The “Not Quite” Recovery Meets the Second Wave
The recovery this summer was vibrant. Cheap credit and accumulated savings were used to satisfy pent-up demand, resulting in strong activity in most of the world. Last month, economic indicators showed a further normalization of retail sales, industrial production, and employment. In the U.S., the consumer is showing up; in Europe, governments keep having the economy’s back; and in Asia, firms are pulling the economy full steam ahead.
But the virus has not gone away. After the summer frolic, daily cases have increased back to, and often beyond, previous peaks. Everywhere, fortunately, the virus appears less fatal. This is understood to result from better contagion management and, importantly, newly acquired treatment expertise in hospitals. In the U.S., President Donald Trump managed to come out of the hospital in three days. In Europe, fatality rates remain a small fraction of what they were in April. In the rest of the world, Latin America is successfully coming out of its first wave. Stringent vigilance and efficient test, track and trace procedures have left most of Asia seemingly immune to a second wave, although a few countries are still combating the virus. Governments are taking preventive measures, particularly in Europe, where mobility restrictions have tightened significantly, including through war time-like curfews.
The dark cloud of the pandemic thus keeps hovering on the horizon. A nightmare feels worse the second time it intrudes your subconscious. This matters, as confidence remains key to the decision to consume and invest. Strong global demand is a necessary condition for a full recovery, as well as for the industrious Chinese manufacturers. Governments have a large role to play in bridging the perilous gap until a vaccine is found. In the U.S., the process of normalization is slowing and nearly 12 million persons remain out of work. A much-needed fiscal stimulus is suspended and faces political headwinds from electoral games. In Europe, the question is not about whether, when and how much the fiscal support will be, but how well it will be spent. There, governments are preparing investment plans for the next five years, focusing on the greening and digitisation of their economy.
Other risks linger on the horizon. The U.S. is engulfed in an election that has seen verbal sparring and polarization increase. The outcome will have a decisive impact on the global order, if the country’s dominating economy goes deeper into populism, protectionism and nationalism. In Europe, Brexit looms, although it will only mark the end of the beginning of the U.K.’s web of negotiations needed for the country to find a new modus operandi with its trade partners.
For all these reasons, we keep our central scenario for the next 12-18 months as the “Not Quite Recovery,” except in China, which is plowing ahead, though growth is slowing and the second wave presents risks to 2021 if restrictions are extended in geographic terms and duration. The probability of a “Fiscal Cliff” has fallen (to 10%), as it is now likely that both U.S. political parties are converging on a significant amount of stimulus—if not now, soon enough in 2021. Draft 2021 budget forecasts released in Europe indicate great care not to reduce the fiscal impulse too early. This time, it is not profligacy but austerity that is considered a risk to the sovereign outlook. In this light, the “Kitchen Sink” scenario moves to slightly more likely (30%). If the second wave thwarts the recovery, governments will likely invent new policies rather than disengage. The next months are likely to see further central bank accommodation and fiscal spending. Rates will turn more negative, in more asset classes, and for longer.
This is why risk assets, in particular equities and high yield credit, present opportunities. Chinese equities should perform well under our central scenario. To the extent that emerging markets tame the virus, EM sovereign debt spreads become attractive in a world of low and falling interest rates. For fixed income investors with a developed country mandate, duration is a friend—except in the U.S., where markets are pricing in further stimulus as inflationary. Central banks have reiterated they will keep rates low for years to come. They will have no choice but to extend their main policy tool (asset purchases) into the foreseeable future. Should the growth outlook deteriorate, equities and credit will suffer.