A summary of our outlook for economies and markets.
8 minute read
Finding the new 'normal'
Measures to avert a public health crisis have had significant impact on activity, with extensive fiscal and monetary policy support helping to bridge that decline in activity.
The COVID-19 pandemic continues to dominate the outlook for the global economy. Measures taken earlier in the year to lockdown most economies greatly helped to slow the spread of the virus and reduce the potential number of associated deaths. While effective in managing the healthcare crisis, those same measures had an immediate and debilitating impact on economic activity. Most economies are expected to see declines of between 10-25 per cent in activity in 2020 Q2. In order to support households and businesses through that, there has been an equally rapid and sizeable set of fiscal and monetary policy measures put in place. These measures have been primarily designed to support the income of households where individuals have either lost their job or have been furloughed. In addition, government loan guarantee schemes for businesses have been deployed to bridge the period in which revenues are severely impacted. At the same time, central banks through their asset purchases have acted to stabilise financial conditions and ensure no unnecessary tightening due to the additional government issuance that has accompanied the fiscal support. These policy measures have undoubtedly averted an even greater economic crisis.
As the spread of the virus slowed, most governments began in either May or June to remove some of the restrictions on economic activity. As anticipated, initial indicators for that period suggest a significant bounce-back in economic activity. That reflected both the ability of businesses to re-open and the pent-up demand on the part of households following the period of restricted spending. However, as we look ahead to the second half of 2020, a great deal of uncertainty remains around the likely path for economic activity.
Downside risks include further outbreaks, higher saving and changed behaviour until a vaccine is found.
First, the spread of the virus has slowed in most developed market economies but has been much less effectively managed in the emerging markets. Moreover, those developed market economies that experienced a more significant spread of the virus earlier in the year (such as Italy and the UK) are generally taking longer to remove restrictions and therefore experiencing a slower recovery. While some economies that re-opened before the number of new cases had materially fallen (such as the United States) are seeing a resurgence of new cases, putting at risk the ability for the economy to recover, or potentially leading to a further downturn. Box A below provides more detail of our current view on the outlook for the virus. Second, while the policy support has been vast, it is unclear how cautious households and businesses might be until, say, a vaccine is found. Fears about future outbreaks and the potential impact on jobs and demand may result in an increase in precautionary savings and a material reduction in investment spending. Third, there may also be a range of economic activities that are simply judged to be too risky to participate in (e.g. travel-related activities) for some time. While households may switch some of that expenditure to other goods or services, it may take some time for the economy to adjust to that new 'normal'. However, it is also possible that the spread of the virus slows through time, that better management of healthcare can minimise mortality rates and that recent promising signs that an effective vaccine could be ready sooner than originally anticipated bear fruit, allowing economies to return to normal. If that were to be the case, when set alongside the monetary and fiscal support, activity could quickly return to the pre-COVID trend.
We have developed three economic scenarios that we think capture the range of possible outcomes over the next 18 months (Figure 1). Of these possibilities, we think that Scenario B is the most likely (i.e. with a probability of greater than 50 per cent), with a roughly equal view of the probability of Scenarios A and C. In our central scenario, we expect a fall in global growth of around 3.3 per cent in 2020 (the first calendar-year decline in the post-war period), followed by a rebound of around 5.7 per cent in 2021 (Figure 2).
Figure 1. Uncertainty about the economic outlook remains elevated
Scenarios for the level of global activity
Figure 2. Global growth projections based on Scenario B
While much of the focus remains on the ongoing impact of COVID-19, we have also identified several other important themes that we expect will drive economic and market outcomes such as strategic competition between the US and China and the upcoming US elections. In addition, we have identified a number of downside risks, including the potential fiscal cliff that may follow from the recent COVID-19 support measures, the balance-sheet vulnerabilities that have increased as a result of the crisis, as well as potential upside risks such as improved European political and economic unity and emerging inflation.
Risky assets have recovered from the sharp sell-off in March, while risk-free rates have hit all-time lows across the world.
While risk assets initially reacted very negatively to developments in the COVID-19 crisis, there has been a sharp rebound in equity indices, which across the major regions at the end of June were down only 5-10 per cent year-to-date. With the deep downward revision to the corporate earnings outlook for 2020, that has resulted in some 12-month forward price/earnings valuations reaching multi-decade highs. Looking at earnings expectations for future years, a rapid recovery is expected, and perhaps has led some investors to “look through” the deeply negative earnings impact felt in 2020. In addition, some companies and sectors are seen to benefit from the changes that have come from COVID-19, such as the more rapid adoption of technology across a range of activities. Credit spreads have also narrowed significantly from their widest point in March, although remain elevated compared to the pre-COVID period. The recovery in risk assets is also likely to be a function of both the direct and indirect support from central banks. Purchases of government bonds (Figure 3) have helped to suppress risk-free yields, while purchases of risky assets, such as investment grade, and even high-yield, credit has supported those assets. This support likely also has an indirect impact on other asset classes as liquidity makes its way through the system and private investors are pushed out along the risk spectrum.
Figure 3. Central bank balance sheet expansion
Asset purchases of big four central banks as a share of aggregated nominal GDP (USD)
Given the combination of stretched valuations and the elevated risks to the economic outlook from the COVID-19 crisis, we prefer to be modestly underweight global equities (Figure 4). With somewhat more attractive valuations, and direct support from central bank purchases, we prefer to be moderately overweight credit, with a preference for US and European investment grade. We have a more neutral view on high yield and emerging market debt. In terms of duration, we prefer to be modestly overweight, with a preference for the US, where there remains some scope for further decline in yields, with an underweight in core European markets. We also prefer a modest overweight to Italy, with the recent developments around the European Recovery Fund and other European fiscal and borrowing measures helping to solidify the solidarity of the bloc. Finally, within currencies we have a preference to be overweight the euro against the pound given the positive fiscal developments noted above, while at the same time the UK continues to find negotiations on a Brexit deal challenging.
Figure 4. Asset allocation summary
Box A: COVID-19 – where to from here?
One of the challenges of trying to make market assessments at the present is the uncertainty around how the COVID-19 pandemic will progress.
When the last House View was published, comparatively little was known about COVID-19. As we enter the second half of the year, many questions remain to be answered; however, the degree of uncertainty is several orders of magnitude lower. Lessons learnt have been both positive and negative as the true nature of the virus has not followed either of the wings of the distribution of outcomes that seemed possible three months ago. On balance, the news has been positive despite daily confirmed infections currently being at their highest. The largest positive is that despite doubts, the virus is containable with focus and determination.
Earlier in the year, there was considerable concern that without the adherence to rule available to an authoritarian regime, once high local transmission became established the best that could be hoped for would be a flattening of the infection curve. These fears have been allayed by the actions of governments across Europe which have not only implemented lockdowns but have maintained their resolve to continue them until virus levels were suppressed to very low levels. So far, the tentative steps of reopening economies have not resulted in uncontrollable infections as ramped up testing, infection tracing and improved treatment protocols have been sufficient to contain spikes in infection. Many parts of Asia such as South Korea and Taiwan are most advanced on this reopening, offering an example to follow for those parts of the world which have more recently started this process. Part of this achievement must be put down to changes in behaviour globally as populations have adapted to infection risk. Across the world we now see estimates of R (the reproduction number, or the average number of people one infected person will transmit the disease to) in a fairly tight band of between 0.5 and 1.5 despite very differing policies. This reduces the threat of sudden breakouts materially from the environment of the first quarter where R was in the region of 3-5 in many countries and delays of action of only a few days could see infection levels double or more.
It has not been all positive news, though. The US had appeared to be following the pattern of many European nations in acting to suppress infection levels which had reached crisis levels in the North East of the country. However, after initial success, we have seen a split in policy with many states reopening swiftly and without following the reopening guidance that the White House COVID task force had laid out. This has resulted in a renewed rise in infections with several states of particular concern. The lower levels of R we now see delay the arrival of crisis, but if current trends remain in place, several states will approach limits of hospital capacity over the coming months with several states in the south appearing high risk.
There is significant resistance to the idea of reinstituting lockdown measures, but at this point we have no experience of the effectiveness of other policies when relied upon at high levels of infection. Should the level of excess death start to accelerate towards levels seen in New York state in early Q2, without effective action from authorities the impact on society is unclear. Given successes elsewhere it would appear unlikely that infection levels beyond the capacity of the health system to treat will be acceptable on an ongoing basis in any developed country. What we would expect though is that responses will be far more localised from here and national lockdowns are unlikely to be favoured. Outside of the US the main concern is emerging economies. It appears that the cost of failing to contain infection at the point of initial introduction carries a greater cost for emerging countries who struggle with the fiscal strength and infrastructural framework required to implement extended lockdowns. This has seen much of South America, India, Pakistan and others with high and growing levels of infection, with governments appearing powerless to control the spread.