COVID-19 has completely, and mercilessly, dictated the direction of economies and financial markets through most of this year.

So, as we rapidly approach the end of an extremely unpredictable and volatile year, what's in store for 2021?

It should come as no great surprise that the global economic outlook and the likely behaviour of financial markets remain hinged to COVID-19, and more specifically to health outcomes and responses.

That's a key finding from our just-released report: Vanguard Economic and Market Outlook 2021: Approaching the dawn.

Authored by senior economists and investment strategists from across Vanguard, the VEMO 2021 report highlights that the pace of economic recovery ultimately will be driven by the rate at which populations develop COVID-19 immunity.

As the human immunity gap narrows, the current reluctance gap – the fear of spending – will also narrow, leading to stronger economic growth.

Room for economic optimism

With the rollout of COVID-19 vaccines increasing, there is room for optimism.

In the VEMO report, we outline our base case that major economies will achieve infection immunity (when the person-to-person spread of COVID-19 becomes unlikely) by the end of 2021.

This would result in economic activity normalising by the second-half and output reaching pre-pandemic levels by the end of 2021. If infection immunity does not occur, economies may only see marginal progress from current levels.

But assuming immunity rates do rise, unemployment levels are set to fall, and a cyclical bounce in inflation is expected to occur around mid-year. This brings some risk that markets could interpret higher inflation with a more pronounced, but unlikely, inflation outbreak.

However, overall, there's more upside than downside to our economic forecast based on vaccine developments.

Country-specific economic growth rates will be varied, with our base case forecast for Australia at 4 per cent. This will trail the United States and the euro area, which are both forecast to grow at 5.4 per cent in 2021.

The strongest forecasts are for the United Kingdom at 7.4 per cent, albeit from a low base, and for strong growth of around 9 per cent in China due to its more successful navigation of COVID-19.

The outlook for markets

The key investment lessons to absorb from 2020 are that it's vital stay the course with your strategy and not become distracted by short-term market events, no matter how severe they are at the time, and that portfolio diversification will ultimately smooth out volatility.

The benefits of diversification played out over the most recent market cycle where investors holding a global equity portfolio would have outperformed someone holding an all-Australian equity portfolio by about 5 per cent in year-to-date terms.

In the period ahead, Vanguard predicts the Australian market should slightly outperform globally as economic conditions improve.

Vanguard's Capital Markets Model projections for global equity returns are in the 5 per cent to 7 per cent over the next decade, and in the 5.5 per cent to 7.5 per cent ranges for Australia over same period.

Although below the returns seen over the last few decades, equities are expected to continue to outperform most other investments and the rate of inflation.

In Australia, equity prices have rebounded roughly 40 per cent from the trough in March and valuations are considered to be in the middle of their fair value band.

US and China valuations are not overly stretched but at the higher end of their value bands given the recent stronger rebounds in those markets.

Despite rising equity valuations, the outlook for the global equity risk premium is positive and has increased since last year given record low bond yields.

Low interest rates will remain a feature in 2021, and Vanguard expects bond portfolios of all types and maturities will earn yield returns close to current levels.

But we continue to believe in the diversification properties of bonds, particularly high-quality bonds, even in a low or negative interest rate environment.

An investor holding a diversified portfolio (60 per cent equity and 40 per cent fixed interest) during the most recent market sell-off in March would have fared better than someone with an all-equity portfolio.

Rather than used as a returns enhancer, bonds are a risk reducer to balance out cyclical risks in portfolios.

In 2021, it will be important for investors to remain disciplined and focused on long-term outcomes, and to accept that current macro-economic events may mean medium-term investment returns will be lower than those recorded over recent decades.

15 Dec, 2020
By Tony Kaye
Senior Personal Finance Writer, Vanguard Australia
vanguard.com.au