As 2021 gets underway, we expect the road to recovery to remain bumpy, shaped on the one hand by waves of optimism linked to progress in the mass vaccination campaign and on the other hand by virus containment measures, which we do not expect to be lifted fully before Q3.
We reviewed the probability assigned to our central and alternative scenarios in terms of expected financial regimes compared to the previous quarter. Our scenarios are contingent on the pace of the massive vaccine rollouts, which we expect to be non-linear and uneven.
Q4 recovery path diverges across regions as a new wave of infections prompts lockdowns,
partially offsetting the sentiment boost provided by the earlier-than-expected start of the vaccination campaign.
- Increasing the probability of our central scenario to 75%.
We have a higher conviction on our central scenario and we raise its probability from 65% to 75%. This scenario assumes that getting the world back in order will be a multi-year process, with relapses in the real economy due to virus outbreaks, while policy intervention will be an option to help speed things along.
According to our estimates, corporate earnings will prove resilient and rebound from their 2020 lows as economic activity resumes. Managed low interest rates should further lift the equity markets, helping to maintain the remarkable gap that emerged between the financial markets and the economy during 2020, sustained by resolute policies.
We confirm our constructive medium term view of a continued and maturing recovery, with more cautious optimism in the short term as far as financial markets are concerned.
Our optimism hinges on three key achievements of the 4th quarter:
1) tangible progress in the Covid-19 vaccine front since November, leading us to be more confident of a “vaccine enabled” recovery, supported by
2) gradual progress on fiscal support allowing us to improve our economic projections2. We believe that fiscal expenditure will have the highest impact by selectively addressing (welfare) support in those sectors that have been hardly hit by the health restrictions. All G4 central banks have further committed to maintaining accommodative financing conditions to stabilize the financial markets and monetize sovereign debt issuances to boost economic growth.
3) major political risks (including US elections, hard Brexit) have disappeared and therefore reduced financial markets volatility.
- The probability of the downside scenario remains high at 15%
Markets participants were a bit early in pricing in a “vaccine enabled” economic recovery. Our downside risks, priced with a probability rate of 15% (down from 25%), remain high and above the historical trend, Hence our cautiousness on the short-term market moves.
We see three main catalysts, which could trigger our downside scenario:
1)a genetic evolution of the virus which could drive the pandemic out of control again and lead to negative growth shocks.
2)policy mistakes, such as execution risk of fiscal plans, or monetary policies being paused or seeing a correction in part of their accommodative stance. The Federal Reserve for instance could be under pressure because of a free fall in the USD, de-anchoring rates or inflation expectations. The latter being consensus trade, it represents a risk per se and might play out as game changers in the scenarios.
3)a prolonged economic downturn affecting business and consumer confidence and looping into sectors that have not yet been infiltrated by the crisis (i.e. the financial sector) and causing the exceptional economic crisis to evolve into a financial crisis.
The risk rotation that began in Q4 20 should
continue over the coming quarters.
- The upside risks with 10% probability
Our upside scenario entails the health crisis being solved in H1 2021, confirming a sustained “vaccine- enabled” recovery. An orderly rebalancing of policy mixes with a boost in economic activity would initiate a virtuous path of economic recovery, prompting productivity gains on new digital/green developments, and a faster normalisation. Private demand would resurge, leading to a demand-led increase of inflation albeit benign.
Given the new probabilities of our central and alternative scenario, we recommend well diversified portfolios, with balanced risk exposures, which are resilient to rising volatility in the case of negative shocks pertaining to growth or institutional policies. We expect corporate earnings to rebound, underpinning even higher risky asset price levels in the context of interest rates controlled by central banks. This should sustain the ongoing risk rotation from Credit HY to value/cyclical equities and into EM assets.