Outlook for the 1st quarter 2021: Setbacks expected despite good outlook for equities

Bond markets: No movements expected in euro bonds; yields decouple from US trend

News of the outcome of the US presidential election and the development of an effective vaccine against Covid-19 boosted corporate bond prices in the fourth quarter – as did the European Central Bank's (ECB) extensive bond purchases. Despite the Corona pandemic and the severe global recession, euro-denominated corporate bonds closed 2020 with gains thanks to the strong fourth quarter. Corporate bonds with an investment grade rating achieved gains of 2.6% and high-yield bonds even of 2.8% – according to the corresponding indices of BofA Merrill Lynch. Government bonds from the euro zone also benefited from ECB purchases with a gain of 4.9% compared to the BofA Merrill Lynch reference index.

Traditionally, yield on ten-year Bunds has always followed the yield on US Treasuries. Since August 2020, however, an upward trend in yield on ten-year US Treasuries from 0.5% to over 1.0% can be observed, whereas yield on ten-year Bunds actually trended slightly downwards during the same period. The break of this historical link is exceptional and shows that the ECB seems to have the European bond market completely under control due to its extensive purchases. As it is explicit ECB policy to keep government and corporate bond yields low in order to provide favorable financing conditions, there should be no major movements in the European bond market in the first quarter.

Equity markets: Serious setbacks in the fight against Corona could jeopardize generally good prospects

In the fourth quarter, prices on the equity markets exploded and achieved double-digit gains. The MSCI World and MSCI Emerging Markets equity indices were up 14.1% and 19.5% respectively in local currency for the full year 2020. Only European equities lagged behind with a loss of 1.7%. The positive performance of the first two indices was mainly driven by technology stocks that are in short supply in Europe. The price jump in the fourth quarter was due mainly to the outcome of the presidential election in the USA and the first approvals of a highly effective vaccine against Covid-19.

In principle, prospects for the international equity markets are good in 2021. The combination of a strongly recovering economy, only slightly rising inflation and ample central bank liquidity in all economic areas is ideal for further price gains. However, most investors have already taken this scenario into account in their portfolios with low cash and high equity ratios. Experience shows there is a high risk of a major price correction on the equity markets if financial market players have positioned themselves in unison for rising prices. In this constellation, a small breeze is enough to cause stock prices to fall significantly. A trigger for this could be, for example, a sluggish vaccination process or the emergence of a new mutation of the coronavirus against which the previously approved vaccines do not protect. This would noticeably delay the upswing and thus the recovery of corporate profits.

Another risk is too strong an upswing in the Chinese and US economies, which would result in a significant increase in inflation. The generally positive outlook for the equity markets is based on the expectation of low inflation and thus low interest rates. At present, however, we see a good chance that many countries will achieve herd immunity against the coronavirus by the summer, and only low inflation risks. A price correction, which is always possible in the meantime, should therefore not lead to a new bear market.

Euro zone economy: Negative scenarios have become significantly less likely

The second wave of the Covid-19 pandemic currently has a tight grip on Europe. As a result, many countries have tightened restrictions on public life and private contacts noticeably in recent weeks. Fortunately, the damage to the economy seems to be much less in the second lockdown, because scientists and politicians seem to have learned from the first lockdown. The technical and organizational conditions for working from home have also been created or improved in recent months. In addition, factories have been able to stay open because companies have managed to meet hygiene requirements and ensure minimum distance between workers. Surprisingly, Germany's gross domestic product did not decline in the fourth quarter, but remained stable. Weakness in the service sector could be offset by strength in industry.

In the fourth quarter, important decisions were also made for Europe's future. The member states of the European Union unanimously approved the EU budget and the Recovery Fund. The EU and Great Britain were also able to agree on a trade treaty shortly before the end of the year. Negative scenarios for Europe have thus become less likely. The question of positive scenarios will be decided by the success of the vaccination process. So far, the pace of vaccination in Europe is still very slow – and thus the risk is high that herd ­immunity against the coronavirus will not be achieved until next year. The coming weeks will show whether Europe can achieve its goal of getting about 70% of the adult population vaccinated by the end of June.

There are realistic inflation risks in the USA because the projected government budget deficits of 15.4% of GDP in 2020 and 11.6% in 2021 are much higher than those projected for the euro zone (8.6% and 6.5% respectively). Also, private economic players in Europe have a much higher propensity to save than their US counterparts, which is why it is highly unlikely that the inflation rate in the euro zone could rise again in the next three years to the European Central Bank's (ECB) inflation target of 2.0% and anchor itself there. Therefore, it is currently hard to say when the ECB will raise the key interest rate again.

US economy: Limited inflation risks despite high transfers to households and businesses

The new US President Joe Biden is setting a fast pace. In addition to the USD 900 billion in government aid approved in December, he wants to launch further support programs amounting to USD 1.9 trillion in the first quarter. However, since the Democrats have only narrow majorities in the Senate and the House of Representatives, many market observers expect a much smaller package of about USD 1.0 trillion. Nevertheless, it is still a large sum that is likely to swell the US budget deficit to over 10% of GDP this year. The largest part is for stimulus payments to private households and companies.

The question now is how much of this money the beneficiaries are likely to save and how much of it they’ll spend. The less saved, the greater the economic boom and the associated inflation risks. Since the financial market crisis, however, US households seem to have fundamentally changed their saving behavior, becoming much more cautious. Losing one's house in a crisis or experiencing this with a friend is a traumatic experience that can have repercussions for decades to come. We therefore assume that a large portion of the money will be saved, making a strong upswing possible but not a runaway economic boom. This should also limit inflation risks this year.

Of course, the risk remains that economic players could suddenly change their minds and decide to use their high savings to boost spending – a scenario that would cause inflation to rise significantly in the course of 2021. Even if inflation picks up noticeably in 2021, we do not expect the Fed to raise interest rates. The new philosophy of "average inflation targeting" means that, according to simulations, the Fed is likely to raise the key interest rate two to three years later than it would have done with the old philosophy of normal "inflation targeting". Currently, the Fed is still buying bonds at a rate of USD 120 billion per month under its quantitative easing program. However, if economic growth and inflation turn out to be surprisingly high in 2021, the Fed could decide to end its bond purchases.

Asian economy: Despite record deficit, no debt crisis in sight in Japan; China strengthens free play of forces

In December 2020, the Japanese cabinet approved the third supplementary budget for the 2020 fiscal year and the first budget for the fiscal year 2021. In the coming weeks, parliament is likely to approve the new budget. The supplementary budget, which is large with 3.6% of the gross domestic product (GDP), includes funds for infection control, social aid programs and funds to strengthen the growth potential of the Japanese economy. On the latter point, the government is focusing on digitization and the fight against climate change. As a result, the fiscal deficit is likely to have increased from 6.4% of GDP in fiscal year 2019 to a record 21.0% of GDP in fiscal year 2020, but without triggering a debt crisis. This deficit is expected to be fully covered by domestic savings. If domestic savings are insufficient, the current account would inevitably have to swing from a surplus of around 3% of GDP to a deficit, but this is unlikely. Overall, the Japanese government’s policies pursue two goals: support those affected by the pandemic and drive structural change. Given the severe consequences of the ongoing pandemic, it is certainly necessary to relieve the economy in order to avoid disruptive shocks. However, prolonged generous political support, even after the pandemic is over, could reduce the incentive for companies to push ahead with structural change.

The Bank for International Settlements (BIS) publishes quarterly data on the interest and repayment burden of private households and companies in relation to income. With an average of about 30% of their income spent on interest and repayments, Hong Kong consumers and businesses are the world leaders in this respect. This is due mostly to a long-standing boom in the property market and the resulting increased indebtedness of private economic players. In the past, this was often a warning signal for an impending banking crisis, but this time, despite the corona pandemic, no major loan defaults have been observed in Hong Kong so far. This may also be due to the fact that the Hong Kong government used its large fiscal reserves early on to stabilize incomes and thus ensure the interest-paying capacity of the population. Therefore, no crisis seems imminent in Hong Kong at the moment; however, if signs of a crisis increase at some point, it’s already clear it will be a serious crisis given the substantial debt burden.

In China, too, the interest and redemption burden of private households and companies has risen in recent quarters. With a burden of around 20% of income, China occupies a solid spot in the middle. However, the interest burden for some individual companies has piled up so high in recent quarters that they have had to file for bankruptcy. For the first time, state-owned enterprises are also among them. We see this as a clear sign that China's government is continuing its policy of strengthening the free play of economic forces at home, with all the associated opportunities and risks.