The key themes and risks our House View team expect to drive financial markets.
13 minute read
A very unusual recovery
This has not been a normal downturn; it will not be a normal recovery either. Around previous recessionary periods there has usually been considerable debate about whether a recession has begun, how long it might last and when it will end. It is often the case that it is only possible to calibrate these dates when looking back at each episode, sometimes after a number of years.
This one is different. Its onset can be dated precisely, almost to the day. Although very deep, it has been mercifully short, and the start of the subsequent economic recovery is also easily identifiable. For most countries, the self-imposed downturn began in March 2020 and intensified in April, but then began to unwind from May onwards. We are now four months into a clearly defined economic revival. Q3 will see the strongest GDP growth rates in the post-war period (Figure 1). But the path of economies after that is less clear-cut. The virus is still with us, second waves of infection are happening and although there has been unprecedented policy support (see below), the true state of permanent loss is still not clear.
Figure 1. Quarterly GDP growth in 2020
Extraordinary swings in GDP in 2020
The last three months have seen the balance of probabilities around our global growth scenarios shift. In July, we assigned a 50 per cent probability to our central view (B) with the remainder split roughly equally between the more optimistic A and the gloomier C scenarios. That latter case assumed the re-imposition of national lockdowns and a related secondary dip in activity levels. Although that is still possible, its likelihood has fallen as most nations seem to be dealing adequately with second waves by means of more localised and targeted measures. This has mechanically reduced the scale of GDP declines in 2020 and also the size of the rebound in 2021. The outlook is still uncertain and dependent in substantial part on the progression of the virus. Higher frequency indicators do show that the pace of economic revival has slowed in recent months and we are now entering the critical Northern Hemisphere winter, when the course of the pandemic – or reactions to it – could change significantly.
Overall, we continue to believe that economies will carry on growing, but that it will not be until late next year or even some time in 2022 that pre-COVID levels of GDP will be reached. The OECD estimates that by the end of next year, world GDP will still be some five per cent lower than it projected before the virus appeared (Figure 2). Beyond that, projections are more speculative, but it is to be hoped that, eventually, the pandemic’s impact will fade steadily into history and “normal” growth dynamics and conduct can resume. Even in this case, it is a matter of some conjecture about how much this experience will have changed attitudes and underlying behaviours permanently. And it could take decades for public finances around the world to return to benchmarks that were previously considered prudent.
Figure 2. Change in OECD GDP projections (pre- and post-COVID)
Growth shortfall more severe in some countries
Central banks have spent much of the last decade grappling with the challenge of low and falling “neutral” real rates of interest. Those have been driven down by a range of structural factors and, alongside inflation targets of usually around two per cent, have left central banks with very little space to move official rates lower. In other words, the distance to the effective lower bound (ELB) has been greatly reduced over time, leaving central banks with little choice but to engage in previously unconventional policies such as large-scale asset purchases, forward guidance, bank funding schemes and, in some cases, negative policy rates. Meanwhile, most developed market central banks have struggled to meet their mandates for much of the past decade, with inflation persistently sitting below target, generally two per cent (Figure 3). That carries the risk of inflation expectations becoming de-anchored to the downside and making it even more difficult to meet the mandate. As a result, many central banks had already begun reviews into their toolkit and their approach to monetary policy before the COVID-19 crisis hit.
Figure 3. Core inflation in the major nations
Inflation has undershot two per cent targets regularly
The Federal Reserve announced the results of its review in August, moving to an average inflation target (AIT) framework, whereby it will seek to offset past deviations in inflation below/ above target by pursuing above/below target inflation for some period. Moreover, it may not seek to tighten policy when the unemployment rate is approaching or even below its estimate of the natural rate, if it isn’t accompanied by above-target inflation. These changes could have profound implications for both the way policy is set over the next decade or more, and similarly on economic and market outcomes. Other central banks, such as the ECB, are also undertaking similar reviews and we think are likely to arrive at similar conclusions. We believe that this could be the most significant shift in approach by central banks since the move to inflation targeting in the 1990s. The immediate implication is that policy rates will be kept low for even longer than would previously have been anticipated (Figure 4).
Figure 4. Policy rates in major regions
Back to the lower bound — and expected to stay there
Ongoing fiscal support
The initial aim of bold and ambitious fiscal programmes that were put in place in March and April this year was, broadly speaking, to substitute public funds for lost private incomes. It was all about support, not stimulus. Without this funding, many businesses would have failed quickly, and millions of jobs would have been lost permanently. As economies are now embarked on recovery, that balance is shifting. Clearly, there is a need for continued fiscal assistance to those impacted by the COVID-19 crisis. Although many activities have resumed, some have not and are unlikely to do so for some time. Individuals and businesses in this position will need ongoing bridging finance to tide them over until conditions allow them to restart. It is another invidious task to attempt to identify which operations are (or will be) viable in the future and those which should be permitted to fail. On labour markets, the approach should change from providing support to those who cannot work to assisting those who are returning to work – in other words to switch the focus to jobs from workers.
Fiscal help will be required for an extended period of time
However, there is also now a growing desire in many countries for more activist fiscal stimulus to help sustain economic recovery. It is not universal – some on the political right are advocating a swifter reversal of fiscal largesse. But against the backdrop of continued uncertainty about the virus and significant economic fragility, support from public spending initiatives and encouragement from favourable tax incentives are generally considered valuable policy tools.
At the start of the crisis there was an understandable wish to distribute financial assistance quickly, almost indiscriminately. Now there can be more nuanced approaches, with more targeted fiscal programmes that can also be more closely monitored. Many are making the case that there can be no better time for Governments to borrow long term, at exceptionally low rates, and to invest in public infrastructure projects that can support or boost potential growth in the future. These will include not simply traditional capital investment in transport and housing, but also health care, education and digital and environmental infrastructure.
Public debt will rise significantly as a proportion of GDP, threatening fiscal sustainability in some cases
Most countries have already seen budget deficits soar higher, exceeding 10 per cent of GDP in several and approaching 20 per cent in others. Yet current circumstances have meant that the unprecedented deterioration in public finances has been accepted with barely a whisper of dissent. Government debt is likely to rise by between 10 per cent and 20 per cent of GDP over the next year or so almost everywhere (Figure 5), adding to burdens that were already considered onerous if not dangerous in many cases. Debt sustainability is not an immediate risk – especially when interest rates are so low – but debt burdens will have to be lowered eventually through a combination of growth, inflation and discretionary fiscal measures. This may well take decades rather than years.
Figure 5. Public sector net debt as percentage of GDP
Big increases in public debt levels are inevitable
Long-term strategic competition
History is littered with examples of battles for supremacy between rival factions. Today the attention is primarily on the relationship between the US and China. The trade war that dominated market sentiment for almost two years (Figure 6) was one aspect of that, and it had seemed that some form of resolution had been reached just before the onset of the COVID-19 crisis in the form of a Phase 1 trade deal. The global pandemic has thwarted a clearer resolution, but the August compromise agreements between the two players indicated that there was still a route to a lasting reduction in the trade conflict.
Figure 6. Bank of America Merrill Lynch Fund Manager survey
Table shows biggest tail risk in survey responses
In some ways, however, that is not the main story here, but is instead just one symptom of broader trends. And while those trends are heavily focussed on China and the US, they will also be influenced by the actions and attitudes of many other countries too. The status quo is being questioned more by a determined and ambitious China, a single-minded US president and changing attitudes to openness in many countries. Such attitudes have probably been hardened by the COVID episode which seems to have intensified the new Cold War between the US and China in particular, although it has also fuelled debates about international openness and free trade more widely too. Future years are likely to be characterised by increasing strategic competition, largely related to China and the US, but also impacting many others. One key aspect is the race for technological global dominance – the trade war is really morphing into this battleground now. China’s trade surplus and alleged currency manipulations are part of it too. But really the heart of the matter relates to forced technology transfer, intellectual property theft and free market distortions. Beyond those specific issues lie others such as China’s human rights violations, their influence in Hong Kong and Taiwan and the desire among other democracies that China complies more with international codes of practice that are broadly accepted everywhere else.
Can China and the US learn to co-exist?
This is unlikely to be a smooth journey. As China’s international influence has grown (Figure 7), it was always likely that they would challenge global standards and institutions and try to impose alternatives. Achieving technological self-sufficiency is one thing, but China has ambitions for much more and there is nothing wrong with that per se. However, if China is to succeed as an integrated global player, a balance will have to be found between their fundamentally different methods of operation and adherence to acceptable international codes of conduct in business and trade. Strategic competition between China, the US and others is likely to frame international relations and influence financial markets over the next decade or more.
Figure 7. China’s share of global GDP, per cent
The Eurozone has had a turbulent 20-year history and has not always made timely or coherent decisions. Shortly after the Global Financial Crisis, the Eurozone experienced its very own disaster – all of its own design – in the form of the sovereign debt crisis. At the low point there was a genuine existential threat to the single currency project. It seemed inevitable that Greece would leave and most of the debate revolved around how many others would follow. Not for the first time the Eurozone not only survived but used the despair of the crisis as a catalyst for critical progress and change. The COVID episode looks rather similar. After a brief spike of discord during the initial onset of the virus when it looked as if some of the old fracture lines would re-open, member states swiftly regrouped and presented a coordinated and united front.
The Recovery Fund is an important step towards a more unified Eurozone
There will definitely still be some difficult times ahead, especially in the light of second waves of virus infection recently, but it now looks more likely than not that Eurozone nations will stand firm and be more closely aligned on a number of key issues. Perhaps most importantly of all, some significant steps have been taken in the direction of closer integration. Nowhere is this clearer than in the design and initial implementation of the “Recovery and Resilience Facility”, as it was revealed in July. While in our view not the “Hamiltonian moment” that steers the Eurozone onto an inevitable path to full debt mutualisation, this was an important step in that direction. The €750 billion facility, comprising a mixture of loans and grants, contains within it elements of common debt issuance and large-scale transfers. There is still significant conditionality and it is ostensibly temporary – a direct response to the COVID crisis and a means by which financial assistance can go to where it is most needed. There are still many ideological differences and alternative points of view across the Eurozone (and EU) which may delay or alter disbursements or influence the governance of the fund. But it is still a key step towards creating the institutional framework necessary for a properly functioning single currency area.
The creation of the fund also suggests that political support for closer European integration is growing, even in areas where there was previously entrenched opposition. Of course, the European banking union is still only half built at best, but at least it is no longer fanciful to argue that the eventual destination is at least more clearly defined and identified. Greater unity should help support European risk assets in general (Figure 8) – including the Euro currency – and should ensure that peripheral bond spreads remain contained.
Figure 8. Euro risk assets have rallied
Recovery Fund an important step to closer unity
The global COVID pandemic has caused many countries to question the wisdom of global supply chains and economic inter-dependence more generally. It could therefore add to deglobalisation momentum that has become apparent since the Global Financial Crisis. There have arguably been four earlier eras for globalisation since the 1870s (Figure 9), but the last 70 years or so have seen sweeping trends towards greater openness, more free trade, international specialisation and global integration. World growth was generally strong and global poverty fell significantly. Since the GFC, world trade has expanded more slowly than world GDP. We do not expect a return to the damaging era of tit-for-tat protectionism of the 1930s but moves in that general direction have already taken place: China has turned inward, the US has embraced an “America First policy” and initiated a trade war. Even open Europe and Australia have become more sceptical. Fear can lead to insularity, so there are clear risks of further moves in this direction in the post-COVID world. De-globalisation could slow potential growth rates and lead to a reassessment of world equity valuations.
Figure 9. Four major globalisation eras in history
Trade openness index: world exports plus imports divided by global GDP
The huge fiscal assistance packages (Figure 10) that were introduced around the world in response the COVID-19 crisis were necessary to prevent a complete collapse in demand. Imposed shut-downs to activity would have resulted in a negative income shock that would have pushed economies into the second Great Depression. Instead the state stepped in to provide subsidy and absorb the risks that the private sector could not. But as economies restart and activities resume, that financial assistance will start to be withdrawn. Calibrating that will be no easy task. Some very unusual incentives structures have been established and it will be almost impossible to distinguish between deserving recipients and others. The key principles underlying the required fiscal largesse were that it was enormous, swiftly delivered and unconditional. Reversing that process means a clear risk of a premature withdrawal of support that risks stifling growth and doing lasting damage.
Figure 10. Substantial fiscal support has been announced since the pandemic began
Official estimates of fiscal support, percentage of 2019 GDP
The OECD, in the past generally a bastion of fiscal cautiousness, recently advocated ongoing fiscal support to sustain incomes and minimise the scarring effects of the pandemic. In their words, there is a “clear need for state contingent policy support that can evolve as the recovery progresses”. This view is probably coloured by the experience after the Global Financial Crisis when there was a perception that untimely attempts to restore fiscal prudence led directly to weaker growth, slower recoveries and lasting damage. The as yet unresolved fourth US fiscal package may yet lead to a growth hiccup in the fourth quarter or in early 2021, while the transition in the UK from the Furlough scheme to the Job Support scheme at the end of October also risks withdrawing too much support too soon. More traditional social democratic approaches across much of Europe (in terms of ongoing labour support schemes) should allow for a smoother transition. Either way, as the OECD also recognises, fiscal support will eventually have to be reined in, but the priority must be to ensure that recoveries are robust enough to allow for such adjustments. The downside risk is that Governments get this timing wrong.
End of US exceptionalism
The US is still easily the most important and influential global superpower and will undoubtedly be a key – even the key – player in the arenas of politics and economics in coming decades (Figure 11). But that does not prevent change and evolution, and the hegemony of America may now start to become more challenged. This does not just relate to China’s inexorable ascent, although that is part of the story, but also to a changing set of relationships among many other countries.
Figure 11. US share of global GDP, per cent
US has seen a slow but steady decline over the last 40 years
In 2010 a poll by Gallup reported that 80 per cent of Americans agreed with the statement “The United States has a unique character because of its history and Constitution that sets it apart from other nations as the greatest in the world”. Most countries exhibit aspects of national pride that is rooted in the first part of that description, but not all would jump to the conclusion reached in the second part. The post-war period has seen other episodes when there has been debate about the possible end of US exceptionalism. These include the end of the Cold War, the aftermath of the Vietnam War, the Watergate scandal and the Global Financial crisis. Each time the US has, as other countries did in the past, evolved and moved on, but it has always retained a position of critical importance in the world order. It may well do so again in the future, but it is still legitimate to question whether the US position in the global hierarchy is now changing once more. If US exceptionalism is retreating, then that would imply a very different backdrop for global financial markets. At the extreme, could the “exorbitant privilege” of the US dollar become more challenged?
With only a few weeks to go until the election, Vice President Joe Biden and the Democrats have retained a comfortable lead over President Donald Trump and the Republicans in both national and key swing state polls (Figure 12). But nothing is certain, the mood can change, and sentiment could shift quickly in the light of economic developments, the path of the virus itself and Trump’s policy stance in a number of possible fields in the short time that is left. There is also the risk of a contested result as there was in 2000, perhaps regardless of whether the officially called result is close or not. Trump and others have already been trying to instil doubts in the legitimacy of any Democratic victory, ostensibly on the back of potential voting irregularities that few others seem concerned about. In broad terms a Democratic win (especially if Biden wins together with a House and Senate majority) would be expected to lead to a significant fiscal package aimed at providing support in the current economic environment, but also for longer-term priorities, such as the green agenda. It would also likely be somewhat less favourable in terms of regulatory requirements on big business. On the other hand, a second term for Trump would likely see a further ramping up in tensions with China (and potentially other countries) and a limited domestic agenda given the likely Congressional outcome.