Will vaccines be shot in arm 2021 needs?

As markets and society consign 2020 to the history books, economists cautiously optimistic on the outlook for 2021 warn that the dominant theme of last year — the COVID-19 pandemic — will not disappear.

In fact, the biggest potential upside to financial markets — an effective, mass-produced and distributed vaccine — could also be the biggest potential downside if they fail in one way or another to thwart the spread of the virus.

"If the vaccines fail, we're in the soup," said Nathan Sheets, Newark, N.J.-based chief economist and head of global macroeconomic research at PGIM Fixed Income. "Then (there is a) risk around distribution, and will people take it. Another important issue is distribution into emerging markets — that's dependent particularly on the AstraZeneca vaccine."

The coronavirus pandemic and subsequent shutdowns by countries across the globe to try to control its spread influenced monetary and fiscal policy in unprecedented ways. Central banks cut rates to ever-lower figures and ranges, expanded bond-buying programs and, in the case of the European Central Bank, brought together members states of the European Union to create a pandemic emergency purchase program worth more than $2 trillion. Governments around the world also embarked on job retention programs and packages to keep businesses going and unemployment in check. The U.S. Coronavirus Aid, Relief, and Economic Security Act amounted to about 15% of U.S. GDP, compared with the 5% the 2009 stimulus package produced to combat the effects of the 2008-2009 global financial crisis.

On Dec. 28, President Donald Trump signed into law a second coronavirus stimulus package, amounting to $900 billion.

And as the realities of a global pandemic set in and markets plummeted in March — with the S&P 500 index down almost 35% on March 23 — markets subsequently responded well to stimulus shots. For the calendar year, the S&P 500 index returned 18.39% vs. 31.5% in 2019, while the MSCI ACWI gained 16.83% vs. 26.6% last year.

The general consensus among money management economists is that 2021 will bring a "strong economic recovery … as vaccines are rolled out and the reopening of economies is more complete," said David Riley, chief investment strategist at BlueBay Asset Management LLP, London.

But a relatively bullish view means "there's more focus on downside risks. And (they) relate to how quickly the vaccine is rolled out and we get to the point where we can have a full reopening."

It was also the consensus view that the effectiveness of vaccines could exceed expectations.

"It means that the percent of the population that you need to vaccinate in order to get to herd immunity … is that much less and can happen that much earlier," with potentially a full reopening by the summer, Mr. Riley said.

However, "if that rollout has meaningful delays so we don't get herd immunity or full reopening until the third or fourth quarter even, that's a downside risk. It's still an economic recovery, but weaker than would be the case. And (for) the most-hit COVID sectors where there is some value for investors willing to take on that risk, some of those businesses won't survive," Mr. Riley warned.

While the recovery so far "has proved zippier and nimbler than first imagined," risks do arguably skew downward, said Eric Lascelles, chief economist at RBC Global Asset Management in Toronto. However, he views that "as being the normal state of affairs. When you start with pandemics and wars, there's kind of no upside risks."

RBC GAM has been considering a number of downside risks: beyond the virus itself, another potential risk is the "high levels of optimism for vaccines — I like high efficacy rates, am reasonably confident uptake would be good (and) distribution manageable. It seems quite conceivable (that herd immunity) happens — but there's no guarantee," Mr. Lascelles said. "The markets right now are assuming something pretty close to perfection … and there are ways in which those might not happen."

Another risk Mr. Lascelles sees relates to inflation — something that other economists brought up as something that would return to markets in 2021, but not as a concern.

"Our forecast is quite benign … but the consequences of surprisingly high inflation would be worse than those of surprisingly low inflation. We know what to do with low inflation. Any bout with surprisingly high inflation could be problematic" as it would necessitate policy tightening. And higher rates "wouldn't be welcomed," Mr. Lascelles said.

Developments in monetary and fiscal policies were cited by other sources as risks that have carried through to 2021.

Karen Ward, London-based managing director and chief market strategist for Europe, Middle East and Africa at J.P. Morgan Asset Management, is optimistic that society can get back toward normal by the end of the first half of the year.

However, "the foundations of my positive view are basically built on this monetary and fiscal coordination — it's really powerful during the weak times, but still is evident (that) it continues to drive the recovery," Ms. Ward said.

Her big risk for 2021 is that the authorities aren't able to continue to drive the recovery, "and the only risk that that happens is that inflation shows up." Central banks would be forced to contend with the fact that COVID-19 has done more damage to the supply side of the economy than demand, "and at that point everything starts to get more difficult."

However, it's not her most likely scenario, "but because the effects would be so damaging — particularly for financial markets — I'll have my eye all over all the indicators or forewarnings of inflation. Because that would be the ultimate downside risk," Ms. Ward said.

Christopher Smart, chief global strategist at Barings LLC and head of the Barings Investment Institute in Boston, said the biggest challenge for financial markets "will be how quickly is monetary accommodation going to start ebbing away. How quickly does the punch bowl start to move toward the kitchen?" While he doesn't think 2021 will be the year for monetary policy tightening, "markets will have to start pricing it in" in 2022 and 2023.

Despite confidence that support will not wane, the early part of this year will still be tough, economists warned. But fiscal policy "can provide a bridge from that tougher first part … into the kind of rebound" for later in the year, PGIM's Mr. Sheets said.

There's also little doubt in managers' minds that central banks and governments can pull more rabbits out of their hats to continue to support the economy.

"Central banks and governments will continue to foster the economic recovery in 2021," said Evan Brown, New York-based head of multiasset strategy at UBS Asset Management. "Monetary policymakers will effectively be adding monetary stimulus just by doing nothing as economies heal. While the fiscal impulse is poised to fade from extremely elevated levels in 2020, budget deficits will still remain ample and a widespread, premature withdrawal of support is highly unlikely."

Should the recovery come up against obstacles or even reverse direction, "governments, particularly in advanced economies, have ample ammunition and an easy playbook to follow: Just do what you did in 2020," Mr. Brown said.

But policymakers will need to do more, building on fiscal actions like the CARES Act, other sources said.

"I do think that, right out of the gate, even right now, where U.S. fiscal discussions land is an important piece of the puzzle," said Mike Pyle, managing director and global chief investment strategist at the BlackRock Investment Institute, New York. Mr. Pyle commented prior to the latest $900 billion stimulus package.

"Among the important things (with a vaccine) is we now know we're building a bridge to somewhere. If U.S. policymakers can show up — (as they did with the) CARES Act in the spring … they've built the bridge two-thirds of the way across the chasm, and now the question is, can we build the bridge the final way across?" Mr. Pyle said. "If policymakers are able to do that, even imperfectly, I think that will continue to limit the degree of scarring that we see overall in the U.S. economy in terms of household challenges, business challenges (and the) labor market. If (they can) accomplish that … that I think will set the table for the vaccine and especially from the summer onward to really deliver a supercharged boost to the U.S. economy. If they fall short … that's a world where some of these risks about more prominent scarring come back onto the table."

Mr. Pyle was named senior economic adviser to Vice President-elect Kamala Harris on Jan. 8.

Following the outcome of the Georgia Senate runoff elections Jan. 5 that resulted in Democrats taking control of the Senate, sources now expect expanded fiscal spending.

However, the degree of economic scarring is a serious concern for other economists.

"We know there is some scarring — the post-COVID path is obviously lower," but the question is also whether economies are also growing at a slower rate than before, said Paul Gruenwald, global chief economist at S&P Global Ratings in New York.

"We think the damage is only on a level sense — we don't see any big change to COVID growth potential globally — that's not what happened after (the global financial crisis). But we don't think supply side is going to be damaged too much after this," he said. "The trajectory is lower" but growth is still on the same path as it was prior to the crisis, he said.

Labor-market scarring is the main risk for Silvia Dall'Angelo, London-based senior economist at the international business of Federated Hermes Inc. "Unemployment has spiked during the lockdowns and crisis" and the longer the situation persists, the longer people are out of work, Ms. Dall'Angelo said.

Despite fiscal plans in place to help businesses to keep people employed, the risk is "that (the plans) don't have really a longer-term objective. For the recovery to be really sustainable and sustained, we need to see more longer-term spending projects — investment in infrastructure, physical and (non-physical infrastructure) — education, research, retraining of the labor force," Ms. Dall'Angelo said.

While politics took a front seat in 2020, some economists think it will take more of a backseat this year. "I'm hoping all that political uncertainty … resolves itself and fuels activity in the second half of the year," JPMAM's Ms. Ward said, referring to the U.S. presidential election and the final negotiations related to the U.K.'s exit from the European Union.

Brexit is "no longer a global risk even, which it had been from 2016 onwards," said Michael Herzum, Frankfurt-based head of macro and strategy at Union Investment Institutional GmbH.

However, geopolitical tensions are expected to carry through from last year, in particular between the U.S. and China.

"The change in U.S. government will not lead to a change in policy," said John Roe, London-based head of multiasset funds at Legal & General Investment Management Ltd. There is an "insolvable problem between the U.S. and China — you've got a dominant power and a new power. The new power threatens the dominant and you get a conflict between them."

Federated Hermes' Ms. Dall'Angelo thinks that President-elect Joe Biden "will be more diplomatic and predictable" in his dealings with China, but that doesn't mean he "will go that easy … and if anything, he might try to build a common front of Western countries to deal with China in respect of (intellectual property) rights, avoiding a tech transfer and state aid, which basically biases competition. And in terms of human rights," he won't go easy either, she said. "I think that tensions between Western countries and mainly China will continue within this broader theme of deglobalization."

Europe could also benefit from Mr. Biden's presidency, said Union's Mr. Herzum. "For us it means more reliable, less erratic, less harsh tone," he said. "We think there's a chance because he takes over when the worst of the crisis is more or less behind us that it could increase his popularity and strength of negotiating power with the Republican Senate." It's especially positive for Europe "as it would mean that global trade would recover a lot," Mr. Herzum said.

However, sources said there is one more election to be aware of: Germany's federal election later this year to replace Angela Merkel.

"In a way, I think it's a bit of an underrated risk. Angela Merkel has been in charge of Germany — and I'd say of Europe — for 15 years," Ms. Dall'Angelo said.

While some may have disagreed with Ms. Merkel's decisions over the years, "I think she has really shown leadership and that has become evident in the response to the COVID crisis," with her coordination with France to "push for a very significant (recovery) package. Her disappearance from the European political stage could be quite problematic," Ms. Dall'Angelo warned. "Those are big shoes to fill."

But actions of politicians — and central banks — in 2020 have overall "changed long-term expectations," Thijs Knaap, senior strategist at APG Asset Management in Amsterdam, said in emailed comment. "The most visible legacy is the increase in (government) debts. This will not change anytime soon and will be another reason to keep interest rates low for quite a while. Central banks have given themselves more room to stay stimulative, and can be expected to do so. It also seems that governments have crossed some boundaries that will make it easier to intervene in the economy in the future; we expect more economic policy, less laissez-faire, also because of the increased interest in defending your own corporate sector from foreign meddling."

Even with Mr. Biden in the Oval Office, "active trade and investment policy will be a new and lasting element of international relations. The European Union looks stronger coming out of 2020 than going in, with progress forged in crisis once again. The same goes for China, which did remarkably better in controlling the outbreak than most developed countries. Thus the shift to a multipolar world is now well underway. Especially for global investors like ourselves, this will be an interesting change from the U.S.-dominated, post-World War II order," Mr. Knaap said.