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Economic Insights: New year, new optimism
Outlook for 2021
Commentary by Robert F. Baur, Ph.D., executive director, chief global economist
Personal note: This will be the last Insights by this author; best wishes to all readers.
The new year has the potential to be much better than 2020.
The late-year surge in COVID-19 cases and fatalities will bewinding down. That virus activity impeded the United Statesand Euro area economic rebound, but growth will bounce byspring with vaccine delivery. The global economy should return
to a sort of normalcy. Confidence will revive. Profits will comeroaring back. Stock markets should have a decent year throughlate summer. At some point, the investment climate may shift
to one with a bit more inflation. That would end the 39-year
downtrend in long-term interest rates and be a problem forstocks and bonds.

Changes afoot
Apologies to Ernest Lawrence Thayer who wrote “Casey at the Bat,”published in a predecessor to the San Francisco Examiner in 1888.
It seemed fitting with baseball fans hoping for a more normal
season in 2021. In fact, we’re all hoping for a more normal year. The
vaccine rollout suggests that yearning is not totally unreasonable.
The continuing wave of new COVID-19 cases and fatalities has
slowed the rebound in the U.S. economy. Consumer confidence
weakened in December and is staying well below pre-pandemiclevels. The latest data shows household spending and retail sales
dipped in November as coastal lockdowns kept people fromnormal activities. JPMorgan Chase private credit/debit card datashows a similar moderate downturn in spending from the pattern
in October. Job growth had been stellar but slowed recently; total
continuing claims for jobless benefits had been falling, but the pacehas slackened for several weeks. However, the American Staffing
Index of temp-help jobs keeps improving.
There’s a clear divergence between households and business as
the latter keeps reviving. National surveys of business purchasing
managers did weaken modestly in December but are still at
healthy levels. The New York Federal Reserve weekly economic
indicator suggests U.S. gross domestic product (GDP) was only
1.32% below a year ago the week ending December 26, thebest datapoint since the pandemic. That measure is an excellent
summation of ten weekly business data series and should be a fairdescription of overall activity.
As the vaccine becomes more widely available, we expect a
gradual return to normalcy. First quarter U.S. GDP may stall a bit
as economic momentum dulled into January. But growth should
rebound vigorously in the spring and summer quarters to thetune of 5% to 8%. U.S. GDP could reach a new record high in thesecond quarter. GDP gains will return to trend of 2.5% or so in
2022 assuming the vaccines are successful in quelling any returnof COVID-19 or its mutants next winter. Employment will jump

Biden at the Bat
The year had started nicely til the COVID crud emerged.
The jobless rate neared record low as wage growth softly surged.
Investment strong as profits grew, stock markets validated
The confidence that households and investors advocated.
All was well, the year robust, economy was rockin’;
But then in March and April, COVID virus came a-knockin’.
Business closed and jobs were lost, the streets were strangely silent.
Work from home and stay indoors; activity went quiet.
The closures brought recession worse than any knew before.
The virus raged; the death toll rose; fear spread from shore to shore.
Investors sold and prices plunged; the Fed stepped in to ease.
They backstopped bonds and markets calmed, investors were appeased.
The virus took a respite as the warmth returned last spring.
A June rebound pushed sprits up as only growth can bring.
The virus spent the summer hibernating out of sight;
But once the chill of fall returned, the crud came back to fight.
Closures, masks, and distance seemed the best that we could do;
But then some great researchers found a way to stop the flu.
And now the country sees ahead a promising New Year:
From restaurants to sports and cruises, travel less to fear.
Mutant strains are still a risk and public debt is soaring;
Investors, looking through the fog, think profits will start roaring.
The risks are real, stock values high, inflation could start rising;
But for a while and with some luck, we see those risks subsiding.
Fiscal programs won this game, but if markets start to fret,We’ll need much more than Biden’s bat to cancel out the threat.

sharply with vaccine distribution. But with jobs still nine million
short of the pre-pandemic peak, the total won’t reach a new highuntil 2022.
Parts of Europe, especially Germany, are still under the scourgeof rising new daily cases and fatalities. Stringent lockdowns andfalling economic indicators suggest a moderate contraction in
fourth quarter Eurozone GDP even though a trade deal has beenmostly finalized as the United Kingdom exits the European Union.
Eurozone business surveys plunged in November, but the collapse
was mostly reversed in December. Retail sales likely tumbled inNovember, even though they are still well above the early year
high. As in the U.S., widespread vaccine distribution and an end tostay-at-home orders should push GDP growth to mid-single digits
by the second quarter and perhaps even 4% for the year.

Expressions of opinions and predictions are accurate as of the date of this communication and are subject to change without notice.
There is no assurance that such events or prospections will occur and actual conditions may be significantly different than that shown here.

Japan’s economy never recovered completely from the October
2019 two-percentage-point hike in the Value-Added Tax when thepandemic hit. So, its rebound from the virus-inspired recession has
been sluggish. Households, self-isolating from a surge in COVID-19
cases, likely flattened activity in December. Global growth is helping;
China’s economic resurgence and U.S. demand are keeping Japan’s
exports surprisingly robust. Inventories fell to almost a decade low,suggesting strong gains in manufacturing output ahead. Businesssentiment is recovering; the purchasing manager survey for
manufacturing companies is the highest since May 2019. The labormarket is improving with a drop in the jobless rate to an ultra-low
2.9%. We look for healthy Japanese growth in 2021.
Overall economic growth in China continues to rocket ahead, pushed
by a stunning amount of government-directed stimulus. Retail sales
have finally picked up nicely versus year-ago levels, but for the elevenmonths through November are still 4.8% below the same periodof 2019. Investment by private companies is lagging dramaticallyeven though capital spending by state-owned businesses is up
significantly. China’s trade surplus hit record levels, with vigorous
exports of COVID-19-related materials. Growth in GDP in 2021 could
be in the 7% to 8% range as the rebound matures.

Looking aheadGrowth in 2021 is partly about the virus. Rapid distribution of a
successful vaccine will bring a sense of normalcy, healthy job growth,and a rejuvenation of leisure and hospitality. Ultra-low inventories
will bring speedy hiring and brisk gains in output. A weaker U.S.
dollar, spirited demand from China, rising commodity prices, andsuper-low interest rates are helping developing countries revive. A
robust rebound will endure. 2021 will also be about fulfilling pent-up
desires: for fun, travel, dining out, social get-togethers, yelling support
for sports teams, singing in church. The revival could be terrific; allheaven could break loose.

Financial market outlook
Investors are giddy with enthusiasm, and it’s no wonder. Just look atstock market performance. In a year with the ugliest recession sincethe 1930s, the highest jobless rate since the depression, the worst
pandemic since 1918, the most violent protests since the 1960s,
when oil was so worthless you couldn’t even give it away, the S&P
500 Index was still up 16.3% after rocketing 67.9% from the Marchlow. The Russell 2000 Index surged 18.4% for the year after nearly
doubling from March 23.
It wasn’t just the U.S. The MSCI Emerging Market Index jumped
15.6% and the MSCI All Country World Index ex U.S. rose 8.2% for
the year. Even most bond investors were happy. Holders of longterm U.S. Treasury bonds had fat profits as interest rates plunged tounheard-of lows. Barclay’s Global Aggregate Bond Index returned
9.2%. Except for oil, commodities had a great year.
In the past, when optimism was this broad, performance this strong,
and investors so capitulated to the bullish story, the signal has been
to sell, to take profits. But is this time different? Once again, in thepast, the answer has always been no. There was no “New Era” forinvestors in 1929, nor in 1972 with the Nifty Fifty, nor in 1989 in
Japan, nor in 1999 with the tech boom, nor with oil in 2008. Investor

euphoria usually ends badly; the question is when. It’s one of timing.
It may not be yet. The fact that the environment for the stock market
and the economy is quite favorable isn’t wrong just because it’s beenendorsed by the investment consensus. There seem to be good
fundamental reasons for this positive climate to persist through partor much of 2021. First, this is the sweet part of the economic cycle,
when just emerging from a recession, when growth is catching up
to its potential. Secondly, there’s plenty liquidity; interest rates areat historic lows. Financial conditions are extremely accommodative.
Third, government policy will remain supportive. Central banks,including the Federal Reserve, have pledged to keep financial
conditions relaxed until the economy is fully back. Another U.S. fiscal
stimulus package has already been passed. Last, broad distributionof the vaccine(s) will allow a return to normalcy. Growth will surge as
consumers strive to satisfy their huge pent-up demands.
But investor enthusiasm, combined with very high equity valuations,suggest that risks may be high and the margin for error low. The
massive upmove since March and the rebound in earnings estimatesmean that much of the positive outlook is already embedded incurrent stock prices. The key risk, however, is higher long-term
interest rates as the super-easy financial conditions extant today
cannot be sustained.
We’ve written before about the strong likelihood of a shift to a bit
higher inflation later this decade--late 2022 or beyond. Globalization
emerged from the world trade negotiations of the 1980s andbrought with it three decades of disinflation. As it fades over time,
especially in response to the pandemic’s origin in China, the low
inflation that came with it will fade, too. Further, giant fiscal initiatives
around the world conjoined with aggressive monetary policy torepress interest rates will create demand faster than supply. And thedemographic certainty of more retirees relative to the number of
productive workers will also increase demand more than supply. All
this implies significant interest rate risk down the road.
Given the robust fundamental underpinnings, we’d stay optimistic
about 2021 and the stock market on a six- to maybe 12-month
basis. We’d keep an equity portfolio balanced among sectors, notoverweight tech or growth. Given recent great performance andlower valuations, one could have some exposure to U.S. small caps.
With the U.S. dollar’s weaker trend likely to persist, emerging market
stocks could be a good overweight. But watch yields on 10-year U.S.
treasury bonds. Stocks could be vulnerable to sizeable setbacks ifyields rise above 1.5% or if the move to 1.5% happens too fast. Yields
at 2% could put a long-term top in the U.S. stock market and might
happen in 2022.
For bond investors, we stick to our long-standing suggestion of twoto four-year maturities of good quality high-yield or emerging market
bonds. There will be better opportunities for bond investing later thisdecade. If inflation does surprise the consensus, real assets--such ascommercial real estate, houses, farmland, commodities rather thanfinancial assets—may win the performance derby for the 2020s.

Expressions of opinions and predictions are accurate as of the date of this communication and are subject to change without notice.
There is no assurance that such events or prospections will occur and actual conditions may be significantly different than that shown here.

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