Another quarter has drawn to a close in one of the more eventful years in recent memory, but the overarching picture is the same. The Covid-19 virus continues to afflict the world’s population, and restrictions on economic and social life remain in place. Governments are still providing fiscal and monetary support to the private sector at a rate never previously seen. Despite this, we continue to see reasons for optimism.
We noted last quarter that preventing a financial collapse was a necessary, but not sufficient condition, for a swift economic recovery. The continued stability of global funding and credit markets over the third quarter indicates that policymakers continue to have success on this front. The question in the second quarter was, as remains now, whether exceptionally easy financial conditions can spur a recovery in the non-financial economy.
If economies are to recover, restrictions on economic and social life will need to continue to be lifted. The reported number of Covid-19 cases continues to rise globally, but the rate of infection is slowing, and importantly the mortality rate has declined considerably. This has paved the way for a paring back of restrictions, albeit that many remain in place. Against this backdrop, the nascent recovery in economic activity that began in the second quarter has continued, although it has been uneven across industries and geographies.
A Cyclical broadening
Financial-market price action over the third quarter reflected this tentative but gradual improvement. Global equities pushed higher, with the MSCI All-Countries World Index returning +7.7% in US-dollar terms (and +3.9% for sterling-based investors) over the quarter, reflecting benign liquidity and credit risk conditions from a systemic perspective. The technology sector continued to lead the market higher for the first two months of the quarter, in particular the mega-cap US tech names. However, the continued economic recovery was also evident in the strong performance of the materials and industrials sectors. The strong absolute and relative performance of these economically geared sectors points towards a further strengthening of the economic recovery.
September saw the market come under pressure, and, in a reversal of the leadership following the March lows, US mega-cap tech led the decline. This prompted many commentators to declare the general equity advance to be over. There were, however, reasons for encouragement. The aforementioned economically geared sectors, alongside other industries, not only outperformed but actually posted positive absolute returns. This is not typically synonymous with a bear market. Alongside the general advance of commodity prices, benign and stable funding and credit markets, and a continued decline of the dollar, the equity-market rotation of September was indicative of a continued economic recovery.
This positive message from the equity market has not been universal. Those businesses that make up industries and sectors still subject to the most draconian restrictions continue to see their share prices remain depressed. Until restrictions are lifted, this is likely to remain the case. While the travails of these industries are unfortunate, they are not indicative of the broader picture.
The message from the government bond markets has been at odds with that from the equity, credit and commodity markets. In a reflationary recovery, we would typically expect to see higher nominal yields and steeper yield curves. On balance, however, global bond yields have continued to trade in the same narrow range in which they have been bound since April. Bond markets have yet to endorse a continued economic recovery.
However, given the weight of evidence, we believe one can overlook the lack of optimism from the bond markets, which, it is worth noting, have tended to lag other markets in responding to changes in macro financial conditions in recent years, particularly coming out of economic troughs. Perhaps the unique nature of the current economic recovery goes some way to explaining bond-price action.
A different kind of recovery
The experience of the post financial-crisis period has been that unorthodox monetary easing has had tremendous efficacy in inflating risk assets, but less impact in terms of nominal incomes and economic activity. So far, we have seen the same again over the last six months. This is prompting many commentators to conclude that we are seeing a repeat of the post financial-crisis playbook. However, there are important differences between now and that earlier period.
Following the global financial crisis, a long process of balance-sheet repair had to play out in the private sector, in particular the banking and household sectors in the US and Europe. This weighed on credit growth, which remained well below the long-term average growth rate. As a result, nominal income growth remained subdued. Quantitative easing (central-bank asset buying) did not, contrary to received wisdom, create purchasing power for goods and services. It helped recapitalise banking systems but, while the process of balance-sheet repair was underway, aggregate credit growth remained muted, and so too did nominal growth.
This time around, nominal incomes collapsed because of the state-mandated restrictions placed on large swathes of economic and social life. If people cannot go out and spend, nominal incomes (alongside economic activity) are necessarily going to decline. As restrictions have been lifted, nominal incomes have begun to recover alongside the pickup in commerce. The recovery, however, has been uneven. Some industries have bounced back sharply, while others have even been beneficiaries of the Covid restrictions, but in those industries still subject to restrictions, incomes and activity have simply been unable to recover. These industries are where revenues and profits are subject to the greatest pressure. Job losses and cuts to investment spending inevitably follow as businesses seek to cut their cloth in order to survive. Some will ultimately fail.
Taking back control
The nature of the economic recovery from here will be determined by how state-imposed restrictions evolve, and to a lesser extent by the lasting psychological impact of Covid. Fears of a ‘second wave’ of the virus in the northern hemisphere (and fear of persistent infection in the southern hemisphere), in combination with sensationalist media coverage, has led to Western governments typically erring on the side of caution. The near-term risk to the economic recovery is that restrictions increase from here. This appears most likely in Europe.
With the virus apparently under control, governments began to lift restrictions over the summer. In recent weeks, the number of new cases of infection has begun to increase across Europe. There are likely to be a number of contributing factors. The increased contact between humans is likely to be part of the reason, as too is increased testing. However, it should also be noted that the recent increase in cases is following the typical seasonal pattern of a virus in the northern hemisphere. On entering the following northern hemisphere winter, there is typically an ‘echo’, with hospitalisation and deaths rising over a couple of months to around 10-15% of the previous peak, before once again dying out. The recent spike in cases across Europe is following this seasonal pattern. Importantly, mortality rates are much lower than they were during the ‘first wave’, reflecting the fact that the medical profession is now much better equipped to manage the virus.
Against this backdrop, the pace at which restrictions are being lifted has slowed, and in some cases economically debilitating restrictions have been reimposed. This has prompted fears that the economic recovery is at risk.
However, while the economic recovery appears to be taking a step back in Europe, restrictions continue to be lifted at the global level. The lifting of restrictions could slow further as the northern hemisphere makes progress, but over time restrictions are likely to ease as the pathology of the virus continues to diminish.
A broadening out of the economic recovery
If the pathology of the virus does indeed continue to diminish and restrictions continue to be lifted, the nascent recovery in the global economy should gain traction. As outlined above, the economic recovery has begun, but it remains narrow. Of the three major economic blocs, China has seen the swiftest recovery. Despite being the epicentre of the virus, a nationwide lockdown was successful in bringing Covid under control. As in other economies, the recovery has been aided by an aggressive easing of monetary and fiscal policy. Where policymakers in China are perhaps at an advantage is in the speed with which fiscal stimulus can be translated into actual activity and spending on the real economy. Infrastructure investment has been ramped up, and curbs on the property sector have been eased. Both have no doubt been a tailwind for many industrial commodity prices. The other two major economic blocs have seen far more muted recoveries. However, it is likely that the US and European economies will gather momentum into 2021.
Assuming restrictions continue to be lifted, household spending will increase. As it does so alongside continued government fiscal support, aggregate corporate profits should recover. As the fortunes of the corporate sector improve, increased hiring and investment should follow. A gathering of momentum in the US and the eurozone would see the global trade cycle continue to recover. We are already seeing signs of a recovery along global supply chains as companies begin the process of rebuilding inventories, having run them down where possible in the face of an uncertain outlook for demand.
Monetary policy revamp
The recovery is set to take place in the warm fuzzy glow of easy monetary conditions. At its September meeting, the US Federal Reserve’s (Fed) Federal Open Market Committee signalled that there are likely to be no interest-rate increases until at least the end of 2023. The committee also indicated that it would not tighten monetary policy until inflation has been higher than 2% for some time.
In doing so, the Fed formally put into practice what had been announced in late August at its annual Jackson Hole gathering. The “let-bygones-be-bygones inflation-targeting” approach, by which the Fed always aimed for 2% inflation regardless of past misses, was to be replaced by “average inflation targeting”.1 There is still considerable ambiguity around what “average inflation” constitutes. The Fed has explicitly avoided adopting a formulaic approach in order to maintain full operational flexibility. Despite this ambiguity, the implication for investors is clear: monetary policy will stay looser for longer. The Fed is no longer worried about inflation overshooting; rather it is actively seeking it out. This implies more aggressive policy responses to downturns (as seen in March and April), and a longer period of loose policy thereafter, even as (if) inflation moves above 2%.
Many commentators have been dismissive of the Fed’s revamped monetary policy framework. The Fed, along with other central banks, has failed to deliver on its mandated inflation targets since the global financial crisis; does targeting average inflation change this? Whether it does or not is beside the point. The Fed’s announcement, in tandem with policy reviews at other major central banks, is an admission that the existing framework of inflation and monetary policy is not working as intended. What matters is what replaces it. Based on what we have heard from the Fed, central banks are not about to give up on using inflation-targeting as the guiding light of monetary policy. Instead, they are doubling down, and this will not be without implications for financial markets.
Every election year feels more important than the last, and the candidates du jour do not dissuade the electorate from thinking the same. This is no less true given the febrile atmosphere surrounding the forthcoming election.
Generally speaking, a US election is regarded as a reason for caution, or at least a reason for investors to sit on the sidelines, in the belief that it is better to wait for the clarity that the result offers so as to know better where to allocate capital. Perhaps in ‘normal’ times, the uncertainty created by a US election would be reason for caution. However, thanks to the Covid-induced recession, and the continuing monetary and fiscal policy response to it, US policy uncertainty is already sky-high.
The wrangling between the Democrats and Republicans over the next round of fiscal stimulus ahead of the election only adds to that uncertainty. Given the context, the election is arguably not as significant as it perhaps would be otherwise. No matter who wins, the US government will continue to run large deficits until the private sector is back on its feet, and the Fed is likely to be footing the bill, either directly or indirectly.
With neither Democrats nor Republicans making any attempt to subscribe to fiscal prudence, the main point of difference between the parties appears to be the scale of government spending. Polling suggests a Biden win is increasingly a foregone conclusion, with a Democrat sweep very much on the cards. If the Democrats take control of the Senate, the path would be clear for a Franklin D. Roosevelt-style ‘Green New Deal’ to drive double-digit deficits through the cycle. This would be a significant tailwind for any economic recovery, not just in the US but globally, via increased demand for imports and a weaker dollar.
The array of fiscal and monetary stimulus deployed by governments and central banks globally in response to the Covid-19 pandemic has undoubtedly helped to underpin risk assets. Liquidity conditions have continued to improve, and investors have started to look forward to some economic normalisation as economies have tentatively begun to exit lockdowns. In the near term, Covid continues to cloud the outlook, but its impact should continue to decline. As the virus fades, a ‘normal’ economic recovery is likely to gain traction. However, away from the aggregate data on economic activity, Covid is likely to have catalysed lasting changes to the fabric of economies – changes that serve up prospective risks and, importantly, rewards.
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