Health uncertainty vs. economic uncertainty: the need to safely restart growth
Economic recovery: A letters’ game
Various prognosticators have attempted to predict the type of recovery we may see—a sharp “V-shaped” rebound from the bottom, or slower “U-shaped” recovery or an “L-shaped” where we linger longer in the depths. To some extent, the type of recovery we see depends on whether one is talking about sequential growth or annualized growth in sequential terms. Right now, we are sticking with our baseline under which, on quarter-over-quarter annualized terms, we should see quite a sharp recovery. Under these terms for the third quarter, we could see a 20%– 30% growth rate. That is pretty V-shaped. That said, in year-over-year terms, it will not be V-shaped as we will be at a lower level of gross domestic product (GDP). Whatever letter you use to describe it, I do think that we could see the sharpest and potentially the shortest recession in US history. It is cliché to say, but we are in unprecedented times.
To determine whether people are starting to return to normal, and how, our fixed income team put together a tracker using Google mobility data, OpenTable reservations, and Homeplace—a series of different tools to get real-time information as to how consumer behaviour is changing on a biweekly basis. OpenTable reservations, the largest restaurant booking system in the United States, showed a 100% drop in most of March and April because dine-in restaurants were closed.
But then very quickly, we started seeing restaurant reservations start to pick up again in May. And it’s not only happening in the United States; reservations are up on a year-over-year basis in Germany, for example. So this trend is something we plan to continue to monitor and track in real time. In the United States, consumer confidence and retail sales have also rebounded strongly. The signs of a V-shaped initial recovery are all there. The question is whether this initial recovery can maintain its momentum— and here it will be crucial to see how different states react to the fact that as some business activity reopens and people go out after isolation, we inevitably see some pick up in the number of new infections.
I think it’s important to recognize that a lot of the people who are more willing to go back to work and go out socially are likely in younger age brackets where COVID-19 generally carries much lower risk of serious health consequences. They have weighed the risks of going out again versus staying at home and have chosen the former.
We also need to recognize that some people have far fewer options than others. Only around 35% of people can work from home, so that leaves 65% of the population that really cannot—for them staying home means not getting a pay check. I think that is something we definitely need to consider when we look at the speed at which people are allowed to go back to work. We also need to look at what might be prudent for someone in a rural area to do might not be for someone in large metropolitan area.
The central bank response
The amount of stimulus we have seen in response to this crisis is unprecedented. Several countries were already experimenting with negative interest rates, leading many observers to wonder whether the US central bank would follow. However, our research has found that negative interest rates are not particularly stimulative. Importantly, the most negative interest rates have gone globally is 75 basis points, and if we use a standard Taylor Rule,1 we would need rates to be –16% in the United States. I think the Federal Reserve will likely pursue other policy measures before it actually considers moving to negative rates—yield curve control seems the most likely candidate, but I also think the Fed will first want to gauge the impact of the massive measures already in the pipeline as well as the strength of the recovery.
Outside the United States, I think the European Central Bank (ECB) has clearly stepped up its response, making up in spades for some initial missteps when COVID-19 first began to spread to Europe; and eurozone policymakers have made important progress towards a greater degree of mutual fiscal support, with a first limited form of debt mutualization. While the outlook for countries like Italy and Spain is poor because the lockdowns had a severe economic impact there, the strong stimulus will help the eurozone as a whole, and should alleviate the problem that the countries which were most negatively impacted by the coronavirus also have the least fiscal bandwidth to combat it.
The question is whether all this stimulus will cause inflation to pick up down the road. Over the next couple of quarters, I am not overly concerned about inflation. After that, I think all bets are off. This is not a prolonged depression where we would typically see deflation. We are seeing a trend of reshoring of production—bringing manufacturing back to one’s home country—particularly production of goods related to the health care and technology sectors. The reason companies outsource in the first place is to reduce costs. When they bring it back home, costs will rise and we may have an inflationary impact down the line. On top of that, we are going to come out of this crisis period with a massive monetary overhang, massively easy fiscal policy, some reduction to potential supply because of weak investment, and more stringent protectionist barriers. As such, it is very hard for me to see a scenario where we do not see some pickup in inflation. For that reason, I think Treasury Inflation-Protected Securities could offer good value over the medium term.
US political uncertainty
The United States is currently going through a period of what I would call intense soul-searching, long overdue and much needed. Unfortunately, times like this also lead to what I would call political opportunism. We are certainly seeing that on every side. Looking through the recent, quite tragic events in the United States, and going forward into the latter half of the year, we need to recognize that the US elections are still four months away. While the polls seem to be showing the Democrats are out in front, a lot can change. Let us remember that the economy was roaring five months ago.
Even without a full Democratic or Republican sweep in November, it is hard to overstate the level of uncertainty in regard to what the likely path of policy will be. Over the next several months, we will get greater detail on what the policy platform of the Democratic presidential and vice-presidential candidate will be, which should help shape our outlook on different sectors. On the Republican side, in the case of a sweep, the outlook is more known. And if it’s not a sweep—if we have a president who is of a different party than the Congressional majority— any incoming administration will find it hard to dramatically change policies. So, putting it into perspective, over the next few months we will have much greater detail on what the policy platforms will be and as the polls become clearer, we will have views as to how the market impact will play out.
Looking into next year, without a doubt, geopolitics will be in focus. Relations with China are going to become a much larger focus, not just for the United States, but also for the euro area—there is a lot of unhappiness with how China has managed its global role in this pandemic crisis. There will also be renewed focus on underlying geopolitical tensions; there are already several hotspots simmering around the globe, and the perceived lack of US leadership increases the risks. Going into next year, this is something that our team is going to be looking at very carefully. We will also be carefully watching how the unwinding of all the stimulus plays out. Finally, we need to monitor most closely how countries decide to confront COVID-19 in the absence of a vaccine. The global economy cannot be stopped and re-started every few months—that would be catastrophic. This type of disruption is simply not priced into any assets and is not currently in any economic models.
Time to be active
Overall, we believe it is a time to be active as investors. There is not a single asset that is unilaterally a buy right now, in our view. More than ever, selectivity by country, by sector, by asset class, and within asset classes by industry and individual companies is required. The importance of thoughtful, skilled bottom-up research cannot be emphasized enough in the current environment.
Looking across credit sectors, we believe high yield has probably gone too far, too fast. Most risk assets have accelerated on the back of both the expectation and execution of the massive monetary easing, but also increasingly an expectation that the economic recovery will validate the asset-price moves. While I am perhaps more optimistic than some in terms of the recovery, I think it would be a wrong to assume that the recovery will be swift. Therefore, I view the recent recovery in risk assets—including high yield—with some caution. We continue to prefer the investment-grade space, but some sectors will be impacted for a longer period of time; for example, those related to business travel, hospitality and leisure.
In sum, the risks to the economic outlook are very real. Our baseline outlook assumes sensible reactions as we are looking at data-driven conclusions as opposed to just knee-jerk reactions.
