As prices of risk assets forge towards new highs, the market will face an important crossroads in the second half of 2020 as clarity related to the paths of the Covid-19 pandemic and economic recovery, the US Presidential Elections, policy stimulus, and US-China tensions begins to emerge. These realities will be set against increasingly optimistic investor expectations reflected in risk asset prices today.
Our base case: Full economic recovery won’t take place until 2022
While we believe the low of the cycle is behind us, in our view a full recovery to pre-Covid-19 levels of output will not happen until 2022. In developed markets, our economics team is forecasting a 5.5% contraction in GDP in 2020, followed by an incomplete 4.4% growth rebound in 2021, with developed market economies as a whole only reaching pre-pandemic levels of output in 2022.
After widespread shutdowns in Q2 2020, we should not be surprised that simply turning the lights on again will inevitably result in an initial sharp spike of growth from an extremely low base. The danger lies in extrapolating this initial sharp bounce to a complete V-shaped recovery.
In our base case, the reality of a drawn out recovery process will be in tension with the optimism in markets today, and already we are beginning to see signs of growth momentum plateauing.
In the US labor market, after 15 weeks of consecutive declines in initial jobless claims numbers from its peak in March at 6.9m to 1.3m, the figure has turned and increased over the last two weeks. Of note, the Conference Board Consumer Confidence index also fell to 92.6 in July, after three consecutive months of increase to 98.3 in June.
Even in China – which is more advanced in the process of controlling the pandemic – high frequency monitors suggest that the pace of normalization in activity is moderating. This should not be surprising given that global economic weakness is posing a significant headwind for China, for which international trade and exports are major economic components.
Rising infection trends unlikely to lead to widespread shutdowns
The recovery momentum has been hindered by rising infection rates in various hotspots. In the US, the good news is that the rate of new cases has started to decline (see Exhibit 1).
We do not expect US policymakers to return to widespread lockdowns given reduced political will and a more subdued death rate due to the lower average age of those infected.
In the absence of an effective vaccine, however, the threat of subsequent waves of infection will continue to loom large. This continues to affect the pace of re-opening and negatively impact consumer and investor confidence.
Wide-ranging stimulus to remain supportive of risk assets
One major force behind the bull market is policy stimulus, and this remains largely supportive. At the July Federal Open Market Committee meeting last week, the Fed reiterated their “whatever it takes” stance to support the recovery.
The Fed also extended seven of this year’s crisis programs, including the Primary and Secondary Market Corporate Credit programs and the Paycheck Protection Program Liquidity Facility, that were due to expire in September to end-December.
These facilities have been critical in stabilizing market functions and providing backstops during this volatile period, and these extensions were likely carried out with an eye on the potential market volatility around the US Presidential elections in November.
In H2 2020, we further expect the Fed to further strengthen their commitment to keeping rates at near-zero levels using an ‘average inflation targeting’ framework, which effectively represents a further easing in US monetary policy.
Expect some brinksmanship but Congress to deliver new fiscal package before 10 Aug recess
On the fiscal side, coming on the heels of the historic EUR750b stimulus passed in the EU, we expect another US fiscal package to be delivered before Congress enters recess on 10 August.
A key decision involves the extension of the USD600 weekly unemployment benefits which expired in July. The Republicans are averse to extending this in full to avoid disincentivizing those unemployed to find work.
Notwithstanding some degree of brinksmanship, we expect an eventual compromise between both parties. A fiscal package between the USD1 trillion proposed by the Republicans and USD3 trillion by the Democrats will likely be delivered before the recess, particularly as both sides will loathe to be blamed for inaction before the upcoming Presidential Elections.
Long-term destination for risk assets is constructive but expect a volatile journey
Under our base case scenario of:
1) a recovery path to pre-pandemic levels that is drawn out to 2022;
2) supportive stimulus efforts from policy makers with rates expected to stay at near-zero levels for up to five years;
3) near-term uncertainties related to the US Presidential Elections and the US fiscal cliff; and
4) risk asset prices reflecting significant near-term optimism,
we believe that the long-term destination for risk assets points to more upside although the path there will be fraught with volatility.
Managing volatility increasingly challenging as rates fall to ultra-low levels, and stock-bond correlation rise
For leveraged multi-asset investment portfolios, managing liquidity buffers and volatility will be key to navigating the landscape ahead.
This is particularly so as rates fall to ultra-low levels, and as the correlation between bonds and stocks rise, which will make it increasingly challenging to manage volatility in multi-asset portfolios.
Historically, when stocks fell, US Treasuries which are safe havens would rally – which in turn result in US Treasury yields falling. As bonds are spread products priced off Treasury yields, taking all else constant, they would benefit from falling yields and rise in price. With rates now at ultra-low levels, however, with very limited room to fall further, the efficacy of this mechanism is now limited. Both stocks and bonds will be driven by equity and credit risks, respectively, which are positively correlated.
Diversify portfolios and incorporate hedges; opportune time to rebalance from growth and momentum stocks into cyclicals and value names
In addition to traditional safe havens such as gold, positions in currency pairs such as going long the JPY versus the AUD over H2 2020 may also be effective in hedging against volatility related to the second waves of infections, the uncertain economic recovery and US Presidential Election.
In our view, while investors will need to maintain core positions in growth sectors such as technology and healthcare, this is an opportune time to rebalance portfolio weights in growth and momentum stocks that have outperformed dramatically into cyclical and value names with resilient balance sheets and stable business models that should benefit from the long-term economic recovery. As can be seen in Exhibit 2, the performance of value versus momentum remains at year-to-date lows, and we expect this to regress to the average over time.
Moreover, rebalancing into value and cyclicals can also help to hedge investment portfolios. As shown in Exhibit 3, an analysis of the performance of value and cyclical equity segments over the last two years show that they have historically displayed a more positive correlation to rates (and more negative correlation to bonds) versus growth and momentum segments, and this can contribute to further diversifying and hedging portfolio concentration risks.
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Version: July 2020