We think the approval and rollout of a coronavirus vaccine by the second quarter, fiscal policymaking, and US voters choosing legislative gridlock will enable corporate earnings in most regions to recover to pre-pandemic levels by the end of the year. We expect the more economically sensitive markets and sectors, many of which underperformed in 2020, to outperform in 2021. Our preferred areas include small- and mid-caps, select financial and energy names, and the industrial and consumer discretionary sectors.

Low interest rates and high government spending will persist, in our view, as policymakers attempt to mitigate the economic effects of pandemic control measures. In the near term, with the threat of inflation low, we think investors can still find positive real returns in emerging market (EM) USD-denominated sovereign bonds, Asia high yield, and select "crossover bonds" with BBB and BB credit ratings. In the longer term, the combined threat of government spending going too far, or not far enough, means investors may need to prepare for heightened inflationary and disinflationary risks across regions.

2021 will bring a different mix of US political leadership, and we think new market leadership will follow. We expect fiscal stimulus and more predictable foreign relations to support cyclicals, including industrials and mid-caps. Meanwhile, we also expect higher deficits to weaken the US dollar.

The coronavirus pandemic has accelerated, rather than halted, most of the long-term trends already underway. We expect a world that is more indebted, more unequal, and more local to result in below-average long-term returns across traditional asset classes. But we believe investors do have the opportunity to earn higher returns by positioning for a more digital future across 5G, fintech, and healthtech, and for a more sustainable one in greentech.

We forecast that advanced economies’ debt-to-GDP ratios will be over 20 ppts higher by the end of 2021 than at the end of 2019. And, given aging populations, minimal societal appetite for fiscal austerity, and low debt-servicing costs, we expect government spending to remain elevated by historical standards. Excess savings should enable relatively comfortable debt financing in the near term. But in the medium term, we think that debt financing will require some combination of higher taxation, regulation to encourage greater institutional investment in government bonds, or moderately higher inflation, underscoring the importance of owning “real” assets such as equities.

Post-COVID-19 debt levels are forecast to increase

US Federal debt held by the public, 2000 to 2050, in % of GDP

The pandemic has had a negative effect on employment for lower-skilled workers, while the nature of knowledge work, which can largely be performed from home, and the financial markets’ good performance have favored high-income and high-wealth individuals. In the future, technological disruption could widen the wealth gap even further. Whether wealth inequality reaches its political limits in the coming years remains to be seen, though we should expect to see more political leaders running on platforms that include some element of wealth redistribution. The resulting potential regional variations in economic policy make global diversification particularly important.

Higher-paid workers are likelier to be able to work from home

% of US respondents who worked from home or stayed home from work and were unable to work

Political considerations in an increasingly multipolar world, security concerns in light of the pandemic, consumer preferences tilting toward sustainability, and new technologies enabling localized production are all contributing to the world becoming more local. The aggregate effect on growth and inflation is unclear. But these factors can be expected to favor companies exposed to automation and robotics, companies already factoring sustainability into their supply chains, and companies based in ASEAN and India that could benefit from supply chain diversification out of China.

The pandemic has triggered more corporate conversations about localization

Number of mentions of keywords related to supply chain diversification in transcripts

The COVID-19 pandemic has forced much faster digital adoption and disrupted established norms. This could transform various industries, and, combined with the unfolding impact of the fourth industrial revolution, could boost medium-term productivity. The crisis could also have the effect of suppressing real interest rates because the more efficient use of capital stock and a shift from tangibles to intangibles lowers the demand for investment capital. On the flip side, a more digital world will produce its fair share of losers too. We see particular risks for physical retail and traditional energy over the course of the next decade.

Demand for carbon is still rising, but in 2020 the EU and Japan pledged to go carbon neutral by 2050, and China promised to do the same by 2060. Stricter environmental regulations could mean higher costs for some businesses. But companies that are well positioned for the transition, such as those providing greentech solutions, stand to benefit from a more sustainable world.

The EU’s goal is climate neutrality by 2050 

High government debt levels, societal calls for higher government spending, and reduced demand for capital in a digital world mean real interest rates are likely to remain at very low levels for the foreseeable future, in our view. Moreover, the move to average inflation targeting frameworks indicates that central banks will tolerate moderately higher levels of inflation. As a result, we think cash and high quality bonds will deliver a negative real return over the long term. We expect returns over the coming business cycle to average less than 1% for US Treasuries, which would likely lead to negative returns after inflation. Such low potential returns, as well as the reduced ability of high quality bonds to provide meaningful positive returns during equity drawdowns, suggest that investors should instead look to credit and alternative assets.

Total returns in credit are likely to be lower than in the previous decade. But, given that many central banks have added credit to their purchase lists, and in light of the very low yields in government bonds, we think credit should continue to play an important role in portfolios. We anticipate default rates and spreads both will decline below past averages as a result of low yields globally. We expect annual returns of less than 4% for USD high yield credit and about 5% for emerging market sovereign bonds in USD. We expect US investment grade credit to return around 1.5%.

The anticipated bounceback from the coronavirus crisis notwithstanding, we expect muted long-term economic growth in developed markets due to aging populations and high debt levels. Corporate net margins also face pressure from potentially higher taxation and minimum wages, political and security considerations, and tighter environmental regulations. That said, we think multiples should be well supported due to low interest rates, and we note risk premiums are higher than historical norms. The increased use of technology and changes to established working practices driven by the pandemic could also lead to higher worker productivity.

Overall, we expect nominal returns to average a little under 6% in the US annually over the coming business cycle, though we foresee higher returns for smaller size segments than we do for US large-caps. In developed markets outside the US, we expect returns to be closer to 8% after underperforming US stocks over the past few years. Regionally, we think the long-term outlook is most promising for emerging market stocks, which we expect to average a over 9% annual return (versus 4% over the past 15 years) thanks to lower initial valuations, a more favorable overall demographic profile, and greater potential for productivity gains. Investors seeking higher returns can also consider specific themes and sectors that we think have higher growth potential.

Amid lower returns in developed market equities, and given the increased opportunity cost of using bonds to stabilize portfolios, investors will need to search for alternative sources of returns and diversification such as private markets and hedge funds. Private markets require long capital commitments, but we expect returns of near 9% per year in private equity, around 3ppts higher than public equity, and 8% per year in private debt. For more on this topic, please see page 53. Meanwhile, we expect funds of hedge funds overall to return approximately 3% (in USD) per year, over the long term. We see particular hedge fund opportunities in the thematic and equity selection space due to the structural changes set in motion by the pandemic.

Prices are currently cyclically depressed, and energy prices in particular have ample room to recover in the wake of the pandemic. Overall, we think broad commodities indexes will return roughly 4% annualized over the coming business cycle, driven by strong expected returns in energy. We expect gold to return 4% a year.

We expect the US dollar to weaken in the years ahead, so it is important to review dollar exposure and implement hedges if necessary. On the other hand, we think broad emerging market currencies, as well as the Japanese yen and the British pound, offer the most upside potential over the long term. International investors who hold assets in these markets should keep the currency exposure to benefit from this expected appreciation, in our view.

In a low interest rate environment, real estate remains an attractive investment for income generation in our view, particularly when compared with cash or government bonds. Real estate’s inflation protection characteristics may prove beneficial in a more indebted world. While we do not think that either city living or the office market has been permanently impaired. due to the pandemic, active private real estate strategies should provide better returns compared with low yield buy-and-hold strategies. We still expect nominal returns to average about 6% annually in private real estate (in USD), compared to the average of 8.5% over the past two decades.

For the first time since 2009, the global economy looks set to contract, with GDP estimated to shrink by 3.8%. Policymakers mandated unprecedented mobility restrictions in an attempt to slow the spread of COVID-19, but also approved over USD 12tr in fiscal stimulus measures to help cushion the blow to individuals and businesses.

Monetary policy played a supporting role too, with over 30 major central banks cutting rates and some reintroducing quantitative easing measures.

Accommodative monetary policy contributed to record-low yields. The 10-year US Treasury yield hit an all-time low in March, and over USD 17tr of bonds now have negative yields. After widening to 1,087bps and 373bps on liquidity and default concerns, US high yield and US investment grade credit spreads tightened to below 500bps and 130bps, respectively, on the back of a rapid recovery.

We witnessed historically volatile markets and the fastest bear market on record. The combination of monetary and fiscal stimulus helped mitigate the initial shock of the pandemic, and led to a record-breaking market rebound. At the time of writing, year-to-date global stocks have returned 6.3%, the S&P 500 9.7%, the Euro Stoxx 50 fell 6.8%, and the SMI is down 2.4%. Growth stocks have outperformed value stocks by 29ppts, large-caps have outperformed mid-caps by 5ppts, and US defensives have outperformed cyclicals by almost 30ppts.

Safe-haven flows supported the US dollar in mid-March, helping it reach multi-year highs versus the euro. But while central banks around the world eased policy in the wake of the crisis, the Fed’s easing program was more comprehensive than many other nations’. The US dollar index now trades 10% lower than the March peak.

WTI oil contracts briefly traded in negative territory in April, reaching as low as USD –40/bbl when investors wanted to avoid taking physical delivery, before rebounding later in the year. Meanwhile, gold was one of the best-performing assets of the year, briefly climbing above USD 2,000/oz at its peak as real rates fell and the US dollar declined.

Survey data indicates that hedge funds lived up to investor expectations in 2020 triggering renewed interest in the asset class. Managers successfully mitigated downside risk in March/April and subsequently took advantage of temporary dislocations to generate returns. Performance across strategies, however, varies. Top performing strategies included tech, healthcare, equity long/short, discretionary macro, and multistrategy funds. Meanwhile CTAs, structured credit, and other event-driven funds lagged other strategies.