Darker Tunnel, Brighter Light
Financial markets pivoted quickly from the U.S. election—especially considering a vote-count that took so long to call—back to COVID-19 in November. The broad flow of economic data has been stronger than expected across Europe and the United States, even as much of Asia continues to recover. The good news, of course, has been the announcements around vaccines that may allow a return to fuller levels of activity much sooner than expected. The bad news is that the fresh waves of coronavirus infections in Europe and the United States have triggered tighter restrictions that will aggravate the scars from the pandemic, perhaps in labor markets, company balance sheets and confidence.
The prospect of a darker tunnel leading to a brighter light gives us more confidence in our “Not Quite Recovery” scenario, which foresees continued progress next year, but slowing momentum as government stimulus stalls in the United States, higher unemployment delays the revival in demand and stretched balance sheets trigger further defaults and bankruptcies. U.S. unemployment numbers continue to improve, but rising numbers of initial jobless claims and permanent unemployed suggest the next 3% decline will be much harder than the last 3%. Meanwhile, our recent work on corporate balance sheets (see the Monthly Spotlight, p 5) suggests that U.S. and European firms have ample liquidity to withstand almost any shock, even if some sectors and firms face significant stress. In Europe and elsewhere, the sectors that are most affected by new lockdown measures account for a disproportionately large part of the labor force. The picture in Asia continues to improve, even contributing to an important revival in global trade, but that depends on a durable recovery in global confidence, which is harder to envision as current COVID cases continue to rise in many areas. It’s a steadily improving picture, but still a long way from 2019. For investors, it still suggests a healthy outlook for risk assets, including equities, credit and private markets. U.S. government bonds and duration bets may face headwinds as rates edge slightly higher and close to 1%, but central banks in Europe and Japan seem committed to keeping rates pinned near current levels.
The vaccine news, however, has led us to eliminate our darkest “Kitchen Sink” scenario, which envisioned an extended pandemic and a collapse of growth that would trigger massive new fiscal and monetary responses. We replace it with a low-probability but much more positive path.
This “Escape Velocity” scenario carries a 10% probability, in our view, assumes a pace of vaccine distribution that is fast enough to restore confidence, a surge of pent-up demand that compensates for current lockdowns and continuing fiscal support, including in the United States. Even Asia, which has managed to contain COVID-19 case numbers, would see a further boost in activity as global trade recovers. This scenario would offer even more support to risk assets, but it may see markets begin to price in future reductions in central bank balance sheets and a mild drift higher for government bonds.
A more likely, alternative scenario is what we have labeled the “Fiscal Cliff,” which repeats the mistakes of the last crisis when governments withdrew fiscal support too soon and undercut the pace of the recovery. We assign a 20% probability to this outcome. Fiscal policy in Asia has been generally supportive, including in Japan as the new Suga government takes office. For next year, European governments have already committed to large spending programs as well as substantial commitments to joint European Union borrowing and spending. The main risk that government support may disappear too soon remains in the United States, especially with the elections likely to deliver a divided government. The new Biden administration will enter office with ambitious plans for fresh stimulus, as well as infrastructure and climate investment. Senate Republicans have signaled their intention to resist these plans and focus on bringing the deficit into balance, which could undercut the recovery as similar policies, especially in Europe, did following the Global Financial Crisis.
Under all these scenarios, investors will soon begin to think about the key challenges to the post-pandemic global economy: continuing friction between Washington and Beijing, prospects for investment in U.S. infrastructure, and post-crisis cohesion of the European Union. Even if the U.S. Congress avoids a “fiscal cliff,” markets will also focus intensely on just how quickly different forms of global policy support should be withdrawn, which will likely shape our next set of scenarios.
