US markets have largely shrugged off the political volatility of the new year, continuing the momentum with which they ended 2020. Looking at different market sectors, value stocks continue to largely outperform growth stocks, and small caps are playing catch-up to large caps. At the same time, international and emerging-market equities are outpacing their US counterparts, driven by ongoing US dollar weakness, the prospects for stronger global growth and generally better valuations.

The financial markets are also counting on additional fiscal and monetary stimulus in 2021, as indicated by the Biden administration and the US Federal Reserve, even as economic growth has already started to rebound. Against this backdrop, investors can start the new year with a positive outlook for the markets. Investors may want to tactically add to or diversify risk in portfolios, but it will be important to be vigilant as the year progresses – including watching for higher inflation down the road.

Three factors driving renewed momentum in the market shift towards value stocks

The Democrats’ “blue sweep” became reality

Following the US election results in November, it appeared likely that incoming President Joe Biden would face a “divided” US Congress and gridlock in the US government, putting most of his agenda in peril. But the resolution of Georgia’s Senate races ultimately ceded control of both the House and Senate to the Democrats, although they still have only slim majorities. That makes a “Biden-lite” agenda likely: for example, tax increases will be less than initially outlined and may not be a year-one priority. Instead, we expect the new administration to first pursue policy items that have more bipartisan support from both Democrats and Republicans, such as stimulus packages and fiscal spending:

• Covid-19 stimulus in the range of USD 1 trillion could be passed in the first 100 days of a Biden administration – including USD 2,000 stimulus cheques (meant to put money directly into the hands of consumers) and support for state and local governments. This should be positive for value cyclical sectors tied to the economic recovery.
• Fiscal spending in areas such as infrastructure is attractive to both Democrats and Republicans. Expect a proposed infrastructure-spending package of under USD 1 trillion. This would include traditional infrastructure as well as areas such as renewable energy and technology (including 5G and broadband).
• Although clean-energy spending is unlikely to hit the Biden team’s original USD 2 trillion goal, they may still seek meaningful subsidies for wind and solar power and electric vehicles. And Mr Biden is committed to returning the US to the Paris Climate Accord.
• Other agenda items that could have bipartisan support include cutting drug prices and reining in “Big Tech”. These are important issues for the markets, but they are not necessarily a high priority for the Biden administration. For now, we expect incremental change rather than wholesale shifts in these industries.

Vaccines are finally here, despite the slow rollout

Stimulus is certainly a helpful bridge for consumers and small businesses, but as long as the pandemic is ongoing, economic activity is likely to remain depressed. Fortunately, vaccine distribution has begun in the US and globally. If it’s effective, the subsequent economic reopening will likely be the biggest market driver in the US and globally in 2021.

In such a scenario, we expect pent-up consumer demand to be unleashed – particularly in sectors such as travel and leisure that would benefit from the reopening economy. This is already reflected in strong economic and earnings forecasts, as Chart 1 shows, although they could move higher in future earnings revisions if more progress is made fighting the pandemic.

So far, however, the US rollout of the vaccines has been slower than anticipated. But this may turn around based on a few factors: states will learn how to make distribution more effective; the Biden administration will focus on increasing the number of doses available; and new vaccines from other companies should reduce supply constraints.

Barring any severe shocks or setbacks – including new variants of the virus – 2021 is likely to be a year of reaccelerating economic growth. For investors, this may mean that a bear-market selloff, which often occurs ahead of recessions, appears unlikely in the near term. As a result, market corrections could largely be used as tactical buying opportunities.

Chart 1: earnings growth is set to reaccelerate in 2021

S&P 500 earnings growth by quarter (year over year)

Source: FactSet, Allianz Global Investors. Data as at January 2021.

The Fed will continue to support markets in 2021

In its final meeting of 2020, the Fed released an updated set of economic projections (see Chart 2). Through 2023, rates are expected to remain near zero and inflation below the US central bank’s 2.0% target. Growth and unemployment expectations were also upgraded, and the Fed is committed to maintaining its monthly asset purchases. This will continue to expand the Fed’s balance sheet and provide liquidity to markets.

Overall, central banks in the US and around the world continue to provide strong support for risk assets against what was already expected to be a recovery year.

Chart 2: the Fed expects near-zero rates through 2023, and an improving growth and unemployment outlook

Source: Federal Open Market Committee. Data as at December 2020.

While keeping this positive outlook in mind, watch for inflationary pressures

While the economic and market outlook for 2021 is solid, there are some accompanying risks. One is that rebounding growth and stimulus could push up the prices of goods and services – driving up inflationary pressures. So far, inflation has been relatively contained, with core PCE – personal consumption expenditures, the Fed’s preferred indicator – still below the Fed’s 2.0% target. However, some forward-looking indicators (which measure the market’s inflation expectations) call for higher inflation, as Chart 3 shows.

Chart 3: core PCE remains below the Fed’s 2.0% target, but the inflation outlook is rising

Source: Bloomberg, Allianz Global Investors. Data as at 11 January 2021. The 5-year/5-year swap is a measurement of medium-term inflation expectations. Low numbers indicate that the markets are doubtful about a central bank’s ability to push inflation higher.

If inflation does accelerate, we see three key risks for investors:

• The Fed is now targeting an average inflation rate regime – meaning it will tolerate a period of higher-than-2.0% inflation without raising rates. But a sustained or rapid rise in inflation may cause the Fed to rethink its approach. Historically, bear markets have begun when Fed rate-hike cycles are on the horizon.
• If higher inflation leads to higher yields, longer-duration assets could suffer. These include certain government and corporate bonds, but also some sectors like technology and healthcare, which tend to be longer duration and could be punished by markets that fear higher inflation.
• Given that some stock valuations may already be stretched, particularly in certain growth areas, higher inflation and higher yields could push down these valuations over time.

Consider tactical shifts towards cyclicals and emerging markets

The global economy is recovering – in part thanks to “reflation” policies, such as fiscal stimulus and low rates, designed to boost demand and spending – and we expect it to enter a true reopening period later this year.

As such, we expect markets will continue to favour the reflation theme – but for how long? Perhaps until the economy either reaches peak reopening growth rates or enters a sustained period of inflation, which makes slowing growth or mounting inflationary pressures key indicators to watch.

Given such strong upwards movement already, periods of consolidation or market pullbacks should be expected in the weeks ahead. But investors can largely use these as tactical opportunities to add to or diversify risk. Consider adding incremental exposure by “layering in” cyclical and value stocks, small-cap stocks and non-US assets. Select areas of infrastructure, 5G technology and clean energy may also continue to do well in a post-election world.

In fixed income, prepare for somewhat higher rates and steeper yield curves. Long rates (which are generally determined by market forces) may rise alongside growth and inflation expectations, while short rates remain anchored by central banks. More stimulus could also mean a marginally weaker US dollar, which would continue to benefit emerging-market assets, gold and those industrial commodities (including copper) that are tied to the reopening.

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