Exists from lockdown proceed with no major mishaps, leading the stock markets to still trade sideways. Progress towards implementing budget supports is slow, which constitutes a potential risk and a source of volatility.
Worldwide COVID-19 cases crossed the 5 million mark, while deaths topped 325,000, as of 20 May.
- More and more economies are easing their lockdown measures, as data on the human impact of Covid-19 continues to improve, albeit slowly. This is helping sentiment and expectations. So far, in countries that have lifted, or that had light lockdowns, the increase in the number of new Covid-19 cases is not significant, and the infection management is under control.
- The development of the pandemic in Brazil however, is worrying, as the death toll continues to climb fast. With over 17,000 deaths Brazil is, by some distance, the hardest hit among emerging economies. The shape of the curve implies Brazil is still weeks away from the likely peak (see Exhibit 1 below). The absence of a nationwide lockdown in Brazil, combined with conflicting messaging from the federal government, has aggravated the situation.
For us, the key issue remains that in the absence of vaccine, this virus will be with us for a long time. For this reason, there can be no rapid return to normality. Levels of acquired immunity remain low according to recent serology studies. The capacity of nation states to conduct mass testing and contact tracing remains limited, with the exception of a few countries in Asia. This, in turn, limits the pace at which re-opening can proceed and sows the seeds of a potential second wave.
A vaccine would be obviously be a game changer. As we have seen this week, with the positive news from Moderna’s vaccine trial, the market enthusiastically responds to every bit of good news about vaccines, no matter how tentative and preliminary the results. Nonetheless, the consensus among experts remains that a vaccine will not arrive until 2021 at the earliest. The logistics required to support mass manufacture and delivery of the vaccine could further lengthen the timeline.
On the data front, the major news is arguably the US data on activity and expenditure for April. The data for the first quarter of 2020 show a far more modest contraction in the US economy than in continental Europe. One plausible explanation is that lockdown measures came in to force later in the United States so the resultant contraction in activity occurred later and therefore had a smaller impact on the March data for the United States. The April data for the United States corroborate this hypothesis somewhat with retail sales, excluding autos, falling over 17% on the month and industrial production falling over 11% on the month. Nonetheless, it still seems likely that the absolute contraction in activity was larger in Europe. In Italy, for example, industrial production in March fell by almost 30%.
Policy measures – a pivotal moment for the European Union?
The major news this week was the Franco-German proposal for the EU Recovery Fund. If anything the size of the proposed fund is a slight disappointment – the EUR 500 billions figure is significantly lower than that discussed in an earlier plan, produced by the Spanish government. The proposal does however favour grants over loans. There is hope that this Franco-German plan could prove a pivotal moment in the creation of a genuine federal state.
The proposal has however not yet been adopted. It has already run into resistance from a familiar set of northern European countries. It may require diluting down in order to win the support of all countries. Moreover, we do not yet know how exactly the scheme will work and whether in particular, it will lead to the EU gaining tax revenue streams of its own.
There have been other significant development this week regarding the policy response to the crisis:
- As the focus shifts from nursing the economy through lock-down to supporting the recovery in demand, we believe that the case for further fiscal stimulus will build. In the United States, the Democrat-controlled House of Representatives has passed another USD 3 trillion stimulus package – called the Heroes Act – but it will not pass the Republican-controlled Senate. However, the Senate Majority Leader, Mitch McConnell has indicated a “high likelihood” that another stimulus bill will eventually pass after negotiation with the Democrats.
- The crisis will inevitably lead to a significant increase in government debt. Borrowing will automatically rise as the economy contracts and then the combined cost of socialising losses through the lockdown and stimulating demand in the recovery phase will lead to additional borrowing. This inevitably raises questions about how this additional debt-load will be serviced. The Governor of the Bank of England has signalled that his central bank will engage in persistent monetary financing to help the UK Government manage the huge cost of fighting the pandemic by “smoothing the profile of government borrowing and the impact that might have on financial markets”.
- Central banks will also need to provide sustained and significant monetary stimulus to the economy to support a recovery in demand once the social distancing measures are removed. One of the most contentious issues here is whether that stimulus should involve negative interest rates. Central banks have sent mixed messages on this point in the last week: Chair Powell continues to signal his discomfort with negative rates as a tool of monetary policy but several members of the Bank of England’s Monetary Policy Committee seem open to the idea in the United Kingdom.
- Activity data in China is showing a marked improvement as lockdowns are lifted and recovery gains ground. In our view, China points the way forward for those economies coming out of lockdown. In turn, this should be positive for oil prices as demand starts to pick up.
- In the short run, the current glass is half-full backdrop should continue for now with slightly lower volatility and markets drifting sideways. This cautious positive tone is supported by the expectation of more fiscal/monetary stimulus. However, the lack of implementation of fiscal support remains a risk and a source of volatility.
- The key headwind to implementation of additional fiscal support, is political fragmentation. This is currently delaying the introduction of broad-based fiscal initiatives in both Europe and the US.
- Whilst the market is pricing in a broad-based recovery, we see the risk that this recovery as being more uneven, pushing earnings and credit dispersion up, with entire sectors or even countries coming under significant pressure. Asset selection and risk allocation are likely to be more important than outright market calls in such an environment.