The first half of 2020 has been unexpected, to say the very least. Our outlook for the year quickly became obsolete with the rapid spread of COVID-19 and accompanying lockdowns across the globe, which have stymied economic activity and caused an unprecedented destruction of demand.
Which brings us to our mid-year outlook.
Admittedly, it’s a challenge to craft a six-month outlook in the middle of a global pandemic. Nonetheless, tumultuous times call for a focus on what we have historically learned about market and business cycles. From past experience, we know that bear markets typically presage recessions and conclude with extreme volatility, lopsided investor positioning, and dire sentiment. We have seen policy responses emerge, financial conditions ease, equity markets retrace higher, and a new business cycle be born from the depths of past downturns. We have also seen the economy-sensitive segments of the market begin to participate in the initial rebound and ultimately seize leadership as the recovery takes hold. The question is – will today’s situation follow this typical pattern?
What shape will the recovery take? Our global base case.
Today, the ongoing debate is over the shape of the recovery. To assist us in formulating our macro outlook, we constructed a simplistic model to combine the structures of country-level gross domestic product (GDP) and the variable shocks to each country. We then layered on assumptions about lockdowns and the hit to trend GDP growth across a range of scenarios. This resulted in a range of possibilities for the shape of the economic recovery.
Our base case is that the global economic recovery in its initial stages will be slow and uneven; we could think of it as having a “square root”-shaped or “swoosh”-shaped recovery. We assume there will be a gradual easing of lockdowns and a gradual return to normal consumer behavior. Our base case also assumes that the development of a vaccine will not occur quickly, and that there will be some additional fiscal support.
This scenario is of course dependent on a variety of factors: infection rates, fiscal policy, monetary policy, public health policy (including the stringency of lockdowns), and progress toward the development of therapies and a vaccine. It is also impacted by consumer and business behavior. For example, there could be some countries or states that choose not to re-impose lockdowns as infections rise, and so consumers and/or businesses might self-quarantine.
In the U.S., “green shoots” have appeared, and these early signs of economic recovery are likely to continue to grow, albeit slowly, in the back half of the year. However, we need to recognize that some parts of the economy remain very weak, including the service sector and the public sector. We also worry about the recent rise in infection rates, which could provide further headwinds for the U.S. economy.
Given these and other challenges facing the U.S. economy in the second half of the year, we believe it is critical that the government continues to provide fiscal stimulus, particularly an extension of benefits to households and businesses impacted by the pandemic, as well as state and local governments. As always, fledgling cycles can be terminated by bad policy mixes, and that is a real downside risk. However, we expect Congress and the Trump administration to come forward with the necessary fiscal support to bridge businesses, households, and municipalities through this period. We also expect the Federal Reserve to provide support for years, as pledged. And so our attention turns to fiscal and re-opening policies.
The re-opening of large segments of the economy is fraught with risk and the number of COVID-19 cases is rising in several states. Renewed shutdowns of economic activity would bring additional market volatility, but importantly we do not expect the same draconian shut-down measures as seen earlier in the year. We know far more about this virus now than in March 2020 (the benefits of masks and social distancing, and the lower risk of outdoor gatherings), which should enable the nascent economic recovery to continue.
It is clear that a new cycle is emerging and that the sharpest and deepest recession in U.S. history is likely to be the shortest. However, we do not expect a V-shaped recovery, as there will be fits and starts given the nature of this crisis. Financial markets are currently reflecting the stabilizing economic growth environment, complete with modestly higher bond yields, moderately weaker “safe-haven” currencies, firmer commodity prices, tighter credit spreads, and equity outperformance. We expect these trends to continue in the second half of the year, although we recognize downside risks to this scenario may include a rise in U.S.-China tensions and a potential second wave of infections. Near-term could bring volatility with larger-cap and secular growth stocks outperforming. However, our base case is that the recovery will progress through the year and, as it takes hold, we would expect a shift in leadership to early cyclical, value-oriented parts of the market.
In our view, visibility on the shape of the initial stage of the economic recovery in the eurozone (EZ) is low, due to the importance of the travel and tourism sector in many large EZ economies, both in GDP and employment, especially France, Italy and Spain, and we would expect greater visibility on the shape of the recovery after the summer ends. At present, we expect the EZ Core – Germany and northern Europe, where activity is more heavily concentrated in manufacturing and professional/business services – to recover faster than the South and France, where the share of GDP is heavier in tourism. These factors suggest continued diversity in national stock index and bond performance within the EZ.
On the positive side, several European countries have introduced legislation to provide at least partial income support for workers and households, and even to protect jobs during the crisis. In Italy, for example, companies are forbidden from firing workers in 2020. These measures should help to support a solid recovery for the economy.
The very good news is that the initiatives under discussion – an embryonic step toward a shared EZ fiscal policy (albeit not yet a fiscal union) – may do something to address competitiveness and economic growth for the region. This is an area where institutional and design weaknesses compound the economic vulnerabilities of Europe, and of the EZ in particular. As discussed many times, having a monetary union without a fiscal union has been extremely problematic. We are optimistic that achieving a shared fiscal policy could be very helpful in improving business confidence and supporting the EZ economy.
In terms of financial markets, the recent rebound has made valuations expensive even for the EZ, albeit not as expensive as the U.S.. In our view, EZ stocks could be more attractive in terms of the equity risk premium they offer, thanks to the lower level of government bond yields. On the fixed income side, some sovereign bonds offer relatively higher yields, such as Italy, but are effectively a bet on the European Central Bank’s support. In general, we see little value there, in absolute terms, for the level of risk investors have to take. The picture is more interesting for credit. Although absolute yields have moved lower and the spreads shrank materially after the mid-March peak, the implied probabilities of default still appear high when compared to the other periods of high market stress of the last 20 years. This is true both for the investment grade and high yield markets. All in all, given that we are entering a severe recession, the potential risk-adjusted return profile seems more attractive for investment grade than high yield, in our view. In high yield, the highest quality portion might be interesting, given the “fallen angels” that have moved from investment grade to high yield status.
UK economic performance in the second half seems likely to be somewhat weaker than the eurozone. The UK had lax enforcement and compliance with lockdowns (as did the U.S.), as well as a weaker public health system than European peers. The result has been higher rates of mortality and excess deaths, and a downturn as severe as countries with more restrictive lockdowns.
Another concern is that Brexit is around the corner. The government has ruled out extending the transition, insisting on a trade deal or a “hard Brexit” by year end (perhaps believing that a no-deal Brexit would not be traumatic compared to the lockdown). While we agree and see improved negotiating signals, we expect mini-deals in different sectors rather than a comprehensive deal, pointing to greater friction in trade and weaker productivity growth.
These combined challenges may lead to a limited return to “business as usual” and higher double-dip risks than other major economies. As the lockdown is gradually released, we expect a bounce in activity that is constrained by both the threat of secondary outbreaks as well as Brexit-induced pressures on spending. Until the parameters of Brexit are clearer, and post-pandemic and post-EU policies are clarified, we expect uncertainties to prevent a rapid return of big-ticket spending by households on consumer durables, by businesses on major new capital expenditures, and major new foreign direct investment plans. However, we also recognize the resilience of the UK consumer and believe there is a very real upside risk that consumer spending might be better than expected in the back half of the year in spite of the headwinds.
Our base case is that subdued economic growth coming out of the lockdown along with Brexit will lead to low interest rates, a weak currency, and some pressure on risk assets in the shorter term. But over time, we believe cheap valuations and policy support should boost sterling and UK risk assets.
Japan’s second-quarter GDP growth is currently expected to drop substantially. Japan’s economy was already weak before the COVID-19 crisis as the consumption tax hike last October hindered consumption. However, for the second quarter, we expect Japan’s consumption decline to be much milder than in the U.S. and Europe – strict lockdown measures have never been implemented in Japan, and consumption activity appears to have bottomed out as the government lifted the state of emergency for all domestic regions on May 25. We expect that an economic recovery under the “new lifestyle” is likely to continue in the coming months. Large-scale fiscal stimulus through two rounds of supplementary budgets, is likely to support economic growth.
The most important risk for Japan’s economy over the next few quarters, in our view, is a decline in exports. Capital goods exports from Japan may deteriorate as the global economy braces for a long period of negative output gaps. A second wave of COVID-19 in major economies could also hurt exports. An increase in bankruptcies in service industries is also a concern.
In terms of markets, Japan’s bond market has maintained stability in recent months despite the pandemic, as the Bank of Japan’s yield curve control policy provided stable conditions. In addition, the central bank’s decision in March to double the size of its purchases of equity exchange-traded funds supported equity prices. If the Federal Reserve adopts a yield curve control policy toward the end of this year, stable interest rate differential between the U.S. and Japan would likely encourage capital flows from Japan to the U.S., which should generate depreciating pressures on the Japanese yen against the U.S. dollar. However, in the very short run, the decline in excess demand for the dollar, which should be accompanied by normalization of global capital markets, is likely to create appreciating pressures on the yen.
Our outlook for China remains constructive. The Chinese economy has largely returned to normal in many ways, although consumption and private investment continue to be weak. However, we still expect sequential improvement as consumers and businesses feel more confident about spending money as pandemic-related uncertainties wane. As with Japan, we worry about the downside risk that the V-shaped bounce-back in the manufacturing Purchasing Managers’ Index that we saw in the first half will not be sustained in the second half due to global demand being seriously impaired by the spread of COVID-19;
China’s fiscal stimulus and monetary loosening policies have been conservative when compared to its peers. We are positive about the additional measures announced at the National People’s Congress meeting, which appear to be calibrated. We think it makes sense for Beijing to save some dry powder in case the macro environment deteriorates. We continue to expect loosening monetary policies in the second half; however, that will likely consist of small targeted cuts to different interest rates.
In terms of financial markets, China was the first major economy to re-open, so it makes sense that China’s stock market has performed relatively well thus far this year. Additional rounds of liquidity injection by the People’s Bank of China over the second half of the year should bode well for the China onshore A-share market. Since the A-share market is largely liquidity-driven, we expect the market to be well-supported by the current monetary-loosening environment and we remain constructive on Chinese A shares for the second half of this year. Market participants should keep watch of the geopolitical tensions between the U.S. and China. However at this point, we still expect the Phase 1 trade deal to remain intact and that tariffs will not be redeployed. With regard to fixed income, the return to normal growth is likely to start in China and other Asia Pacific countries, which we expect to benefit corporates and financials. We remain positive on Chinese and Asia Pacific credit.
Emerging markets outlook
Many emerging market (EM) economies are experiencing severe challenges from the direct impact of the pandemic and the economic costs of the lockdowns – and they have limited capacity for fiscal support and public health system support compared to developed market economies. The recovery in capital flows to EM after the sharpest, fastest reversal ever recorded in March was a result of the Federal Reserve’s sharp easing. The prospect of continued easy monetary policy and easy financial conditions in a perennially low/negative interest rate world points to continued yield-seeking and a desire to invest in countries that are geared to global recovery, which we would expect to eventually boost commodity prices and the terms of trade, as well as inbound investment inflows.
That said, major differences in economic structure and policy responses point to a large differentiation in EM countries’ emergence from lockdowns, longer-term economic performance, and financial returns. In turn, we expect this to increase the importance of country and asset class selection. To illustrate, let’s compare India and Brazil – two continental EM economies on opposite sides of the world with very different economic structures and endowments of resources.
India is experiencing a drastic surge in infections, and the lockdown has taken a severe economic toll, worsened by the lack of fiscal space to cushion the blow of lockdown. As a result, the economy is being re-opened even as the epidemic curve seems to be steepening rather than flattening. The good news is that the government is pursuing important supply-side reforms that it had avoided ahead of the 2019 elections, concentrating on redistribution and demand-boosting measures. These reforms to labour markets should encourage investment and boost growth, especially if the government follows through with financial sector reform including recapitalization, and restructuring of accumulated bad debt. If and when the government of India really follows through, foreign direct investment and capex may well respond strongly as it has in every past major episode of reform in Indian history. The risk remains that the reform process may prove slow and insufficient, however, in which case India’s recovery could well disappoint.
In Brazil, the pandemic has begun running rampant, while the federal government has held back on imposing restrictions even as state governments have taken a more hands-on approach. The government has suspended its self-imposed fiscal restraints in response to the pandemic, and the central bank has cut rates further from record lows. All of this should help put a floor under the economy, but a return to business and a sustained growth recovery in Brazil, in Latin America and in EM as a whole will likely hinge on successful containment of the pandemic and a sustainable recovery in the global economy that helps boost commodity export prices and volumes.
Most of Asia’s emerging markets have been able to successfully contain the pandemic and have embarked on a recovery. Countries such as South Korea have a strong contact tracing infrastructure and are better equipped to manage any resurgences in the virus. The greatest threat to these countries is, as with Japan and China, weakness in global demand for their products. In our view, the outlook is more attractive for Asian emerging markets equities and debt relative to other parts of emerging markets.
In conclusion, we expect the nascent economic recovery to continue in the back half of 2020, although at a slow and uneven pace, with the help of additional fiscal and monetary support. Without a doubt, our views can shift meaningfully given the large amounts of uncertainty today around a variety of factors impacting the macro environment. The greatest upside to our outlook would be a meaningful change in the health outlook for COVID-19 that leads to a return to normal consumer behavior. Downside risks include a sharp uptick in infections that results in lasting changes to consumer behavior, a renewal of lockdowns, and a premature reduction in policy support.
In this environment, we expect risk assets to perform well given the massive monetary policy support that has been provided. We favour broad diversification within the equity allocation of one’s portfolio. Within fixed income, an overweighting of corporate investment grade and a smaller overweighting of corporate high yield may be beneficial. And we favour adequate exposure to alternative asset classes, including real estate, commodities and cash. In this environment, we expect increased volatility for a variety of assets. Now more than ever in the last decade, we believe being well-diversified will be extremely important.
With contributions from Paul Jackson, Global Head of Asset Allocation Research; Brian Levitt, Global Market Strategist; Luca Tobagi, Strategist, Multi-Management; Arnab Das, Global Market Strategist; David Chao, Global Market Strategist; Tomo Kinoshita, Global Market Strategist; Talley Leger, Investment Strategist; András Vig, Multi Asset Strategist, and Ashley Oerth, Investment Strategy Analyst.