1 We’ve entered phase two of the recovery: the stall out
Recent economic data suggests we’ve entered the second phase of the global economic recovery. As the rush of stellar week-over-week/month-over-month economic prints fade, anxiety will creep back in, creating an obstacle to general risk appetite. This implies that gains in risk assets will likely slow relative to what we saw between April and July.
The same set of global high-frequency data that flagged mid-April as a positive inflection point is now showing that economic improvements have stalled over the course of July. As we had detailed in an earlier commentary, our views are based on the expectation that pent-up consumer demand would fuel a recovery that would recoup 60% to 70% of economic output that was lost in March and April. However, making up the remaining lost output would prove stickier and more challenging.
We now expect the global economy—and particularly the United States—to be defined by two key challenges:
- Reduced business operating capacity, constraining revenues, restricting investment and hiring activity, which in turn prolongs the existing trend of bankruptcies and closures.
- The lasting damage that the pandemic has inflicted on the U.S. labor market becomes more visible in the coming months. In the initial stages of the pandemic, those who were unemployed were “temporarily” laid off with the expectation of being rehired; at this stage in the recession, those still unemployed—including workers who’ve just lost their jobs—are more likely to remain jobless for an extended period, if not permanently. This is a more painful form of unemployment than the initial stages of the recession.
Crucially, while the first phase of the recovery, the rapid rebound, was characterized by forecast-beating economic and earnings data (a function of expectations that were way too low), we expect the current phase to be marked by excessive optimism, which has the effect of making upside surprises much less likely.
To be clear, we’re not calling for a double-dip recession, or W-shaped recovery, although that remains a risk. Instead, we see a material slowdown in the improvements experienced between mid-April and July. This will likely dampen growth expectations for the second half of the year, creating an environment that’s more challenging for risk assets and may herald the return of sector/country rotation strategies.
"To be clear, we’re not calling for a double-dip recession, or W-shaped recovery, although that remains a risk."
2 We’re in a fiscal air pocket and the fiscal impulse is set to weaken
The United States has hit a fiscal air pocket and the global fiscal impulse will now wane. This will challenge growth and could distort data.
The first phase of the recovery was characterized by extraordinary fiscal support to U.S. households that created as much as a 14% year-over-year surge in incomes1 which substantially softened the economic impact of the shock in the country.
Unsurprisingly, the expiration of the US$600 per week unemployment insurance top-ups at the end of July will no doubt weigh substantially on personal incomes, hurting confidence and spending. While an additional aid package, in our view, is likely to be formally introduced at some point, this temporary income shock will, at best, lead to data distortions in August/September and, at worst, create a more damaging income and confidence shock that could persist through to year end.
What’s striking is that the United States isn’t alone—we’re entering a period when most major economies are reducing fiscal support and phasing out the emergency benefits programs, creating a temporary air pocket when support is still needed. This marks an important inflection point in the tactical and strategic global macro landscape.
The fading fiscal impulse is predominantly a growth problem, but a tangential issue for the rates market will be, in our view, a growing focus on sovereign bond issuance along with the reduction in central bank purchases of government debt. Combined with rising inflation concerns, this could lead to a steepening at the long end of the U.S. yield curve.
3 The market will become preoccupied with the risks of stagflation
We expect the market to become at least temporarily preoccupied with stagflation concerns as the second derivative on most inflation statistics begins to turn.
We expect investors to become particularly concerned about the prospect of rising inflation in the coming weeks. The convergence of several trends does—on the surface at least—seem to confirm or reinforce those fears. The expected second-derivative turn in most inflation metrics (as base effects drop out of year-over-year price levels) could certainly add to the impression that inflation is coming back, as would the reflationary impulse that’s evident in the commodities complex.
Meanwhile, the weaker U.S. dollar is likely to lead to some mild inflation; indeed, we’re seeing price levels creeping higher in components that contribute to the measurement of inflation, in particular in segments that have been exposed to supply chain disruptions and ongoing pressures in healthcare costs. Finally, the U.S. Federal Reserve’s (Fed’s) widely expected announcement in August/September that it will target 2% inflation more symmetrically—meaning it’ll tolerate a persistent overshoot of 2% inflation—will exacerbate this concern.
However, we’re not convinced that inflation will return in a material manner. Broadly speaking, we expect U.S. inflation to stabilize in the 2% to 3% range over a multi-year period.
In the short term, a stagflation scare is likely to push nominal U.S. yields to the upper end of their recent range, particularly at the long end, and possibly beyond. We expect assets with inflation protection qualities, like gold, to continue to do well. Longer term, we don’t foresee a prolonged period of reflation.
4 Expect a reacceleration in central bank activity to contain rates
A sudden spike in rates and a slowdown in growth will likely usher in a reacceleration in central bank action in the coming months, particularly from the Fed and the European Central Bank (ECB). Should they act as expected, it’ll help to contain nominal rates as real rates continue to fall.
Stagflation concerns and extensive sovereign debt issuance will likely push nominal government bond yields higher. While central banks worldwide will probably be cheery about disappearing deflation fears, we believe they’ll also want to contain the rise in yields.
We expect the Fed to communicate a sizable dovish shift at the upcoming virtual Jackson Hole meeting on August 27 and August 28 and/or the FOMC meeting on September 16 in a bid to calm the rates market. In our view, the most probable policy adjustments include a formal change in the Fed’s inflation targeting mechanism and/or a move toward providing more explicit forward guidance. Further adjustments to its bond purchasing program is also possible. We don’t, however, expect the Fed to formally implement yield curve control, although it may continue to make reference to it.
In our view, central bank activity won’t be limited to the United States: Globally, we expect several key central banks such as the Bank of England and the Reserve Bank of New Zealand to actively discuss—or even possibly implement—negative rate policy. The ECB may also intensify its negative rate discussion in response to the strengthening euro, which we expect will pick up.
Central banks have the most direct control over the front end of the yield curve, so any pop in short-term nominal yields will likely be calmed by the end of the third quarter. However, the rise in inflation expectations and additional easing from global central banks are likely to lead to steeper yield curves. Put differently, steeper yield curves will likely be the result of both bearish moves at the long end as well as bullish moves at the short end.
5 A resurgence in geopolitical uncertainty heading into November
Global geopolitical concerns will likely become a larger market focus in the next few months, with various issues—ranging from a U.S.-China decoupling to November’s U.S. election, and turbulence in select key emerging markets such as Turkey—coming into focus.
In our view, macro concerns about the U.S.-China relationship will intensify in the coming months because of two reasons:
- The issue is likely to regain prominence as we get closer to November’s U.S. presidential election—voters expect candidates to detail how they plan to engage with Beijing, while both candidates are likely to view their approach to the issue as an opportunity to win support.
- We believe the market will come to recognize that the Democratic presidential nominee Joe Biden’s position toward China might be more hawkish than expected.
But heightened geopolitical risks won’t be isolated to the United States and China. Recent developments suggest that tensions are rising between Turkey and its European neighbors. The Turkish lira has come under heavy selling in recent weeks,1 reflecting a significant deterioration in the country’s current account balance and a depletion of its foreign exchange reserves. Financially, European banks, most notably Spain and France, have large exposures to Turkey. Territorial disputes in the eastern Mediterranean also appear to be escalating in the aftermath of Greece’s recent maritime boundary agreement with Egypt and warrants monitoring.
Foreign exchange markets are most likely to be affected by shifting geopolitical risks. In our view, an escalation in U.S.-China tensions would be positive for the U.S dollar, and any subsequent market reaction would likely be potentially violent, but also short-lived. Meanwhile, correlations between the dollar and election probabilities suggest a bearish path for the greenback in the event of a Biden win. For Turkey, turbulence in the lira typically translates into trouble for the euro. However, these episodes are also typically short-lived and therefore shouldn’t be a major concern for investors from a longer-term perspective.
6 Non-U.S. outperformance over U.S. outperformance
U.S. growth and market outperformance will likely be challenged as non-U.S. assets become more attractive in this environment.
The recent period of U.S. outperformance—in terms of macroeconomic data and financial assets—appears to be ending as we enter the second phase of the recovery. Given that the COVID-19 recession is firmly a services-based recession, it’s likely to translate into a headwind for the U.S. economy, which has a huge services component. This implies that the stall out in the United States will likely be more pronounced than in other countries. In contrast, manufacturing-based economies, particularly those in Asia, could be poised for a relatively stronger and faster rebound—a development that, along with a weaker U.S. dollar, can only enhance the appeal of non-U.S. assets.
From an asset allocation perspective, it’s likely that global investors have over-allocated to U.S. markets and under-allocated to emerging economies in the last few years in a bid to maintain a defensive position in response to lingering uncertainties. In our view, the phased transmission of policy stimulus offers an opportunity for investors to rebalance their asset allocation on the basis of valuation and potentially further diversify their portfolios.
1 Macrobond, Bloomberg, as of August 11, 2020.
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