Inflation, government spending and US dollar top list of what to watch.

What lies ahead in 2021 for investors? After 2020, it feels a fool’s errand to guess. But these guidelines for investors might prove useful. 

1. Inflation versus deflation

After 40 years of falling interest rates and declining/low inflation in the developed world, investors have been trained to believe inflation is impossible. 

However, copper prices, freight rates, the Chinese yuan, the Korean won and the gold price are all relatively strong in late 2020 – in the middle of a colossal deflationary pulse caused by COVID-19. 

Central banks globally for a decade begged elected officials to spend money – and in general they refused to do so in most large economies … until 2020. 

Just as the GFC saw the abandonment of monetary rectitude among central bankers, so the reaction to COVID-19 may have seen the abandonment of any pretence of fiscal discipline among elected officials in the developed world. 

2. Threading the fiscal needle

Central to the inflation question will be the behaviour of elected policy makers in the West. We are reminded of Milton Friedman’s aphorism, “there is nothing so permanent as a temporary government program”. 

Elected officials in most developed nations have chosen to offset the deflationary shock of lockdowns and consumer caution with fiscal programs aimed principally at transfer payments [for example, wage subsidies]. The budget deficits that have resulted are large by historical standards. 

This is utterly different to the fiscal response to the GFC in its scale, but we are yet to see if this also differs in duration. 

Most major economies recorded large deficits in 2008 through 2010, then shrank those deficits every year thereafter until the Trump tax cuts of 2017 and then the COVID shock. 

We think large deficits may have become a feature of fiscal policy in many major economies for the time being, as elected officials wrestle with how to withdraw stimulus from economies as they re-open in fits and starts, with gradual vaccine rollouts and the likelihood of ongoing virus outbreaks. And once economies are reopened, the temptation to leave stimulus in place may prove irresistible. 

3. US dollar weakness

The US is leading the way in terms of budget deficits, due in part to having entered the COVID-19 shock with large deficits. 

Fiscal 2020’s deficit of 15% of GDP is unmatched in peacetime and only exceeded by deficits during World War Two [1]. This is substantially larger than that of other major economies, many of which have handled the COVID crisis far more effectively than the US, particularly in Asia. 

The US dollar has weakened markedly since April as a result. We expect this to continue: US-dollar moves are usually long in duration; we see little amelioration of the US deficit situation in the near term, with large deficits expected over the long term absent serious reform efforts in the US [2]. 

Apparent political gridlock in the US following the 2020 election would seem to militate against successful reform. 

4. COVID-19 vaccines/treatment

There has been early success in the hunt for a vaccine, as our Platinum colleague Dr Bianca Ogden (PhD in virology) has discussed [3]. However, vaccine distribution will be a challenge, as will the ramp up to full production. 

Unfortunately, behavioural changes will remain a feature of combating COVID-19 for some time, along with the economic imposts this implies. This will likely force governments to maintain strongly accommodative policy stances in the near term.

5. Economies returning towards capacity

While the path may be uneven, economies will eventually return towards capacity in the next year or two as vaccines are rolled out and treatment regimens for COVID-19 improve. 

This will likely be in the presence of the large government deficits discussed above. And we already see incipient signs of industrial recovery and inflation in basic materials prices, freight rates and currency movements. 

6. Resurgent China 

Which brings us to the main reason for the industrial recovery evident in steel, iron-ore, copper and shipping prices – China. Its GDP, industrial production, automobile purchases, infrastructure investment and retail sales have all returned to healthy growth [4]. 

For those sceptical of Chinese data, this is corroborated by the prices of commodities and trade-exposed currencies like the Korean won. China is growing. 

Meanwhile, China’s equity market is no higher than it was 13 years ago, and is among the cheaper equity markets globally. Relative to the US, China’s equity market valuation is slightly off its all-time lows [5]. 

7. Ongoing US-China tension 

Joe Biden’s apparent victory in the US election will do little to stop ongoing tense rhetoric between his nation and China. However, this may belie a calming of the trade uncertainty faced by those investing in global supply lines. 

Trump and his trade team, Peter Navarro and Robert Lighthizer, have led an extraordinary policy of “chaos ball” in the last three years, which has seen not just China, but Japan, Germany, Brazil, Vietnam, Canada, Mexico, among others, threatened with trade sanctions [6]. 

This has caused uncertainty and discouraged investment, contributing to a global industrial recession even before COVID-19’s onset. 

This uncertainty is likely to improve under a Biden administration, further reinforcing the growth and inflation dynamics described above. 

In summary

There is every chance that the economic context of the post-GFC world has shifted. This may entail higher rates of inflation and nominal growth, along with steeper yield curves and somewhat higher interest rates. 

This may feel a remote prospect, but inflation regimes can change rapidly: In 1915, US consumer price inflation was 1% – in 1917 it was 20% ; in 1945 US CPI was 1% – in 1947 it was 19% ; in 1972 US CPI was 2% – in 1975 it was 12% [7]. (All figures on a per annum basis).

Given commodity prices and a steepening of the US yield curve, this trend may have already started. Investors who assume low growth and low inflationary conditions will persist indefinitely, and who therefore seek the safety of bond-like equities and the excitement of profit-free growth (high revenue growth but little or no profit growth), may find these assets a poor store of wealth in 2021 and in the years to come.

DISCLAIMER: This article has been prepared by Platinum Investment Management Limited ABN 25 063 565 006, AFSL 221935, trading as Platinum Asset Management (“Platinum”). This information is general in nature and does not take into account your specific needs or circumstances. You should consider your own financial position, objectives and requirements and seek professional financial advice before making any financial decisions. The commentary reflects Platinum’s views and beliefs at the time of preparation, which are subject to change without notice. No representations or warranties are made by Platinum as to their accuracy or reliability. To the extent permitted by law, no liability is accepted by Platinum for any loss or damage as a result of any reliance on this information.

[1] https://www.cbo.gov/publication/56746

[2] https://www.cbo.gov/publication/56516 

 [3] https://www.platinum.com.au/Insights-Tools/The-Journal/A-Diversified-Vaccination-Strategy; https://www.platinum.com.au/Insights-Tools/The-Journal/mRNA-Technology-Delivers-Vaccine-Breakthrough 

[4] Bloomberg

[5] As measured by 10-year average price to earnings, with thanks to Gerard Minack for his excellent data

[6] https://www.piie.com/blogs/trade-investment-policy-watch/trump-trade-war-china-date-guide 

[7] Quoting Grant Williams; see also Robert Shiller’s CPI data http://www.econ.yale.edu/~shiller/data.htm