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Optimism and caution for the second half of 2020

23 July 2020 Michael Hasenstab, Ph.D. Chief Investment Officer at Templeton Global Macro

After four months of economic shutdowns, re-openings and relapses around the world, the global economy unfortunately still appears many months away from a sustainable recovery.

It has been encouraging to see the resilient determination to reopen businesses under varying protective measures, but it has been equally concerning to see the resurgences in COVID-19 cases that have necessitated a return to shutdown policies. Stories of restaurants that reopened, only to have to permanently shut down after entire staffs contracted COVID-19 are emblematic of the struggles facing businesses and people around the world. The pandemic is still with us, and its impact on our economies will continue until it has run its course, either naturally or through a cure. While there are reasons for optimism amid the crisis, we are also grounded in the reality that the current predicament may persist for much longer than any of us prefer to believe.

As we pass the midway point of 2020, it still appears too early to pursue additional investment risk, in our view. Recent rallies in risk assets appear to underappreciate the ongoing economic damage and the risks for successive waves of infections that could further suppress economic activity. Some economic data have improved in recent months, but the figures reflect a rebound from the extreme shocks in March and April, not early signs of a trending growth recovery. A V-shaped recovery is highly unlikely, in our view, given the magnitude of job losses, massive aggregate demand destruction, capacity constraints in reopening and ongoing economic damage that is incapable of being reversed in the short run. Instead, we anticipate a more drawn-out gradual recovery.

While we are likely to see a much needed swell of optimism in the summer months as people venture out to enjoy some sunshine, dine outdoors, patronize reopened businesses and head for vacations, the realities of the economic crisis and the health crisis will remain omnipresent. Months ago there were hopes that many jobless claims in the US would prove temporary, but many temporary claims (six-months) are increasingly at risk of becoming permanent job losses as businesses close for the second time or become insolvent. Historically, it takes years for unemployment to return to pre-crisis levels—after the 2008 global financial crisis it took more than six years.

Sharply rising bankruptcies will be the next challenge policymakers will need to address. Solvency conditions will likely continue to deteriorate the longer the pandemic lasts and the longer economies take to recover. Central bank efforts to bolster liquidity in financial markets through extraordinary policy interventions have been effective, but they do not engineer demand, replace lost revenues or cure insolvencies; they only deepen the debt burdens. We have concerns that as the pandemic persists through the summer and into the fall and winter months, business insolvencies will worsen with each month of stifled economic activity.

Adding to the complexity of the crisis is the precarious state of the world that existed before the COVID-19 pandemic. Escalating geopolitical risks, rising trade tensions and political polarizations have made it highly difficult for countries to find the collective good will needed to address both domestic and international challenges. In the United States, an increasingly divided population and polarized politics have undercut the cohesion and compromise needed to solve critical issues. These types of political polarizations are occurring around the world, making it difficult to design collaborative solutions to the most profound economic crisis in the post-war era.

Additionally, the deglobalization trends that were already underway before the pandemic erupted are likely to accelerate during the ongoing crisis. As countries increasingly focus on health concerns, national security and other domestic issues, globalization is at risk of being further cast aside. Intensifying trade tensions between the United States and China are a prominent concern but are also just one example among many other decaying trade relations around the world. Structural shifts toward domestic production and regional supply chains would have major implications for the global economy and financial markets.

From an investment standpoint, we are modelling two phases to the global crisis. Financial markets currently remain in the first phase, which is characterized by a prolonged period of elevated risks and uncertainty, with the potential for additional market shocks that could last for multiple quarters. In the second phase, we expect an eventual recovery to gradually take hold, shortly preceded by periods of distorted asset prices and compelling investment opportunities.

Similar to the playbook we used heading into and eventually out of the global financial crisis in 2008/2009, we are taking a two-staged investment approach. In phase one, we are maintaining a largely defensive stance that focuses on higher allocations to safe haven assets, lower duration exposures in select emerging markets, broad risk-reductions and optimized liquidity. In phase two, we anticipate pursuing undervalued risk assets, with a particular focus on distressed valuations in higher duration local-currency sovereign bonds, emerging market currencies, and various credit sectors.

Overall, we remain confident that these types of phase two investment opportunities will ultimately arise, but we also recognize that the pandemic may persist for multiple quarters, potentially pushing out the timeline for when certain investment opportunities may become suitable. We expect multiple stages of relief rallies and corrections in financial markets before a sustainable recovery eventually takes hold many months from now. Until that point, we are focusing on select areas of value in the phase one environment, including a select set of emerging markets as well as developed market safe havens.

There is still profound uncertainty over the full economic ramifications of the pandemic and how long it will last. Nonetheless, we continue to glean new information and new insights amid the evolving crisis, as we monitor the global economy on a country-by-country basis to uncover the next opportunities that will arise in the post-pandemic world. We will ultimately get to the other side of this crisis.

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