Is the Tunnel Getting Longer?
In a race between vaccine research and virus mutations, logistical challenges are setting up hurdles that are lengthening the distance to the end of the tunnel. Governments are distributing vaccines at varying speeds and levels of efficiency. Also, each new virus strain risks putting into question the efficacy of existing vaccines. Emerging data suggest the vaccines will continue to be protective, though they may need retooling. The challenges remain daunting, and the role of fiscal and monetary policymakers providing support along the way will be key. There is still light at the end of the tunnel, it’s just that different countries may reach it at different times.
Markets have priced in a strong recovery amid hopes of a fast and smooth end to the pandemic. Credit spreads even in COVID-sensitive sectors are near pre-crisis levels. However, there are near-term concerns in the real economy, in particular as labor markets remain damaged. The tough winter months that brought high case counts and restrictions spared no region, and firms have been reluctant, or unable, to call everybody back. There are also signs that we will see different recoveries at different speeds. In Asia, where global trade has been crucial, China remains the leader; in the U.S., the pandemic has been worse, but additional fiscal stimulus has kept consumers spending; and Europe is falling slightly behind, hindered by fast virus spread, renewed restrictions, and lower income replacement than in the U.S. While the deployment of vaccines will likely support the global recovery this year, many sectors are still reeling and many challenges have yet to be overcome; this is why we stay with our central scenario of the “Not Quite Recovery."
Our baseline outlook is moderately supportive of risk assets—equities, credit and emerging markets in the medium term. After retracing much of the recent rise, U.S. Treasuries may drift slightly higher as better data arrives, but output gaps and monetary policy will keep rates near the current range. Meanwhile, sufficient accommodative policies by the European Central Bank should keep European government bonds strongly supported. In the near- term, valuations continue to look stretched and volatility is likely to persist, especially on uneven vaccine distribution and cheap liquidity in the system that is fueling speculative bets on asset prices.
While a tough winter weighs on U.S. employment, confidence, and spending, fiscal support to consumers will aid Q1 growth. With Democrats now seemingly in control, brighter prospects for further fiscal stimulus have boosted the medium-term outlook. However, spending bills, including an initial stimulus proposal and a broader set of priorities later this year, will likely face tough negotiations by a deeply divided Congress. The Federal Reserve continues to signal its commitment to accommodative monetary policy and won’t likely begin tapering asset purchases until at least 2022.
In Europe, the winter months proved damaging as partial lockdowns returned. A double-dip recession is likely leading the European recovery to lag the U.S. However, investment is set to drive improvement later this year, funded by governments and EU institutions, which both have finally learned the joys of a spending spree. Tellingly, an Italian political crisis has been triggered over how to spend government money, rather than whether to spend it.
In Asia, even China proved it is not immune to a second wave, while Japan remains stuck in the mud with high case counts, slow vaccine deployment, and weak consumers. In lieu of a widely distributed vaccine, exports are the source of strength on the path to recovery, aided by strong U.S. and recovering Chinese demand. In China, the supply-side recovery continues unabated, while demand should become a bigger source of strength this year. In Japan, despite a gloomy outlook, continued government support should limit downside risks.