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Research and Market Commentary

Global Markets Insights: Vaccine rollout, excess cash lifts outlook

December 11, 2020

The outlook after a tough 2020 has started to brighten as COVID-19 vaccines arrive earlier than anticipated. The Bank of Canada in its latest statement may have subtly distanced itself from its previous forecasts, while the expected unleashing of excess cash from both consumers and corporations next year could fuel an upturn. However, while the loonie's rise appeared to have stalled this week, the CAD will continue to be supported by a relatively resilient Canadian economy.

 

Scotiabank analysts and economists weigh in on what the pandemic means for foreign exchange, the Bank of Canada and equities.

 

Foreign Exchange

 

  • The USD’s ongoing decline on vaccine optimism corrected slightly during the early part of the week amid uncertainty in markets over a Congressional impasse on a new stimulus bill and no-trade-deal Brexit risks. A failure to pass a new bill risks an ‘income cliff’ at year-end that would leave over ten million unemployed Americans with no significant source of income amid the US’s most severe wave of COVID-19. This possible sharp drop in income would heavily dampen the US recovery and with it impact the risk mood in equity markets, with a concomitant rise in the dollar.

  • The rising chances of a ‘hard’ divorce on trade with the EU has led to a notable underperformance in the British pound (GBP, down ~1% for the week) as markets incorporate the economic impact of a switch to WTO trading rules. With negotiations extended to a new Sunday December 13 deadline (one of many), markets are still reflecting a fair degree of optimism that the two sides will reach a deal—an opinion that we do not share. The rising chance of a no-trade-deal departure has increased the odds that the Bank of England will cut rates to below zero despite mixed evidence of their benefits; we think the BoE would instead expand and/or accelerate its asset purchases. Overall, the pound should weaken in the near-term as a no-trade-deal Brexit on January 1 fast approaches.

  • The dollar’s gains through the early part of the week reversed as USD-selling pressure resumed. Market angst over Brexit and a continued surge in COVID-19 cases in the US and lockdowns in Europe (where cases are stabilising/declining) will likely not be enough to counteract the long-run bearish view on the USD maintained by investors. The rollout of vaccines next year will put global economic activity on track to pre-pandemic levels, increasing demand for commodities and riskier assets and a move away from the now relatively lower-yielding USD. 

  • The Canadian dollar’s (CAD) rise appeared to have stalled around the 1.28 mark on a USDCAD basis during most of the week before nearing its strongest point since April 2018 near the 1.27 level joining in the outperformance of commodity currencies within the market’s tilt versus the greenback. The CAD will continue to be supported by a relatively resilient Canadian economy—in no little part owing to the Federal government’s aggressive fiscal impulse.
     

—  Shaun Osborne, Managing Director, Chief FX Strategist, and Juan Manuel Herrera, FX Strategist
 

Bank of Canada
 

  • Markets paid attention to the Bank of Canada for a period of time measured in minutes before volatile US stimulus headlines took over. For the most part this statement was taken by markets as a placeholder until forecast revisions are presented in the next Monetary Policy Report on January 20th.

  • I may be employing some literary licence with this argument, but in my view, if there is anything interesting at all about this statement then it lies in the possibility that the BoC subtly distanced itself from the forecasts it issued on October 28th.

  • How so? Note the last paragraph that states “In our October projection, this does not happen until into 2023” in reference to when spare capacity is expected to shut with inflation sustainably back on the 2% target as guidance surrounding when Canadians can expect the rate hike debate to really heat up. If the BoC still held to the views expressed in October in today’s statement then presumably it would have conveyed unchanged confidence in this forecast by, for instance, removing the reference to October and indicating this to be a current view. Instead, it put a best-before date on the forecasts that may have already turned into sour milk.

  • This is significant to note because the arrival of vaccines much earlier than anyone had anticipated just a few weeks ago may have a marked effect on the outlook. We still won’t hear the Governor talking about raising rates for quite some time to come as Ottawa continues to focus on priming the pump, but three years? That seems a tad far fetched if the pandemic essentially comes to an end over the next year and forms of activity that were perhaps prematurely written off return earlier than previously anticipated.

  • In my view, debate over further tapering of bond purchases will heat up over 2021H1. That would be consistent with shutting down the purchase program well before the possible closure of the output gap as a measure of overall spare capacity around a year ahead of prior BoC guidance.

  • This possibly earlier closure of the output gap should also be viewed through the same lens that sees Canada having more quickly ramped up monetary and fiscal stimulus than in the US despite having one-seventh the per capita COVID-19 case rate and core inflation closer to target than in the US.
     

— Derek Holt, Vice-President and Head of Capital Markets Economics, Scotia Economics
 

Equities 
 

10 Themes for 2021 – Unleashing Excess Cash

  • Piles of Stacked Cash Could Soon Turn Into Hot Money. An economic rebound is broadly expected for 2021, but we believe the US economy could exceed expectations. Three factors could move the needle: consumer spending, an inventory re-stocking cycle, and corporations opening the spending spigots.

  • Synchronized Downturn, Synchronized Upturn. The global downturn experienced in Q1/Q2 has now morphed into a global upturn which should extend into 2021, underpinned by fiscal and monetary largesse around the world. The leading economic indicator for OECD countries and six major non-OECD economies has indeed been spiking, hinting towards firmer growth ahead. China could be the growth engine next year according to Scotia Economics, which expects the economy to grow 8.5% – a pace of expansion not seen in years.

  • The Road to US$200 EPS. We believe that a combo of above-average top-line growth and impressive resiliency in profit margins could push S&P 500 EPS near the US$200 mark in FY 2022. S&P 500 revenue growth is usually quite strong in the two years following a crisis. Moreover, the Q3/20 reporting season highlighted the surprising resiliency of corporate profit margins. Corporate Canada (and America) has done a great job of taking costs out of the system during the pandemic. Turbo-charged top-line growth in ‘21/’22 (7%-8% CAGR) and profit margins reverting near pre-pandemic highs could pave the way to record earnings and higher stock prices.

  • Income Scarcity: The Hunt for Yield Intensifies. Interest rates on cash deposits and government bond yields should remain quite anemic next year. As traditional sources of income can’t fulfill their role anymore, the hunt for yield will likely intensify and investors will have to look for alternatives. Equities appear an obvious choice. After a challenging year, dividend growth should resume in 2021 on the back of improving profitability trends. Moreover, dividend yields have rarely been this attractive versus government bonds in over half a century.

  • Bond Yields: The Great Normalization. From an asset mix perspective, we believe government bonds have the worst outlook and possess the greatest risk of generating negative returns. Despite a broad normalization in macro data since last summer, bond yields have remained well anchored near their lows until recently. If growth is firmer next year, LT inflation expectations drift higher, and investors demand a higher premium to finance massive fiscal deficits around the world, we believe bond yields could also normalize. Prior to the pandemic, US 10-yr yields were hovering around 1.5%. Our US 10-yr bond yields model is even more aggressive, pegging fair value near 1.8%. Since short-term rates remain anchored by central banks, rising LT yields would imply a steeper curve. The steepening phase rarely stops at 75 bp: most of the time, it steepens well in excess of 100 bp. Investors should also start discussing and pricing-in less accommodative central banks by the end of 2021 if global growth is firmer and the COVID-19 stands in the rear-view mirror. A 2013-style “taper tantrum” is thus an increasing possibility late 2021 / early 2022.

  • Go Global. Our preference goes to international equities (TSX, EM, EAFE) over the US. After having underperformed almost continuously since the GFC, a synchronized economic lift-off should stimulate risk-appetite and provide more support to equity markets that have been left behind and trade at more compelling valuations than the US. Although MSCI EAFE and EM indices have surged of late, it is surprising to see them still comfortably below their all-time high reached in 2007! A breakout to a new high would be, technically-speaking, quite bullish after having traded sideways for over a decade now.

  • Small Could Be Big in 2021. If U.S. small caps end 2020 behind large caps, it would mark their fourth consecutive year of underperformance with six of the last seven years seeing underperformance. All U.S. small cap underperformance cycles since the 1920s ended when the small cap to large cap ratio (using total return indices) was in the vicinity of the ascending trend line. The ratio hit that trend line recently, suggesting the underperformance cycle has likely run its course. Historically, large cap domination cycle tends to last about six years on average. If the current cycle started in 2013 as we believe, its longevity roughly matches the historical average. Moreover, small cap equities have not been this attractive in years relative to large caps. While small caps’ profitability has contracted this year, the percentage of small businesses losing money has likely peaked and should improve sharply next year.

  • Hard Assets Shining, CAD Roaring. Accelerating growth, dollar weakness, and a decade of falling capex in the mining industry could offer decent support to commodity markets in 2021/2022. However, the backdrop could be more supportive of base metals/energy than precious metals/gold. A wave of investment in green energy over the next few years bodes well for copper. Regarding energy, we believe oil & gas stocks have probably much more upside than the commodity. For the bullion, USD weakness should help, but lower uncertainty is usually less friendly and real US 10-yr bond yields (while still extremely low) could face upward momentum. We believe gold could trade sideways in a broad range unless inflation pressures accelerate. The environment should help the CAD to reach, and potentially exceed, the US$0.80 mark next year.

  • Sector Rotation Favors Cyclicals. We believe the economic revival should provide more support to “old economy” stocks/sectors relative to their “digital” peers. Granted, cyclical sectors have enjoyed solid gains so far in November, but as illustrated below, some remain down on a YTD basis. Taking a longer-term view, it’s worth highlighting that US Financials are lagging Tech by 46% YOY, which still appears quite extended to us. If growth is visible, cyclical-value sectors appear well positioned to lead next year.

  • No Value Left Behind. Value’s sharp gain in November could be hard to repeat in the short run, but the number of quantitative and qualitative arguments for Value leadership in 2021 has never been greater. First, Value’s underperformance cycle has rarely been this extended while relative valuation levels have rarely been as much in favour of Value as they are today. The potential for mean-reversion is thus extremely high. Second, after such a long run of underperformance, there are few true Value believers left. Institutional investors have been mostly net sellers of Value names in 2020 (up to Q3/20), creating large UW to the style. Sell-side has also set the bar extremely low in terms of consensus estimates. Positive surprises/performance in the sector could force a positive feedback loop as investors try to close down their exposure gap. Finally, Value typically enjoys an environment of rising yields and economic recovery. Overall, Value is extremely well positioned to outperform in 2021.
     

 — Hugo Ste-Marie, Director Portfolio & Quantitative Strategy; Jean-Michel Gauthier, Associate Director, Portfolio & Quantitative Strategy; and Simone Arel, Research Associate, Global Equity Research
 

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