Executive summary

4 minute read

Economic and financial market prospects brighten

The global economy has proven to be more robust to the COVID-19 crisis than many anticipated. Following the unparalleled decline in the first half of the year, activity has bounced back sharply, as mobility restrictions have been eased and the pressures on hospital systems have remained low. While some restrictions remain in place in most countries, particularly following the recent increase in coronavirus case numbers in Europe, these are far removed from the strict “stay-at -home” orders earlier in the year.

Caution on the part of most households and businesses, including the widespread adoption of face masks, hand-washing and social distancing, has undoubtedly helped in preventing the extremely rapid spread of the virus seen earlier in the year. But the combination of caution and restrictions on travel and hospitality continue to impede the recovery in those sectors. As such, until a vaccine is available, economies continue to search for the new “normal” that we described in our Q3 House View publication.

Essential to the recovery in activity has been the vast amount of policy support – both monetary and fiscal. Developed market central banks have cut rates to their effective lower bound (or very near to it) and engaged in large-scale asset purchases. As in past episodes of quantitative easing (QE), those purchases have been primarily government bonds, but risk assets such as corporate bonds have also been purchased. Funding schemes have also been introduced to assist with bridge financing either through the banking system or direct to businesses. These measures both restored market functioning and provided a much-needed easing in financial conditions.

Figure 1 shows that long-term real yields on government debt have fallen to historic lows. Perhaps even more significantly, governments pro-actively moved to support household incomes through the period of economic shutdown by supplementing the traditional automatic stabilisers. In many economies that came in the form of a wage subsidy or furlough scheme that kept employees attached to their employer by covering much of their wage bill, even if not working at all.

Figure 1. Real government bond yields (aggregate GDP-weighted)

Central bank actions pushed real yields to new lows

Figure 2 shows that the decline in GDP would have been expected to have resulted in a very large decline in aggregate income. The impact on activity was several multiples of that seen in the 2008 financial crisis, but in the United Kingdom incomes fell by proportionally much less. In the United States, unemployment benefits were increased significantly, and one-off payments were made to all households. Actions there resulted in overall household income rising after the onset of the pandemic. These swift actions meant that governments, rather than households, carried much of the economic burden of the crisis. In so doing, private sector demand recovered quickly, with retail spending rising above pre-COVID levels in many economies in recent months.

Figure 2. Percentage change in disposable income and GDP

Government policies supported household incomes

While the pace of the economic recovery has been encouraging, risks clearly remain. The recent increase in coronavirus cases in Europe and elsewhere has the potential to lead to more severe restrictions once again. If that were to occur, governments and central banks would once again be required to step in to support the economy. There is a risk that they might be less willing to do so again, although there appears to be little evidence of that for now. Perhaps a bigger risk is that the path to the new normal is somewhat slower from here and fiscal support is removed too quickly.

On the upside, however, the timeline for a widely available and effective vaccine appears to be at the more optimistic end of the spectrum of views from earlier in the year. It is possible that more than one vaccine could be approved in Q4 and begin distribution in early 2021. While that roll-out process may take a year or more, it would remove much of the uncertainty that hangs over the service sector. Figure 3 shows our updated range of scenarios for economic activity through to the end of 2021. We put around a 60 per cent probability on scenario B, which is little changed from our view three months ago. However, we now judge the downside (Scenario C) to be less severe than previously thought, with the prospect of another global economic lockdown like that seen earlier in the year much more remote. Meanwhile, there remains the potential for activity to return more quickly to the pre-COVID trend in the event of a rapidly deployed vaccine, alongside continued monetary and fiscal support (Scenario A).

Figure 3. Global activity scenarios

Downside risks have receded

One of the most significant policy developments in the past three months came outside of the immediate response to the COVID crisis. In August the Federal Reserve delivered its muchanticipated policy framework review. The review, which began in 2018, was commissioned to address the challenge to the effectiveness of monetary policy from the era of very low “neutral” interest rates. The outcome was a decision to move away from a framework that ignored past deviations of inflation from target, to an average inflation targeting (AIT) regime that would try to make up for those past deviations. In effect, it would mean allowing inflation to run above the two per cent target for some time over the coming years, following several years of belowtarget inflation.

Moreover, less emphasis would be put on removing accommodation as the labour market improved, but rather waiting until inflation was at or above target. The change in approach is likely to result in rates stay anchored at zero for even longer than previously anticipated – maybe for another four to five years. Over the longer term, it is also likely to mean somewhat higher and more variable inflation and more economic and market volatility. Other central banks are also pursuing reviews, with similar outcomes likely to be delivered over the next year or so. While the initial market reaction to this development has been muted so far, there is potential for this to be the most significant change in approach from central banks since the start of the inflation targeting era in the 1990s. When set alongside the renewed interest in fiscal policy, it could usher in a period of steeper interest rate curves, more volatile currencies and a rotation towards value stocks.

The brighter economic prospects, and even more importantly the receding downside risks from COVID-19, have led us to take a relatively neutral view on global equities (Figure 4), with relative valuations and cyclical recovery favouring Europe and Emerging Markets over the United States and Japan. We prefer to express more risk in credit markets, with overweight view in global high yields and US investment grade. While credit spreads have narrowed materially in recent months, high yield has potential to deliver further capital appreciation, while remaining supported by central banks should downside risks materialise. The decline in government bond yields has made them less attractive, particularly as an effective risk-reducing element. We prefer to be neutral overall, with overweights in the United States, Italy and Australia offset by underweights in core Europe. But perhaps the most significant asset allocation change has been in currencies. A long-held preference for US dollars has given way to what we believe could be a sustained decline in the dollar against G10 currencies. With a preference to be overweight euros and yen, we continue to be underweight sterling given ongoing risks from Brexit.

Figure 4. Asset allocation summary