28 August 2020

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Macro update

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Steven Bell Chief Economist

Markets versus the virus: big changes ahead Let’s start with the virus. Looking at data for the 7-day moving average of new virus cases, there’s been a major peak in the US and the rate of new cases remains high. In emerging markets, we can see a peak in the two worst affected countries, India and Brazil, but still very high infection rates. And looking at Europe, despite the recent dip, major second waves are underway in France and Spain, and Germany is still relatively low but gradually getting worse.

What does this all mean?

I have argued in these webinars over the last few months that we will defeat the virus – the economic cost will be huge but the policy of suppression with gradual easing of lockdowns would succeed. Recent evidence has caused me to change my mind.

It’s now clear that we have reached the limits of this approach and the virus is fighting back. Outside of China, lockdowns are being re-imposed, from South Korea to Madrid. As long as social distancing remains, economic recovery will be incomplete. And the approach of autumn in the northern hemisphere does not bode well. Treatments are improving; the second waves are focused on the young who are more resilient; fatality rates are falling. But financial markets are pricing in a full recovery in corporate earnings and as things currently stand that will not be the case.

Suppression of the virus appears to have reached its limits, and this has been with strict measures. For the UK, as we continue to ease lockdown measures, the weather changes and we congregate more indoors, we have to expect an increase in cases. But a successful vaccine would be a game changer, not just for the UK but globally.

Suppression of the virus appears to have reached its limits – as long as social distancing remains, economic recovery will be incomplete.

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What about the near-term outlook for economies and markets?

At the global level, we’ve had a massive policy response, and as benchmark government bond interest rates have hit record lows, this has been a huge support for risk assets as well as the gold price.

Response to the employment challenge has varied widely. There has been a huge rise in US unemployment. But in Europe, governments have been able to keep many workers attached to their jobs even if they’re not actually working – arguably a better system. The US had been giving very generous unemployment benefit, at $600 per week. But that programme expired, and the White House and Congress have failed to agree on a replacement, and that is hitting consumer spending hard.

However, despite this, and despite second waves of infections, both the US and Europe are recovering strongly according to the closely-watched Purchasing Managers’ Indices (PMIs).

UK recession worst for Q2, but all is not as it seems

When it comes to the UK, the general view is that our economy has been hit hard, but the reality may be quite different. The OECD has reported that the UK’s GDP fell the fastest in the world in Q2 – we have had the worst recession on that measure. But that owes much to the unusual way we measure health care prices. The truth is that our recession probably wasn’t very different from the European average.

And high frequency data is showing a powerful recovery. Electricity, a real time measure of manufacturing has surged, retail spending is actually above pre-Covid levels, and the ‘eat out to help’ out scheme is transforming restaurants.

Analysts have been cutting their forecasts for earnings since March, with the UK equity market seeing the biggest cuts, but I expect that to change. I anticipate around 15% quarter-on-quarter growth for the UK for the third quarter. The current consensus is 10%, but surprises are still very positive, and this should feed through to improved forecasts.

Headwinds in the US

However, there are negatives. The power struggle between the US and China goes on. Trump doesn’t want to impose any more tariffs on China ahead of the Presidential election, so for now, there is a truce on trade. But other issues, from Huawei to intelligence, military manoeuvres to Hong Kong, things are tense. And as for the upcoming elections. The odds of a Democratic ‘clean sweep’ (President plus control of both the House and the Senate) have increased. That could usher in an anti-business administration with higher corporate taxes, higher income taxes on the wealthy, greater regulation,

including even the break-up of Google and Facebook, but the race is far from over.

So, we have an improving world economy, stronger earnings to support stronger equity markets despite political tensions and uncertainty. But this could all run into the sand if the virus continues to gain ground. And that is where the vaccine comes in.

Positive news on the virus, but markets yet to price this in

The Oxford vaccine has passed its phase I and II trials, which means it’s safe, it produces antibodies and T cells. The phase III trial tests whether it works to protect against catching the virus. That involves recruiting tens of thousands of people, and the initial signs are good. One estimate put the chances of success at 80%. And if for some reason the Oxford vaccine doesn’t work, I believe it is likely that one of the others, and there are many others, will work. The Oxford vaccine does have many advantages; mass production is already underway, and it can be chilled rather than needing very low temperatures for storage. If the early results are good, there will be enormous pressure to grant regulatory approval and begin a mass vaccination programme in the UK before the winter. Food distribution companies – who have the capacity for large scale distribution of chilled product – have been contacted and polling stations are to be used for the actual vaccination.

Just how radical a mass vaccination programme would be is only just beginning to dawn on financial markets. The prospect of a vaccine has been long discussed, but the extent to which it would be a game changer has only become a major topic in the last week or two. It is far from being fully priced in by markets.

Risk assets have the potential to outperform

The policy of suppressing the virus has allowed the world economy to begin recovering. But it has more or less reached its limit. We need a vaccine to move ahead. And that would be positive for risk assets.

Just how radical a mass vaccination programme would be is only just beginning to dawn on financial markets. We need a vaccine to move ahead – and that would be positive for risk assets.

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Q&A

QYou mention that markets have priced in a lot of positive news already, does this mean that as we move into autumn and winter with the increased potential for second waves on infection, markets are vulnerable for negative corrections?

A Yes it is a possibility and I would be cautious. Markets are hugely driven by news flow and expectations. For example, the raft of negative

news flow earlier in the year when the virus took hold and much of the world was in lockdown led analysts to sharply cut their estimates for US corporate earnings, leading to a 44% drop in earnings estimates from before the pandemic. Actual earnings came in at a 35% drop, better than expected, so relatively, this was taken as good news. Conversely, when you have a full recovery of earnings priced in for next year, then there is a very real possibility of disappointment, and this can negatively affect markets. The most recent news flow has been positive on economic data, strong US capital goods (vehicles, machinery and equipment) orders, positive French business data, much stronger UK economic data. This is good but it won’t come through indefinitely, restaurants and public transport can’t go back to full capacity any time soon. The only thing that could change that is a successful vaccine. Yes, there will be market setbacks as more negative news gets priced in but the chances of a successful vaccine are high – I think high enough to make positive investment decisions.

QThe economic cost – is it really worth it considering the low fatality rate of the virus?

A We have responded to this crisis in the same way people in the middle ages did to the plague – we quarantined people. We actually quarantined the

entire population, and I think when we look back, we will surmise that we overreacted. But at the time we knew very little about the virus, its impact on the young, ethnicity, prior medical conditions and long-term effects. Even if there is a large second wave I don’t think we will go back into a full lockdown again.

QAre earnings estimates too high compared to GDP growth expectations?

A As I explained in the webinar, analysts earnings estimates a year ahead are always too optimistic. So if you knock 5 to 8% off earnings estimates for next

year, you get numbers that are a little lower than pre-Covid levels. However, I think earnings will recover to pre-Covid levels, and I think estimates will improve as more positive economic data comes through, and there will be a further boost if we get positive news on a vaccine. In addition, central bankers will be "virtually" meeting for their annual Jackson Hole summit, and they will tell us that rates will stay low for an extended period. There will continue to be downward pressure on inflation as unemployment levels remain elevated. Central banks have learned their lessons from the aftermath of the Global Financial Crisis, where they raised interest rates too early, which caused serious problems. Short-term interest rates will remain low and this is positive for risk assets, as the alternatives of cash and bonds look unattractive. The huge improvements that we have seen in markets since March will not be repeated but I still expect a decent return from equity markets going forward.

QInput prices are already at pre-Covid levels and there has been news that food prices are starting to move upwards – your thoughts on inflation over the next 9 months?

A On input prices – they used to be called raw materials and fuel prices – oil and copper wire prices have picked up, but this has been a unique recession

as manufacturing has been relatively immune and it has been services that have taken the brunt. There has been a lot of pent-up demand, consumer durables sales have been really high and there have been some supply issues, but most of the input costs rise has been due to oil prices going from very low levels back up, so I’m not worried about input price inflation or manufacturing inflation. Yes, we will see some cost increases: restaurants, hotels, airlines. But broad-based inflation, which includes wages, I do not think will increase – some analysts do, but as long as there is slack in the economy then the outlook for inflation is pretty benign.

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QUnemployment – this is likely to tick up, do you think it will impact consumer-reliant economies such as the UK?

A It is a risk. Many people have taken six months of mortgage holidays and neither the lender nor the individual knows if they can afford to resume

payments. Over the fourth quarter, the government will unwind the furlough scheme – at one point, one-third of the UK’s workforce was furloughed with the government paying 80% of wages. There will be some redundancies and bankruptcies but I think that the fiscal package has been extremely successful and there hasn’t been the complete collapse in employment that many feared. The ‘eat out to help out’ scheme and cut in VAT have helped a pickup in the economy. The recovery will have headwinds but governments can roll over this debt, and the savings ratio for many has actually gone up, so I think there are enough tailwinds to keep the recovery going.

QIf there is no vaccine this year, and a no deal Brexit, what does the start of next year look like? And what happens if there is no vaccine at all?

A A vaccine is not fully priced in to markets but it is partially priced in, so if there is no vaccine, markets look vulnerable. There are actually over

200 vaccines being worked on, but of course there is no guarantee that any of them will be successful. Regarding Brexit, during the negotiations there have been very substantial concessions on both sides – regarding fishing from Europe, and on the Irish border from the UK. The big problem has been the continued insistence on limits on state aid from Europe, which means that Europe could pass legislation that we would agree to match, and we have not conceded on this. Europe has also only offered a very ‘skinny’ trade deal, not covering proper rules of origin, nor covering financial services, or indeed any services. So the UK is thinking what is the point of agreeing to this when it is hardly more substantial than World Trade Organisation rules, which would mean very small tariffs. This would arguably hurt Europe more than the UK in some industries so Europe has to come up with a trade deal that is substantial enough for the UK to agree to. And a further issue is that this has to happen by October or it will not leave enough time for the deal to be ratified. I believe Boris Johnson wants a deal, but he will not agree to a deal where the European Court of Justice impinges on UK sovereignty.

The UK market is currently priced at a discount, this is partly due to sectoral composition, as there is a big

banking sector and these are currently out of favour. We are still mildly negative on the UK equity market even if the UK economy looks as if it will do a lot better than many expect. The FTSE 100 gets most of its revenues from overseas and this is a problem, but for more domestically-focused companies there could well be some upside.

QOver to the US – you mentioned the government possibly breaking up the big tech companies – is this possible? And if they did, what would the impact on the market be?

A If they could separate the data storage arms of Google and Facebook from the social media side, it would weaken these companies substantially. There

is a growing opinion among Democrats and the wider public that these companies are becoming too big and too powerful. It feels similar to the anti-trust movement at the turn of the century, back then it was the oil and railroad companies that people felt were too powerful and were overcharging farmers and the public. There is not the same sense of antagonism now as there was back then, because a lot of the services that these tech companies are offering are free, but there is still a real appetite to protect personal data. What we should remember is that Joe Biden has been out of mainstream politics for a long time, so we don’t really know what he is going to do. History tells us that, over the past 100 years, no president has won re-election when there has been a recession in the election year; but let us also not forget that many pundits, including myself, got it wrong that Trump would be elected, and also that he would be bad for markets.

QYour thoughts on the dollar, and on commodities?

A We have been bearish on the dollar because the economic data was improving strongly in Europe, the US was about to suffer from a

second wave, and the consumer confidence data in the US was weak. But the dollar has moved, positioning is now much more neutral so we are less bearish now. For commodities, they have rallied, the Chinese economy has recovered significantly, domestically it is booming, there is only weakness from external demand. There is a huge infrastructure push in China so construction is strong and this is a big boost for commodities. It is very unlikely that we will see the oil price dip as we saw earlier this year.

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QWhere do you see the price of gold at the end of this year?

A Gold is a very special commodity – there is no real production, it is not really used for anything, it is just about holding the stock. Central banks are the

biggest holders of gold; if they are worried about US assets, and about the negative Bund yield, then there are no real alternatives and this is supporting gold. So I think gold will head higher into the end of the year. But looking further out, over two years or so, if there is a pickup in rates, this would be bad for gold, but I’m not bearish right now until the end of year – there will still be demand. I don’t see gold outperforming equities over the longer term, I think it is more volatile, and I don’t think gold acts as an inflation hedge.

QIf inflation does pick up, what do you think central banks will do?

A Central banks can tolerate some upwards pressure as inflation is well below most targets. Europe and Japan have been trying to bring inflation up to target

but have got nowhere near. If there is a real pick up above target, and heading higher, then central banks would be forced to take action, but only if it was clear that it was a long-term trend, as there is evidence that inflationary pressures can disappear relatively quickly. Interest rates are likely to stay lower for longer, but the threats of further rate cuts and negative rates have now dissipated.

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QIn light of the enormous pile of debt that we are accumulating, what is your view of government bonds and how do governments deal with these debts?

A I’m bearish on gilts as I think our economy is

recovering. There is a lot of supply, benchmark 10-year gilts are currently yielding 0.3%, they are incredibly

low, and there is still downward pressure on government bonds. When I was at the Treasury many years ago and the medium-term financial strategy was wobbly, we were looking to have a debt target. I looked into the history of government debt, we have 300 years of data, and the debt-income ratio has been all over the place, from 350% of GDP down to zero. I could find no impact on economic activity, or growth, or inflation. It is our institutions that own a lot of our debt, and as long as we print our own currency then there is very little threat from the high level of debt, there is no ‘debt trap’.