COVID vaccine, the economy, and the markets

The vaccine may be a catalyst that accelerates existing trends.

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Key takeaways

  • The release of vaccines for COVID-19 may be a catalyst for the acceleration of trends that are already in place. Economic growth may pick up, unemployment may drop sharply, and the bull market may keep running.
  • Small-cap stocks may be poised for outperformance. They were hit hard by COVID in 2020, but the early cycle is typically good for small companies as the economy recovers. Several factors may make 2021 a good year for smalls.
  • The shift to digital may last, as e-commerce and online payments could gather steam.
  • The vaccine could spark outperformance in emerging markets (EM) stocks. The combination of a weaker dollar, big differences in valuation between EM and US stocks, and the economic recovery could give EM stocks a boost.

The rollout of vaccines for COVID-19 may be a shot in the arm for more than the health of the populace. It could help boost the economy and accelerate some trends that are already in place.

"As of now we have 3 vaccines that seem to be as much as 90%, or more, effective against the virus, without any significant side effects. By the fall of 2021, we may start to feel much of the economy is more like it was prior to the pandemic—probably not 100%, but closer," says Naveen Malwal, institutional portfolio manager at Fidelity

Here are 5 trends to watch as 2021 unfolds.

1. Sustained acceleration in growth and jobs

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"The vaccine rollout makes it more likely that we'll see a sustained acceleration in GDP and jobs and a continued deceleration in the unemployment rate," says Fidelity sector strategist, Denise Chisholm.

Chisholm notes that the direction of GDP and employment and the rate of change are almost as important as the end rate. "It's the directional change in economic indicators that often matters the most to markets," she says.

2. Strong signs the bull may keep running

Chisholm expects credit spreads to further tighten next year and that could be a bullish sign for stocks.

The term "credit spreads" refers to the difference in yields on one type of bond compared to another of similar maturity. Chisholm specifically means the difference between junk bond yields and the risk-free yield, which would be the 10-year Treasury.

“The difference in yields gives you a perspective on the sentiment around increasing bankruptcies, with investors demanding more income to offset the perceived risk. It’s usually a pretty good leading indicator—typically a quarter or 2 after spreads increase, loan defaults begin to increase as well," she says.

"The better that metric is, the better the recovery has been—and the lower the loan defaults were," says Chisholm.

2020 has been a difficult year for many businesses. Even though there is optimism for the recovery, ratings agency Standard & Poor's forecast predicts that US corporate default rates could nearly double to 12.5% as a result of the COVID crisis.*

3. Small companies may get an extra boost

US small caps have struggled over the past 5 years compared to the big companies. Most of 2020 was no exception—even when the economic recovery started.

"Historically, small caps outperform 70% of the time during the economic recovery following a recession. Despite this year's recovery, earnings growth continued to lag badly as small businesses were hit hardest in the pandemic," says Chisholm.

"In fact, this was one of the only cycles where relative earnings growth in an economic recovery has not been V-shaped. The vaccine has the potential to change that trajectory," she says.

There are some factors aligning now that may be especially good for small caps:

  • The economic recovery
  • Earnings growth for small companies has lagged
  • Valuations are down—on both book yield and free cash flow, measures that have been predictive of outperformance

"So you have sort of a trifecta of signals, with the catalyst of the vaccine. That actually makes it very rare. All of these factors together have led to sort of a coiled spring alpha (or outperformance) following the rare times in history where this has happened," Chisholm says.

4. The shift to life online may stick—producing new winners

The pandemic hastened a shift to the internet. "Most of us are using areas like technology and communications more than we have perhaps at any time in our lives. And it's no surprise that those parts of the market have done relatively well for the most part," says Malwal.

For instance, the MSCI World Information Technology Index, which tracks large and mid-cap technology companies across 23 developed countries, increased about 37% from January through November in 2020. The S&P 500 was up about 12% over the same time.

As the vaccine is released, some businesses in neglected areas like commercial real estate and restaurants may perk up again as more in-person shopping and services resume. But the shift to the internet may be permanent in many ways. The pandemic gave many retail businesses a strong incentive to learn how to do things online.

As business picks up, some of these trends may gain steam and become a permanent part of life for consumers and businesses—including digital payments and e-commerce.

"We could wind up seeing an environment where there's been a faster adoption of some of these ways of living in a more online world. That can be a trend that can help businesses lower their costs, by needing less real estate and doing more business online instead," Malwal says.

5. Emerging markets stocks may outperform

Emerging markets stocks can be more volatile than the stocks from developed countries. But with the economic recovery poised to heat up around the world, stocks from developing countries could get a boost in 2021.

Investors ready to take on more risk for the chance to get outsize returns may look to emerging markets stocks as they anticipate a global recovery in hard hit industries like tourism, trade, and exporting of commodities.

Stocks in developing countries trade at valuations that are only 0.61x the price to earnings ratio of the US, "the lowest in almost 20 years," says Jurrien Timmer, head of Global Macro at Fidelity.

The strength of the dollar is also important for emerging markets—and there are indications that the value of the dollar may stay relatively low for the foreseeable future. With the combination of the lower value of the dollar, big differences in the value of stocks, plus the catalyst of the vaccine, investors may find that 2021 is the year for emerging markets stocks to flourish.

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