The latest wave of market euphoria prompts us to realize gains and adopt a patient stance. Economic recovery could end up being slow and erratic, and a further round of volatility is possible.
Post-lockdown re-openings have triggered a sharp bounce back in economic activity across many countries, in line with what we had expected for the third stage of the Baa-shaped growth trajectory outlined in our previous Quarterly Outlook. While we take encouragement from the unprecedented ‘anything goes’ fiscal and monetary policy support in developed markets, as well as from efforts to contain the risk of a renewed outbreak, some countries are still struggling to contain the first wave of infections.
To us it seems prudent not to downplay the risk of a slow recovery path or even a second downleg in growth – the fourth stage of ‘Baa’ – as the OECD recently also warned. With virus developments diverging sharply across and even within countries, we favor an increasingly selective approach, especially in emerging markets. An ‘anything goes’ policy response has lifted valuations, but that leaves risk assets pricing in economic outcomes that we believe are more uncertain. After extremes in euphoria in January and risk aversion in March, the latest wave of euphoria into July prompts us to realize gains and adopt a patient stance for the next potential wave of volatility.
We continue to think V, W, U and L remain inadequate descriptors for the growth trajectory. To be clear, we do not expect a relapse of April 2020 proportions. But we think that virus uncertainty, the existing pre-Covid debt overhangs now exacerbated by the H1 2020 revenue decline and the collateral damage to spending from bankruptcies and job shedding, will dampen the outlook more than many suspect. The V-shaped case rests on the idea that the recession is purely exogenous. Yet in our analysis there were huge imbalances in private sector debt coming into this, be it in US corporates, Chinese credit, or income inequality. Threats to trade are evident too. The US expansion was the longest in history. Per JK Galbraith and Irving Fisher, these traits all have the hallmarks of initial conditions heading into 1929.
We prefer to place the pandemic in its cyclical context and be humble about filling in the blanks of the non-mathematical part of the growth outlook. To us, this has clear market ramifications where only the rosier scenario is currently being priced in.
Fiscal and monetary policymakers around the globe have responded to the crisis with, it seems, an ‘anything goes’ approach, in their efforts to prevent the initial shock from morphing into a protracted aggregate demand slump. We expect policy intervention to remain in place, with the emphasis now shifting to the fiscal.
For the ultimate impact of the crisis, it matters a lot whether or not a country is able to orchestrate a fiscal cushion to bridge the gap in income and kickstart the economy. Here there are key differences between developed and emerging market countries, and also divergences within emerging markets. Those countries that were already suffering from waning investor trust going into the crisis will probably experience the most difficulties in financing a fiscal impulse to deal with the economic impact of the virus.
Governments face tough choices and policy dilemmas, as they have throughout 2020. As the south and west of the US is now experiencing, and as China found in late January, the dilemma is: do you reopen the economy to save jobs and businesses and seek to avert 1930s outcomes, or do you focus on the virus and prioritize health? The risk with the first approach is that you might initially win the battle on the economy, but then lose the war on the virus in any case, and thus the economy, too.
So, with fiscal policy, it is all very well to extend bridges, SME lending and furlough schemes. But by making them semi-permanent while removing incentives, the usually helpful free market Schumpeterian forces and reallocation of resources across the economy will be blocked, leading to permanently lower growth amid higher government debt overhangs. Some tapering of support seems advisable, but there are no easy answers.
Looking ahead, we believe central banks will remain instrumental in allowing the huge fiscal loosening to continue, while aiming to keep sovereign rates curves in lockdown. For the Fed, this could eventually imply increasing the maturity of purchases and/or reaccelerating the purchase pace – or even embracing some form of yield curve control in due course. For the ECB, a further increase in the size of PEPP beckons around the turn of the year.
We have had the ‘anything goes’ period of policy already. But just as Lady Gaga offered her own version of the Cole Porter original, for policy to be effective from here we will need a remix.
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