors.