Light at the End of Tunnel

by Sean Tweedie | December 18, 2020

As the year draws to a close, we look at some key themes in financial markets for 2021.

Despite the recent surge of new COVID-19 cases globally, we are beginning to see the light at the end of the tunnel. A factor that is key for a recovery in 2021 is a widely available vaccine. Now, ten months since the start of the pandemic there is hope that this is becoming a reality with more countries having developed vaccines. Both of the vaccines developed by Pfizer-BioNTech and Moderna using mRNA technology have demonstrated efficacy rates of around 95%. AstraZeneca’s vaccine, produced in collaboration with Oxford University, showed an efficacy rate of 90% in one of its clinical arms. Russia and China have also launched vaccines. Such high efficacy rates are on par with the measles and smallpox vaccines, and well above the typical 30%-to-50% success rate for the seasonal flu vaccine. Large scale production has begun and at present it is estimated that there will be enough doses available to vaccinate 200 million Americans by the end of the second quarter of 2021.

Over the medium and longer term such a safe and effective vaccine will certainly bolster economic activity. We may see a similar effect over the short term however it remains a lot less certain. On the one hand, vaccine optimism could reduce household precautionary savings. It could also prompt more firms to invest in new capacity. On the other hand, the expectation that a vaccine is coming could motivate people to take even greater efforts to avoid getting sick in the interim.

Europe has been successful in containing the spread of the virus, with a 45% decline in daily infections since the highs of early November. This was achieved through various lockdown measures which came at a cost. As such, growth in Europe has suffered but should hopefully pick up as we move into 2021.

The US may see an expansion in the fourth quarter of 2020 which has been largely attributed to a recovery in personal consumption, strength in residential and non-residential investment as well as inventory restocking. However, the number of new daily cases in the US is on the rise again with the 7-day average of confirmed new cases having jumped to around 200,000. The Centers for Disease Control (CDC) estimates that for every single case that is caught, seven go undiagnosed. This implies that over 11 million people are being infected each week, or about 3% of the US population. This may force the US into more lockdowns in the coming weeks which will not be good for economic activity. See Figure 1.

There is still considerable uncertainty over whether the US will approve a new round of stimulus to support struggling households and business. After a burst of stimulus earlier this year, US fiscal policy has tightened sharply. See Figure 2.

Since peaking in April, real disposable personal income has dropped by 9%, reflecting a steep decline in government transfer payments. The US Congress has not been able to come to an agreement over the stimulus package, however we believe that ultimately one will be approved.

China has been able to weather the pandemic better than any other major country. November saw Chinese export growth accelerate to 21.1 % year-on-year and the manufacturing PMI rose to 54.9, the strongest reading since November 2010. Improving Chinese growth will continue to support countries with strong ties to China and who are reliant on exports to them.

In response to the pandemic, almost every central bank cut interest rates to ease the burden on households and businesses alike. BCA Research does not foresee any significant change to the accommodative global monetary policy stance. For one, inflation needs to be high enough to warrant raising interest rates but with employment unlikely to be at pre-pandemic levels anytime soon, inflation expectations remain fairly low.

The US dollar has been in a bear market these past few months and this trend of broad dollar weakness is set to continue in 2021. See Figure 3.

For one, interest rate differentials have moved significantly against the dollar. At the start of 2019, US real 2-year rates were about 190 basis points above rates of other developed economies. Today, US real rates are around 60 basis points lower than those abroad. A further factor underpinning this theme is the fact that the dollar is a countercyclical currency.

This means that the dollar moves in the opposite direction to that of the global business cycle. When global growth is higher relative to US growth, the dollar tends to weaken. See Figure 4.

A successful vaccine will allow economic activity to expand globally which will allow global growth to rise and this should underpin continued weakness in the dollar. Lastly, the dollar remains about 13% overvalued based on Purchasing Power Parity (PPP).

The dollar tends to be a high momentum currency and so it pays to be a trend follower when it comes to valuing the dollar. This means that once the dollar is trading below its moving averages, the trend generally continues for some time. Today, the trade-weighted dollar is trading below its 3-month, 6-month, 1-year, and 2-year moving averages.

In summary, interest rate differentials, rising global growth, valuations and trend all point to dollar weakness next year. This view is barring any significant economic or geopolitical shock which would see a movement back into the safe-haven dollar. In this environment we can expect both the euro, pound, and Scandinavian currencies to strengthen together with riskier and developing currencies like the Rand and Asian currencies.

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