Commentary 2021 Outlook: Reflation, Reopening, and Readjustment Dirk Hofschire, CFA KEY TAKEAWAYS Senior Vice President Asset Allocation Research • Most global economies enter 2021 in early-cycle recoveries, with a prospective economic reopening likely to lead to a broadening expansion as the year unfolds. Jacob Weinstein, CFA • The winter rise in virus cases represents a strong near-term headwind but is unlikely Research Analyst to cause a double-dip recession. Asset Allocation Research • Global monetary policy remains highly accommodative and supportive of asset Lisa Emsbo-Mattingly, CBE prices, but the fiscal policy outlook is more uncertain. Director of Research • Amid positive vaccine news, investors’ expectations for a full economic reopening Asset Allocation Research have underpinned a reflation trade driving Treasury yields and stock prices higher. Jenna Christensen • With higher asset valuations already reflecting positive expectations for reopening, Research Associate financial markets may be influenced heavily by the trajectory of policy, inflation, and Asset Allocation Research real interest rates; therefore, some volatility is likely. Cait Dourney, CFA Research Analyst Asset Allocation Research Macroeconomic backdrop: Constructive cycle progression despite winter doldrums The global business cycle will begin 2021 in recovery mode. • Most major economies exited brief but sharp recessions during the third quarter and have generally made improvements since the first half of 2020. • China’s progression is ahead of most other economies, in part because of its quicker emergence from lockdowns and the rapid recovery in global manufacturing (Exhibit 1, page 2). • The U.S. is in an early-cycle recovery phase, progressing toward a mid-cycle expansion. • Although activity remains below 2019 levels in most major economies, the prospect of a vaccine-related full reopening over the next year makes us constructive on the continued broadening of the economic expansion in 2021. EXHIBIT 1: Most global economies remain in the early-cycle recovery phase, though a rise in COVID-19 cases has moderat- ed the pace of growth. China has advanced to the mid-cycle phase of expansion. Business Cycle Framework Cycle Phases EARLY MID LATE RECESSION • Activity rebounds (GDP, IP, • Growth peaking • Growth moderating • Falling activity employment, incomes) • Credit growth strong • Credit tightens • Credit dries up • Credit begins to grow • Profi t growth peaks • Earnings under pressure • Profi ts decline • Profi ts grow rapidly • Policy neutral • Policy contractionary • Policy eases • Policy still stimulative • Inventories, sales grow; • Inventories grow; sales • Inventories, sales fall • Inventories low; sales improve equilibrium reached growth falls Infl ationary Pressures Red = High China U.S. Australia, Brazil, India Eurozone, UK, Canada + RECOVERY EXPANSION CONTRACTION Economic Growth – Japan, Korea, Mexico Relative Performance of Economically Sensitive Assets Green = Strong The diagram above is a hypothetical illustration of the business cycle. There is not always a chronological, linear progression among the phases of the business cycle, and there have been cycles when the economy has skipped a phase or retraced an earlier one. Source: Fidelity Investments (Asset Allocation Research Team), as of Nov. 30, 2020. The winter virus resurgence presents a near-term • The U.S. consumer is better poised to weather this headwind for economic improvement, but not one that near-term economic lull due to the approximate we expect will generate a double-dip recession. $1 trillion of excess savings built up over the past • Recent European restrictions were less stringent several months (Exhibit 3, page 3). and therefore less harmful to economic activity than • Although the savings is unequally distributed across those implemented in the spring, some countries U.S. households, the aggregate savings cushion have already moved to loosen their restrictions, and is the result of reduced spending and massive the global industrial upswing continues to benefit government transfers during the first half of the year. European manufacturing and exports. Personal savings rates averaged 20% from April • We expect new U.S. restrictions to be on the lighter through October—nearly three times as high as the end of the range of those taken in Europe and the rate at the end of 2019. overall economic impact to represent a stalling rather than a severe reversal of economic momentum in the very near term. Service activity has slowed amid the recent surge in virus cases, but manufacturing activity remains strong (Exhibit 2, page 3). 2021 Outlook: Reflation, Reopening, and Readjustment | 2 EXHIBIT 2: The recovery in manufacturing has persisted, EXHIBIT 3: U.S. consumers have amassed excess savings while service industry activity has slowed amid the new over the past several months; which should help them wave of virus cases. withstand a near-term economic setback. AART High Frequency Composite Indices Excess Personal Savings Breakdown Manufacturing Services Rise in Personal Income Decline in Spending Jan. 2020 = 100 $ Billons 130 1,200 100 1,000 90 $307B 800 80 600 70 400 60 $684B 200 50 0 Jul 20 Jan 20 Jan Jun 20 Apr 20 Oct 20 Oct Feb 20 Feb Sep 20 Mar 20 Mar Dec 20 Nov 20 Nov Aug 20 Aug May 20 May AART Services and Manufacturing Indices are proprietary indices based on Source: Bureau of Economic Analysis, Haver Analytics, Fidelity Investments high-frequency data from multiple and variable sources. Source: Haver (AART), as of Oct. 31, 2020. Analytics, Fidelity Investments (AART), as of Dec. 4, 2020. Policy environment: Supportive monetary, Fiscal-policy uncertainty contributes to the cloudy uncertain fiscal inflation outlook for 2021. Global monetary policy remains extremely • The U.S. Congress approved a roughly $900 accommodative, with the Federal Reserve and billion stimulus package in late December that will other central banks anchoring short-term interest help offset some of the near-term, virus-related rates around zero and expanding their balance economic weakness. sheets through quantitative easing (QE) and other • However, a growing budget crunch at the state and extraordinary programs (Exhibit 4, page 4). local level implies the possibility of a fiscal drag on • The QE tailwind is less forceful than it was at the the economy in 2021. beginning of the pandemic outbreak in the spring, • The Georgia Senate runoffs in early January will but it remains a supportive liquidity backdrop for determine which party controls the Senate in 2021, asset markets. which will shape fiscal policy for the remainder of • Near record-low Treasury yields also support higher the year. asset valuations, as all other types of assets look attractive by comparison. 2021 Outlook: Reflation, Reopening, and Readjustment | 3 EXHIBIT 4: Monetary policy from central banks around the EXHIBIT 5: Real yields bottomed in early September and world remains extremely accommodative. rose modestly since, as investors anticipated a reflationary Central Bank Balance Sheets economic backdrop. Real Yields in 2020 U.S. Eurozone Japan Total Weak growth Rising inflation Disinflation $ Billions (12-Month Change) Reflation Real Yields $8,000 % of Days (21-Day Rolling) Yield (%) 60% $7,000 0.75 0.50 $6,000 50% $5,000 0.25 40% $4,000 0.00 $3,000 30% -0.25 $2,000 -0.50 20% $1,000 -0.75 $0 10% -1.00 -$1,000 0% -1.25 Nov 07 Nov 08 Nov 09 Nov 10 Nov 11 Nov 12 Nov 13 Nov 14 Nov 15 Nov 16 Nov 17 Nov 18 Nov 19 Nov 20 Nov 1/2/20 1/30/20 2/27/20 3/26/20 4/23/20 5/21/20 6/18/20 7/16/20 8/13/20 9/10/20 10/8/20 11/5/20 12/3/20 Source: Federal Reserve, Bank of Japan, European Central Bank, Haver Shaded areas represent regimes with respect to the direction of real rates. Analytics, Fidelity Investments (AART), as of Nov. 30, 2020. The regimes are determined by the dominating factor between the change in 10-Year Treasury bond yields and 10-Year breakeven rates as implied by Treasury Inflation Protected Securities. Source: Bloomberg Finance L.P., Fidelity Investments (AART), as of Dec. 11, 2020. • If the Senate remains in Republican control and Reflation driven by reopening expectations: results in a divided government, fiscal policy will Expect some volatility too be less likely to experience significant changes and Positive vaccine developments and expectations for a would be less supportive of economic growth (and full economic reopening in 2021 generated a “reflation” inflation) in 2021. trade in financial markets during the final months of • A Democrat-controlled Senate would likely move to 2020. A reflation trade is marked by upward pressure legislate larger fiscal deficits and higher-multiplier on Treasury bond yields amid rising expectations for government spending. This scenario could generate an acceleration in nominal growth. greater inflation risk on a 12- to 18-month basis if • After a period of weak growth amid falling real a renewed fiscal push accompanies a widespread (inflation-adjusted) rates though the first two-thirds reopening of the economy. of 2020, real rates bottomed on September 1 and rose modestly from extremely low, negative levels (Exhibit 5). 2021 Outlook: Reflation, Reopening, and Readjustment | 4 EXHIBIT 6: Performance leadership has shifted amid a EXHIBIT 7: With Treasury yields near all-time lows, riskier reflation dynamic, with small caps and emerging-market assets appear to have priced in good news and are trading stocks outperforming since September. near the top of their historical ranges. Asset Performance During 2020 Percentile Valuation of U.S. Assets: Today Vs. History (1989–2020) 100% Jan 1– Sep 1– Aug 31, 2020 Dec 11, 2020 90% 80% U.S. Small Cap -5% 22% 70% EM Equities 2% 13% 60% 50% DM Equities -4% 10% 40% U.S. Value -10% 10% 30% High Yield 2% 4% 20% 10% U.S. Large Cap 11% 4% 0% Treasury bonds: Stocks: High-yield bonds: U.S. Growth 36% 1% Yield-to-maturity Price-to-earnings Yield-to-worst IG Bonds 7% 0% Treasury bonds represented by 10-year Treasuries.