Monthly Agenda August 2020 – A World of Possibilities
Today’s investment environment is one where there is a world of possibilities but few certainties. Part of the issue, in our view, is that this recession was caused by an event, rather than anything cyclical. How that event unfolds is uncertain.
We take a look at five possible scenarios and consider what the investment and portfolio implications would be.The scenarios are not mutually exclusive. We could, for example, see a situation where Trump wins the election and we get a vaccine approved. Given this, the assigned probabilities don’t add up to 100%.
An event, not a cycle
We subscribe to Howard Marks’ view that the current situation has been driven more by an “event” than by anything “cyclical”. In other words, we are in a recession not because of anything that happened within the workings of the economy, the usual suspects being excessive debt or excessive exuberance.
This current recession was caused by an exogenous shock which then caused government’s around the world to order economies to stop.
The heatmap below compares the key features of the 2008 Global Financial Crisis with the recession today. The map highlights when and where the key features where present with green suggesting little evidence and red suggesting significant evidence.
The policy response today was more immediate and larger in size, starving off the likelihood of a financial crisis. This, in combination with the fact that there were fewer structural issues present before the current crisis hit (in contrast to 2008 when the housing market was in bubble territory), means the economic damage done is likely to be more limited.
Understanding this difference is crucial in understanding what the next phase looks like. An endogenous shock, once it goes away, can take years to recover from. An exogenous shock, once it goes away or is at least mitigated, can allow an economy to re-start providing there is little scar tissue.
The two keys to determining how well and how fast the economy re-starts is how well the shock is addressed and or removed and how extensive the scarring is. These two things are related. The faster a mitigation drug can be found, the faster the economy can re-start, the less long-term scarring there will be. The extensive fiscal and monetary support provided by governments will certainly help in keeping scar tissue to a minimum.
Effective vaccine discovery
According to the World Health Organisation (which is tracking more than 140 vaccines in development) eight vaccines are in phase 3 trials – this is the last trial phase. The next step if successful is regulatory approval and then finally the manufacture phase.
Confidence is growing that some kind of mitigation drug will be available by early next year that will allow us to live and work with the virus. The greatest economic impact under this scenario is that social distancing measures can be relaxed, the economy can open up and people can live, work and consume more freely again.
This would boost economic growth as the sectors of the economy most hit by the shut down can begin operating again. It is estimated in the US about 30% of the economy was affected by the social distancing measures but about half of that 30% were able to continue operations remotely or online.
There is no doubt some damage has been done to the economy. There are some businesses that will not come back and it will take some time for employment to recover but in contrast to past cycles, this event saw most layoffs come with a handshake agreement to re-hire when reopening is possible. Already, half of the 1.3 million Australian jobs lost have been re-employed.
Consumption typically rebounds ahead of the labour market. Consumption will be supported by the pent-up demand that exists and the support provided by governments. Household saving rates have increased across the US, Europe and Australia. This will be spent when social distancing rules are relaxed. This spending will generate the activity needed to re-hire employees, household income levels will rise as a result and the economic flywheel will re-start.
There may be some structural changes that will affect how we work, live and play in the future as a result of the virus. Telecommuting is likely to have received a structural boost, e-commerce and even perhaps e-health. This may mean the property sector is the one sector that will have to deal with longer term issues even after a vaccine is found with office and retail likely suffering the most permanent scarring.
Financials may also be a sector that will feel the consequences of the virus long after a vaccine is found. While most deferred repayments will be repaid, banks will need to digest some proportion of bad debts, particularly for loans in the worst affected sectors such as accommodation, cafes, restaurants, culture and recreation.
The investment winners in a vaccine discovery will likely be the sectors that have lagged the winners to date. This would include transport, materials, consumer staples, consumer services such as hotels, restaurants and leisure and education.
The biggest underperformers under the pandemic, airlines, will likely come back with a bang should vaccines be cleared for broad use and virus counts decrease. At the same time, some of this year’s biggest gainers would slump, especially gold.
Gold tumbled and value stocks gained after Russia’s vaccine news, imagine how much stronger the moves would be if an inoculation received full approval from a western nation or two.
Vaccines should spur investors to focus on those sectors that would benefit from the release of pent-up demand for travel, entertainment and other pursuits that lockdowns stymie. Even though the road back for such industries will be a long one, stock markets will race to price in recoveries.
What if the US Federal Reserve actually succeeds in generating inflation?
The aggressive monetary and fiscal stimulus in response to the coronavirus crisis could trigger a burst of inflation. Money supply growth has soared hitting 8.4% in Australia (versus a long run average of 6%), 12.6% in Europe (versus a long run average of 9%), 13% in Japan (versus a long run average of 7%) and an incredible 38.1% in the US (versus a long run average of 10%).
After the global financial crisis (GFC) there was a school of thought that quantitative easing and low rates would generate substantial levels of consumer price inflation; that never materialized. Much of the liquidity provided by the central bank found its way into asset price inflation (and vintage Ferrari price inflation) but not into consumer price inflation.
Will this time be any different? There are reasons to think that perhaps that will be the case. In the aftermath of the GFC, domestic non-financial private-sector credit declined in nominal terms, not reaching its prior peak for five years. This de-leveraging likely blunted the inflationary impact of government borrowing and the Fed’s financing of it. This time around, de-leveraging may not occur to the same extent given the absence of imbalances going into the recession.
It remains to be seen what happens to global and local supply chains, but it’s hard to see them moving in anything but a more cost-heavy direction. Meanwhile, one of the missing links of inflation over the past decade has been the absence of the expected household formation from the millennial age cohort. If that trend reverses, it should provide a nice tailwind to a nominal growth rebound.
It has now been formally announced that the US Federal Reserve is going to adjust its strategy to countenance higher inflation in the future. This commitment to allow inflation to move past the 2% target to make up for years of undershooting may ultimately send inflation higher. Certainly, that is the intention of the move.
Depending on how large the spike in inflation is, it could result in the central banks withdrawing monetary stimulus. This would put upward pressure on bond yields and likely cause the yield curve to steepen. This would be a positive development for banks as their net interest margins are positively correlated to the steepness of the yield curve.
Double dip recession
The most likely cause of a double-dip recession would be another severe breakout of the pandemic causing a surge in hospitalisations, forcing governments to resort to generalised lockdowns again.
Economic activity would once again grind to a halt as tighter social distancing measures are enforced. Governments would be forced to pump further stimulus into the economy, raising government debt levels even further.
The stimulus is likely to be less effective given even more business are likely to fail under this scenario.
Financial markets would have a serious correction that would likely take longer to recover from given the effect a new outbreak would have on business and consumer confidence. The economic scarring would be deeper and take longer to heal.
The financial market winners would likely be once again IT and healthcare but given already elevated valuations it is difficult to imagine significant gains. Equities overall is likely to be a relative loser under this scenario.
A win on November 3 for Joe Biden and the Democrats would not be as significant as a win for the Democrats in the Senate as well. This would mean the Democrats take control of the White House and Congress.
Should Joe Biden prevail over Donald Trump - as current polling suggests - gold may be in the thick of the action as the White House incumbent could contest the result. Trump, of course, has repeatedly warned the election would be “rigged” if voters are permitted to mail in ballots, instead of going to polling places amid the pandemic.
Expectations of a Biden victory may be a short-term bullish factor for the US dollar, though a win might revive risk appetite while lowering tension with China, both adding downward pressure on the currency.
Investors looking for U.S. equity upside from a Joe Biden presidency should be focusing on investments in green energy technology and the U.S. infrastructure complex.
Beyond a change in the White House, the chance of a Democratic straight flush through both the House and Senate races could make the first 100 days of a Biden presidency very lucrative for investors in sectors that may be of the highest priority for a new government looking to boost an economy out of the Covid-19 induced Doldrums. "Green deals" and unfinished infrastructure funding plans present low-hanging fruit for a single-party government.
Presumably, if the Democratic Party gets control of both the White House and Congress, it could increase the risk of rolling back the corporate tax cuts Trump delivered. Though given current circumstances, that seems unlikely at least in the first one or two years of the new term.
Positive news flows on vaccines and the prospect of a win for Joe Biden would be a relative negative for the tech sector. Some of the money leaving tech could shift into selective value sectors, EM sovereign debt and haven assets such as gold and Treasuries.
Emerging markets would probably benefit the most from a Biden victory with a split congress (i.e. the Senate remains Republican controlled). This assessment is based on:
- the assumption that Biden reduces geopolitical uncertainty
- the likelihood that Biden would negotiate to roll back tariffs on China, in return for market opening
- the relatively poor relative performance of EM assets following Trump’s election. Note that Mexican and Brazilian stocks, bonds and FX consistently fared the worst in the month following the 2016 election.
The benefits of a Biden Presidency, however, would be offset (but probably not overwhelmed) in the event the Democrats win a clean sweep. In the extreme case, with Democrats winning the Senate by a large margin the outcome would be bad for EM. The risks of significantly higher corporate taxes and re-regulation would probably be overwhelmingly negative.
President Trump trails his Democratic opponent in the national polls, but then that was the case four years ago, so few would count him out this time around.
Most emerging markets did poorly following the result of the 2016 U.S presidential election. Back in 2016, from election day through until early December, only 2 stock markets in our survey of 17 outperformed the SPX (which rose 5.4%) - Russia (13%) and Poland (7.1%). In FX, the U.S. dollar rose against everything except the RUB and COP. Treasury yields rose 58bps. Mexico and Brazilian stocks and FX fared the worst.
On tax policy, a Trump victory that was not expected would likely see a relief rally in US equities as investors anticipate stable, lower taxes for a second Trump term.
On global trade, if President Trump is re-elected, the stand-off with China will likely worsen and tariffs may increase again. That would slow the global economy and, in turn, hurt equities especially emerging markets. Tariffs on European goods, or lumber and aluminium tariffs with Canada would create additional uncertainty. With a second term won, Trump may take an even more aggressive stance against trading partners. A further roll-back of globalisation and free trade would put upward pressure on supply chain costs and so benefit gold as a hedge against inflation.
On global relations, a win by President Trump may help aerospace and defense contractors. If the president does decide to continue on a global decoupling agenda and withdraw U.S leadership from the world, the theme of USD decline might gain more traction but this would be offset by dollar strength on weaker global growth.
Chief Investment Officer