LGIM: 2021, a time for recovery for the economy, environment and society

by | Dec 2, 2020

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Legal and General Investment Management (LGIM) has published its 2021 CIO Outlook. Sonja Laud, CIO at LGIM together with specialists from across the business, believe that 2021 will be marked by a possible economic, environmental and social recovery despite this year’s pandemic toll. The report also forecasts that investors can thrive, albeit with the appropriate approach.

The Outlook offers views from across LGIM that suggests optimism, founded on a view that even though the geoeconomic immediate prospects may have darkened, 2021 could still be a strong year for growth. Other key points in the report include:

  • The bull case for equities at this point in the cycle
  • How a Biden administration could create ripples in the bond market
  • The role of cashflow-driven investing in tackling market gyrations
  • Why 2021 could be a pivotal year for battery technology and renewable power
  • How China’s financial sector is opening up opportunities for investors

As highlighted in LGIM’s Autumn update, COVID-19 has accelerated a number of long-term investment themes that were previously underway. The global energy transition is an obvious example, as the shock of coronavirus has focused attention on the looming threat of climate change just as it has shaken up carbon-intensive industries.

 
 

Environmental regulations are likely to tighten under the incoming US administration, whose climate policies will have a worldwide impact. The changing of the guard in Washington, meanwhile, brings us to the continuing momentum of an underlying long-term trend: populism. We will continue to monitor the way politics has changed as a result of forces that propelled the outgoing president, and other populists around the world to power.

LGIM’s experts believe that Americans will continue to view China unfavourably, with the uneasy relationship between the world’s two largest economies likely to be a key driver of geopolitics for the foreseeable future.

Whilst looking forward to a post-pandemic world, societies are still living with coronavirus and the dramatic containment steps. Further debate is expected over fresh monetary and fiscal stimulus as the ultimate cost of such measures is contemplated.

 
 

Sonja Laud, Chief Investment Officer (CIO), at LGIM commented:

“After contending with the human and economic costs of Covid-19 as well as market volatility reminiscent of the global financial crisis, we believe that we are close to being able to turn the page, thanks to positive news on the vaccines and their roll-out, which should start in the coming weeks. 

“We cannot predict the outcome of risk events on the horizon, let alone identify black swans fluttering menacingly, but based on our research and available information, we can sketch out the contours of next year’s market landscape.  Pleasingly, we believe investors can thrive with the right approach.

 
 

Equities

The fundamental backdrop should boost equity markets as investors start to see a potential end to the economic and social hardship of the past year. We are only early in the economic cycle, with a meaningful output gap still to be closed, while recession risk is low and there are limited inflationary pressures. Risk-adjusted equity returns from this point in the cycle have historically been strong.

Valuations are not a troubling headwind.  While Equities may look expensive in absolute terms, on a relative basis the equity risk premium – the equity earnings yield minus bond yields – remains attractive. Sentiment has turned bullish for the first time since the pandemic, and at some point in 2021 it is very likely that markets will price in too much optimism.

All things considered, our base case would be that equities are likely to be among the best-performing asset class in 2021; we would not be surprised to see double-digit returns.

Fixed Income

We continue to believe in our ‘lower for longer’ theme in fixed income, seeing limited upside potential for bond yields from their current levels. We expect inflation dynamics will become more important than growth dynamics in determining bond yields once we get past the recession phase. That has been true for the past four cycles but should be even more important now that the Federal Reserve has indicated it will not react pre-emptively.

As a consequence positive news on the vaccine rollout is unlikely to be enough to put sustained upward pressure on bond yields. We will also need evidence that inflation is moving sustainably above 2%, which is very unlikely to happen in 2021 with unemployment still extremely high.

A low yield environment provides challenges for investors both from a return and a risk mitigation perspective. One of the measures we believe investors should take is to look at smaller, non-traditional fixed income markets to find better risk-off hedges. Smaller rates markets with higher yields that could still become more interesting and important. These include South Korea 10-year bonds yielding over 1.5% and Australian 30-year yields over 1.8%.

On the corporate side, investment-grade credit is less attractive than risky assets like equities. Returns from credit do not typically accrue evenly but tend to be higher when starting spreads are wider. That suggests there is potential value in having space in portfolios to add significantly to credit in extreme selloffs. This comes at a cost – namely the returns given up by patiently waiting for a better entry point – but we believe it’s the right framework for thinking dynamically about credit for the medium term.

Battery Technology

Battery technology is the key to unlocking the potential of renewable power, and 2021 could be a pivotal year for this market. The sector is in an early growth phase, but thanks to recent breakthroughs, is ready to power the next technological revolution in 2021 and beyond.

Two events late in 2020 really electrified the industry: Tesla’s admission to the S&P 500, and the UK’s plan to ban the sale of new cars fuelled solely by petrol or diesel from 2030. These welcome steps illustrate how investors can focus on batteries principally as an element of the electric-vehicle revolution.

Fossil fuels have accounted for most of the world’s mix of power generation since the 1970s, but according to BloombergNEF, renewables are now poised to take the lead. Wind and solar technologies alone are expected to provide 48% of all our electricity by 2050.

This progress is exciting and essential, but utilizing clean energy will be limited without better and more extensive battery storage. Without an upgraded storage infrastructure, much of the electricity potentially generated by renewables will be lost, and coal and gas-fired power stations will remain necessary to cover supply shortfalls.

Encouragingly, 2021 should be a marquee year for storage capacity. The world’s largest 250 megawatts  battery installation was completed in the US near San Diego in August, and we expect that record to be exceeded  with a new project just south of San Francisco, due to provide 400 megawatts of storage on completion in 2021.

China

China’s financial sector is clearly becoming more dynamic and we believe this is opening up significant opportunities for international investors.

While global investors have understandably focused on the US election, virus waves and a potential vaccine, seismic events have also been occurring in the world’s second largest economy with similarly significant implications.

It is easy to underplay just how successful the country has been at controlling the virus and returning to pre-pandemic economic output. The benefits of an efficient track-and-trace system are obvious. China has avoided much of the sustained unemployment and defaults that will scar Western economies for years to come. The cost is government control of private data. For now, economic practicalities dominate such concerns and China is well placed to be a relative winner from this crisis.

The technology sector has been another pandemic winner, but the second key event in China has been the regulatory focus on its domestic players. The country has some extremely successful technology companies, with Alibaba* recently announcing that Singles Day sales totalled 498.2 billion yuan, an increase of 26% versus last year.

Despite this Chinese regulators suspended Ant Group’s impending IPO, causing the $35 billion capital raise to be postponed. This doesn’t look like an isolated incident, with China announcing a set of draft rules against the broader monopolistic behaviour of its technology sector.

Constrained expansion

Is this the end for the Chinese technology boom – not if you believe the latest plenum of China’s Communist Party, which declared that self-reliance in science and technology is a strategic pillar of national development.

Unconstrained expansion may be over, but even constrained growth is attractive in a country expanding much faster than Western economies.  Many investors could see recent market volatility as an opportunity to add exposure.

The opening up of domestic Chinese financial markets is also key indicator of this constrained growth; the internationalisation of the renminbi; and the introduction of risk into previously ‘bullet-proof’ investments, such as dominant property developers and bonds issued by state-controlled entities.

The direction is clearly towards a more dynamic financial sector, with significant opportunities for international investors. Here, the result of the US election is influential, as the new administration will have to decide how much to push against China’s globalisation and how much to embrace it.

Despite the challenges, we see next year as a time for recovery – for the economy, environment and society – in which we can play an important role on our clients’ behalf, by seeking to create a better future through responsible investing.

 

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