18 Oct 2020
Most major markets made modest progress during the third quarter, although currency moves were in some cases as important as actual index movements. For non-sterling investors the fall in the UK currency mitigated or wiped out the modest progress of that market, although within the UK mid and small caps both outperformed. Gains in the American market occurred with some businesses helped by weakness in the US currency in terms of translation of overseas profits. Within Asia, China was once again a standout performer, although the Indian market, despite rising Covid numbers, rallied as the economy began to open. Whilst the economy in Japan remains sluggish, the market made modest progress and emerging markets also enjoyed a small rally, but overall have still struggled year to date.
Stock markets look forward, so investors are now looking out to the end of 2021 to try to see how far the global economy will be below what it would have been pre-Covid. A key question is whether there has been financial scarring, and if this does not occur, although extremely sharp, this recession will not last as long or impact nearly as much as the GFC. A lot will depend on governments making the correct decisions on health. With so many vaccine candidates, sifting through the news flow does suggest a vaccine should be available by Q2 next year with debate likely to soon focus on its effectiveness, rather than whether it will work or fail. A vaccine which prevents large numbers of the population contracting the disease and for those who still contract the Coronavirus only to show mild symptoms and avoid hospitalisation would be a positive result for markets and the global economy. Furthermore, treatments for Coronavirus are improving, which partly explains the lower mortality rates, even in countries now enduring a second wave.
With the end of the summer in sight in the Northern hemisphere, in Europe and some parts of the United States there has been a pickup in new Covid-19 infections. This may partly be as a result of more indoor mingling as temperatures fall because the colder temperatures (9oC has been described as a key trigger), that appear to facilitate a more rapid spread of the disease have yet to occur. During the summer months consensus economic forecasts were generally revised upwards, but in the light of further lockdowns, especially in Europe, these could be challenged. Even in the States, if authorities persist with keeping local economies open even if numbers rise, consumer confidence could decline curtailing consumption. Whilst the third quarter saw the start of a V-shaped recovery, this is likely to flatten off before there is a full rebound in economic activity.
With the end of government furlough schemes in some European countries and the prospect of many job losses and before the end of the year, there is likely to be higher precautionary saving by households. In the US political squabbling has so far prevented a further extension to fiscal stimulus measures. There is also likely to be lower business investment whilst uncertainty persists, so vaccine announcements are likely to have a significant influence on market volatility.
Even if there is a successful vaccine available from say the start of the second quarter next year, there are structural changes in the economy which have been accelerated by the pandemic and will result in permanent change. Whilst some businesses will have done well there will be bankruptcies and job losses, and whilst capitalism has thrived long term on the process of creative destruction, in the short term there can be an economic hit with lower levels of output and higher unemployment. This was demonstrated in the early 1980s in the UK when the early days of the Thatcherite revolution saw the country initially enter recession before reaping the benefits later. Given the nature of this pandemic and the unprecedented response to it, policy makers are understandably uncertain about the scale and long-term effects of the Coronavirus.
The countries best placed in terms of lower levels of scarring are those in North Asia and particularly China, whilst other parts of the emerging world look likely to end 2021 with growth levels far below that which had been previously forecast.
Amongst the advanced economies, the US is expected to record a smaller drop in output this year than the EU and UK and it is likely that Japan will be slow to recover all of its lost ground. By the end of 2022 in most major economies global output should have recovered to pre Covid-19 levels, but the previous or expected growth path will not be achieved for some years after that. Post the GFC initial forecasts were for a much more rapid recovery than occurred, and the demand deficiency, higher levels of unemployment, and the pre-Covid low levels of interest rates make a strong or rapid economic rebound unlikely. Furthermore, at some stage in the future, governments may look to reduce deficits by fiscal tightening, in which case borrowing today will reduce the potential for future growth. This will depend on how long-term a view governments are prepared to take on fiscal deficits and a sensible option might be to lock in today’s low levels of long-term interest rates, as markets have shown they are prepared to look through headline deficit numbers as long as an economy is growing and the overall deficit is declining, albeit slowly.
Monetary stimulus is likely to have run its course and there seems little scope for further cuts to policy interest rates or lower bond yields to further stimulate the global economy. Even in places such as Brazil, policy rates have fallen to 2% and the low levels of interest rates in the emerging world are a factor behind these currencies not rallying in the risk-on market rebound which has occurred since April.
Minutes from the Federal Reserve’s mid-September meeting on monetary policy will be released next week and will give investors greater insight into the US central bank’s latest approach to setting interest rates and supporting the economic recovery. The Fed had revealed in August that it would tolerate higher rates of inflation to balance out prolonged periods of undershooting its target of 2%. The Fed has predicted it will not raise rates until through 2023 at the earliest, and until it achieves full employment and inflation remains on track to moderately exceed its target for some time. Whilst this might have been expected to result in a gentle tick up in yields at the long end, to date the Fed has in the post Financial Crisis period, not managed to hit its 2% inflation target and many market participants remain deeply sceptical about the central bank’s inflation generating capacity.
Coronavirus numbers in the US have not shown any significant decline over the past month, and so it was not surprising that the pace of US jobs growth slowed in September. The unemployment rate fell to 7.9% which means Donald Trump will be shouldering the worst September jobless rate of any incumbent US President in post-war history (the data released last Friday is the final monthly update before the November election). In July and August, the US economy created on average 1.6m jobs per month compared to 661,000 in September, and America has now recovered just 11.4m of the 22.2m positions shed between February and April. The resurgence of the virus has clearly constrained the pace of re-opening and this does not augur well for October jobs numbers. In the States the economic rebound has entered a new weaker phase - there was also a 0.3 percentage point decline in the labour force participation rate in a discouraging sign for the recovery. Fed Chair Jay Powell has called for further levels of government stimulus, and this seems necessary to avoid a significant economic slowdown in the fourth quarter.
In contrast, European unemployment figures have not increased nearly as much, but this is due to furlough schemes where governments have provided high levels of subsidy to encourage firms to maintain employment. The US has followed a different course with workers losing jobs but receiving significantly higher levels of unemployment benefit over the short term. ECB economists have estimated that between 15-18% of the eurozone workforce are without jobs or would like to work longer hours, almost double the official unemployment rate. Youth unemployment is far higher as this sector has been hard hit by the closure or restrictions on the hospitality industry.
Purchasing managers index data for France, Germany, the eurozone as a whole, the UK, and the US are due to be released and these will give further indications on whether lockdowns have seen a slowing in the pace of economic recovery. It is likely data will show the spectacular V shaped recovery in the global recovery has probably now come to an end. JP Morgan estimate that global output rose at an annualised rate of 34% in the third quarter.
Year to date there has not been that huge a difference between manufacturing and non-manufacturing sectors. Factory closures meant that goods output fell more than services in the second quarter, but then rebounded faster in the third quarter. The fourth quarter and the first quarter of next year in a pre-vaccine world is likely to see greater differentiation. Manufacturers will continue to benefit from growth in inventories and a continued catch-up in demand for consumer durables. The picture is not so buoyant in the service sector, with many households either choosing to avoid sectors involving a high level of personal interaction such as hospitality or travel or finding new government restrictions prevents this. For those who have remained in employment or older members of society, household saving ratios have been very high as normal spending patterns have been interrupted. Even workers in vulnerable industries have had spending protected due to the high levels of government support through furlough schemes. There are now indications that excess savings are being allocated towards groceries, household goods, durable consumer items including home office and furniture, and cars.
Europe has seen renewed levels of lockdown in many countries and business surveys in the eurozone have shown that in some instances the recovery in economic activity in consumer services has moved into reverse. Leisure activity has seen spending fall, something likely to occur anyway as the summer months came to an end. At this time of year northern hemisphere countries would always see a fall-off in outdoor leisure activities, but consumers do not have the confidence to visit indoor entertainment venues such as cinemas, gyms, or restaurants, and many governments have precluded crowds from attending large sporting events. Furthermore, travel remains difficult so southern European countries will not be seeing the pickup in tourism from northern Europe which would normally occur at this time of year. In the UK and Ireland governments have re-encouraged working from home, and this will clearly affect city centre service orientated businesses. Eurozone services activity declined in September with the IHS Markit flash eurozone purchasing managers index for services falling to 47.6 in September from 50.5 in the previous month. This was the first time in three months the reading had dropped below the 50 mark, and the lowest level since May. A reading below 50 indicates the majority of businesses reported a contraction in activity compared with the previous month (previous readings above 50 did not indicate a return to pre-Covid levels of economic activity). Services sentiment indices fell in Germany and France, the eurozone’s two largest economies. In contrast manufacturing activity improved with the eurozone PMI in September for this sector rising to 53.7, up from 51.7 the previous month. Germany showed particularly strong numbers. Overall, in Europe services are more important than manufacturing and this is true for a number of the worst hit European economies during the Covid crisis. The stop / start / stop cycles in virus sensitive service sectors can only have a detrimental effect on business confidence and there are signs that as a result some businesses will close down on a more permanent basis, at least until there is a vaccine.
In the States, this widening gap between goods and services activity is not yet evident but cases there are rising again, even in areas such as New York and New Jersey, as well as California. In contrast, the newly industrialised Asian economies, notably China, has seen manufacturing activity boosted by exposure to increased global demand for goods whilst service sectors are benefitting from their impressive control over the virus.
Graham O'Neill, Senior Investment Consultant, RSMR
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