BNY Vantage Point Q4 2020 Non US
By Shamik Dhar,
Chief Economist of BNY Mellon Investment Management
Vantage Point
The fear of fear itself
For financial professionals and
institutional investors only.
Welcome to the latest edition of Vantage Point.
The Roman alphabet has outlived its usefulness – at least as far as labelling the economic recovery is concerned. Having spent six months talking about ‘V’, ‘U’, ‘W’, ‘L’ and even ‘K’-shaped paths, for this edition we have decided to ditch the letters and go back to a simpler classification. The course of the disease remains the single most important determinant of the kind of economic recovery we get, but we now think a simple ‘good’ or ‘bad’ classification covers everything we need to discuss.
In part that’s because the recovery we have seen to date has been very ‘V’–like in many parts of the world. China’s economy troughed in late March and Q2 saw a very quick return to pre-crisis levels of economic activity, at least according to the official data. In Europe and the US the economic trough came in April and May, and again we have seen a relatively rapid recovery in both household spending and industrial activity. The pickup has been less dramatic in the US and the UK than in Europe, but Q3 is likely to see very strong growth rates, probably double-digit in a number of countries. Real-time, high-frequency digital data confirm this.
Much of the economic and news commentary has been more downbeat however. The overwhelming concern seems to be the possibility of a second wave this northern winter, building on the upsurges we have already seen in a number of European countries, US states and major emerging economies like Brazil and India. Moreover, most economic commentators expect the recovery to be slow – many pointing to the decline of income support and large looming rise in unemployment as reasons to believe the bounce back will be short-lived and restricted to Q3.
We remain slightly surprised by the tone of the coverage. No doubt there are still plenty of things that could go wrong. Unemployment could rise sharply if fiscal support falls away sharply and not enough jobs are created in expanding sectors to make up for those lost in hospitality, tourism and the like. It could rise if widespread pessimism manifests as permanently higher precautionary saving by households and firms – saving that isn’t offset by even greater fiscal stimulus. It could rise if it takes a lot longer to match workers in hard-hit industries with new jobs, or because it takes time and a good deal of shoe leather to move to wherever the new jobs are.
But it strikes us there are as many good reasons to be optimistic about the outlook. We summarize these in a presentation accompanying this document: 7 reasons why the ‘V’ is still more likely than not. My own view is the most important of these are: (i) the data to date have surprised to the upside; (ii) the disease appears to be falling away quicker than expected in most countries (at least when measured by hospitalizations and deaths); (iii) there is a large amount of pent up demand still to be released; and (iv) the global fiscal and monetary stimulus amounts to around 15% of world GDP, much of which has yet to be felt.
For those reasons, we give our ‘good recovery’ scenario a 40% probability. Remember, we defined that scenario as one in which we get back to the pre-crisis level of global activity around the middle of 2021. For a number of European economies, which shrank by around a quarter in the first half of the year, that would mean opening up around a quarter of the quarter of the economy that was shut down, per quarter for four quarters – not a huge ask.
We also have another scenario in which the recovery is strong. So strong in fact that inflationary pressure starts to build much sooner than many had expected and central banks are faced with a dilemma in 2021. We were early to include an inflation scenario amongst our possible outcomes, and this is something the market has started to pick up on of late. Both inflation data and market inflation expectations have started to rise recently, while fears of overly-loose monetary policy, coupled with high levels of debt that will have to be inflated away, are driving some of that rise. As well as outlining the inflation scenario in this Vantage Point, we have also written a deeper dive to be released shortly that examines in greater depth some of the complexities around this subject. We still think this is an odd-against outcome, but its probability has risen to 20%. That means, together, our ‘strong recovery’ scenarios add up to a 60% probability – an odds on bet, or more likely than not.
To our ‘bad recovery’ scenario, which feels closer to the consensus, and in which unemployment stays high, we assign a 30% probability. A northern winter spike is an important element of this scenario, but it’s not the only factor. In this world, the pessimism we see and hear today becomes a self-fulfilling prophecy, as households and companies sit on their savings and governments are unable to offset the hit to private demand. To misquote FDR, ‘the fear of fear itself’ plays an important role in holding the economy back and we don’t return to the pre-crisis level of economic activity until mid-2022.
We have also reintroduced a ‘deglobalization’ scenario in which, irrespective of the course of the disease, the major influences on economic outcomes over the next couple of years are heightened geopolitical tensions and the shrinkage and diversification of global supply chains. That gets a 10% probability, so together, the nastier economic outcomes, driven by pessimism, winter spikes and economic restructuring sum to 40%.
The fear of inflation sits slightly oddly with the fear of mass unemployment. Economists often distinguish between so-called ‘Keynesian’ unemployment, and ‘structural’ or ‘frictional’ unemployment. The former refers to a situation in which a shortage of aggregate demand, coupled with an inability or unwillingness to provide fiscal stimulus generates high levels of involuntary unemployment. The latter describes a world in which the costs of matching available workers with new jobs rises and those higher costs persist, causing the natural rate of unemployment to rise. When ‘Keynesian’ unemployment exceeds the natural rate, wage and price inflationary pressures tend to fall, and vice versa.
One way of distinguishing our scenarios is by referring to the amount of each type of unemployment created. In the ‘good recovery’ scenario, there is little of either – because total spending returns to its pre-crisis level relatively quickly and labor markets are flexible enough to create new jobs quickly, especially at lower skill levels. In the ‘inflation’ scenario there is no ‘Keynesian’ unemployment, but perhaps the natural rate rises modestly – generating upward pressure on inflation expectations and therefore wages and prices, which cautious central banks accommodate. In the ‘bad recovery’ scenario, we see both ‘Keynesian’ and ‘structural’ unemployment rise, the former more than the latter, leading to deflationary pressure. Finally, with deglobalization, the rise in unemployment is largely structural, associated with lower aggregate supply and a rise in production costs, which also generates inflationary pressure, but later and for longer than in our ‘inflation’ scenario.
Cutting across all our scenarios is the prospect of a US election in November, which has important economic and market implications independent of the course of the disease. We discuss the repercussions for our forecasts and investment conclusions in a dedicated box.
No doubt readers will have different views about which outcome is the more likely, but one of the nice things about the scenario-based approach is it allows reasonable people to disagree in a situation of enormous uncertainty. At the same time, we still have to make decisions, not least investment decisions, based on our assessment of the future. As usual we compare our fan chart forecasts with what is priced into markets to help us draw those conclusions.
We hope you find Vantage Point a stimulating read from that standpoint. As usual, we welcome your feedback.
SHAMIK DHAR
CHIEF ECONOMIST
Executive Summary
WHAT WE THINK – ECONOMIC SCENARIOS
SCENARIO
‘Good disease’ – Rocking Horse
Disease continues to fall away – both because of changed behavior (social distancing, hygiene) and falling potency. Occasional regional/local flare-ups are contained and effective 4T (test, track, trace and treat) in a number of countries keeps global R rate below 1 and death rates falling until a vaccine is found early next year. Global activity reaches pre-crisis levels around mid-2021. Some rebound more quickly (China, South Asia), others more slowly (those encountering delayed ‘first wave’ now and some key EMs). Household finances are healthy in a number of economies, with high saving rates and relatively low debt – implies plenty of pent-up demand, even if saving rates don’t fall all the way back to pre-crisis levels. Corporate sector recovers more slowly, with large variation between sectors and those most reliant on face-to-face interaction (hospitality, travel etc.) the clear losers. But relative price changes encourage shift of resources to ‘winning’ sectors – so composition of demand changes even as overall aggregate demand restored to pre-crisis levels. Lagged effects of ultra-loose fiscal and monetary policy start to come through strongly towards end of this year. Inflation remains contained, since plenty of spare capacity. Rates on hold, no additional QE or fiscal packages, equities make moderate progress.
SCENARIO
‘Bad disease’ – Stormy Seas
Disease resurges as social distancing breaks down in a number of countries and northern hemisphere winter returns. Vaccine search proves unsuccessful. But as important as the course of the disease is the impact on individual behavior and confidence. Negative news coverage undermines confidence and becomes a self-fulfilling prophecy – boosting unemployment and bankruptcies as precautionary saving by households and firms stays high. Fiscal policy, constrained by concerns about debt, cannot replace weak private demand, while additional rounds of QE prove less marginally impactful. Those losing jobs in key industries struggle to find alternative employment, boosting long-term unemployment and undermining demand further. Likewise, bankruptcies of major companies reduce capital stock and raise the cost of capital. Inflation falls further, more countries are forced to consider negative rates and markets begin to focus on long-run debt sustainability. Flight to safety resumes – dollar and US treasuries rise as EM carry trade reverses sharply. Global financial conditions tighten sharply. Central banks are unable to offset this entirely and equities sell-off sharply.
SCENARIO
Inflation – It’s Back
Recovery in economic activity is also strong in this scenario, but unlike the ‘good’ recovery scenario, strong, fast growth in consumption meets constrained supply in some sectors. Firms pass on increased cost of doing business to customers. More broadly, firms raise prices to rebuild profit margins on the back of strong demand. Inflation data, at first weak and volatile, quickly starts to signal broad-based inflationary pressures. Under its new mandate, the Fed does not tighten until late 2022, significantly after inflation reaches the 2% inflation target. By then, inflation expectations are destabilized and prove difficult to get back under control. US real interest rates reach historically low levels. Equities and real assets perform strongly. But the US dollar takes the brunt, driven lower by expectations of low US real interest rates relative to other advanced economies. By the end of the forecast period, the Fed however starts raising rates, limiting the upside for risky assets and providing a floor to the dollar.
SCENARIO
Deglobalization – Closer to Home
In this scenario, irrespective of the course of Covid-19, we see a fundamental shift to protracted, full-scale deglobalization and a rise in geopolitical tensions. Covid-19 has simply accelerated the transition. Deglobalization leads to trade frictions, causing supply chains to shorten. Global trade disintegrates into 3 blocs: a European trade bloc; an Asian trade bloc centred on China; and an American trade bloc centred on the US, Canada and Mexico. Costs and the cost of capital rise, while fear of geopolitical fracturing/de-globalization leads to less investment. As a result, global growth is structurally weaker for some time, and inflation is higher. Global financial conditions tighten. Heightened concerns about IT security and the desire to protect national champions hits the tech sector hard, driving stock markets down. Eventually, economies will adjust as capital substitutes for cheap labor (automation) and domestic/regional supply alternatives emerge, but this takes time and in the interim growth slows and inflation rises for much of our forecast horizon.
SECTION 1A
Economic Scenarios
US LABOR MARKET – UNEMPLOYED PER JOB OPENING AND SMALL BUSINESS HIRING OUTLOOK
GLOBAL ECONOMIC SENTIMENT AND PMIS
Charts are provided for illustrative purposes and are not indicative of the past or future performance of any BNY Mellon product.
Past performance is no guarantee of future results.
US CONSUMER CONFIDENCE AND OUTLOOK ON JOB AVAILABILITY
US UNEMPLOYMENT DURATION
Charts are provided for illustrative purposes and are not indicative of the past or future performance of any BNY Mellon product.
Past performance is no guarantee of future results.
CHANGES IN PRICE AND QUANTITY FOR GOODS VERSUS SERVICES
DECOMPOSITION OF CHANGE IN US SAVINGS IN 2020
Charts are provided for illustrative purposes and are not indicative of the past or future performance of any BNY Mellon product.
Past performance is no guarantee of future results.
TRADE MEASURES INTRODUCED GLOBALLY
S&P 500 PRICE PATHS UNDER OUR 4 SCENARIOS
Charts are provided for illustrative purposes and are not indicative of the past or future performance of any BNY Mellon product.
Past performance is no guarantee of future results.
The illustrations are based upon certain assumptions that may or may not turn out to be true.
SECTION 1B
Economic Forecasts
The two solid lines show the most likely (highest probability) scenario mode or the “good disease” recovery and mean (probability-weighted average) forecasts. The darker bands towards the center of the fan chart show the more likely outcomes, while the lighter bands show progressively less likely outcomes covering 90% of the forecast distribution. The width of the fan chart shows the level of uncertainty and when the bands below the central forecast are wider than those above shows the balance of risks lies to the downside.
Charts are provided for illustrative purposes and are not indicative of the past or future performance of any BNY Mellon product.
Past performance is no guarantee of future results.
Charts are provided for illustrative purposes and are not indicative of the past or future performance of any BNY Mellon product.
Past performance is no guarantee of future results.
Charts are provided for illustrative purposes and are not indicative of the past or future performance of any BNY Mellon product.
Past performance is no guarantee of future results.
Capital Markets
SECTION 2
Section 2A
Capital Market Pricing – What is Priced In?
OVERALL
Looking across a wide range of different assets, price action suggests markets are expecting a reasonably strong recovery in economic activity, coupled with a long-lasting period of very easy monetary policy. Discount rates are low and payoff expectations relatively high, so valuations have moved up, especially for riskier assets. Inflation is increasingly a concern – as reflected in the rising inflation risk premium in breakeven inflation rates and inflation swaps. However, those concerns are not particularly elevated compared with historical inflation averages. Financial crisis fears have dissipated significantly since March – so relatively illiquid assets have done well too. Bid-ask spreads have narrowed, as have cross-currency bases, but perhaps the most important fear gauge has been the dollar, and its slide signifies the market’s perception that extreme left-tail outcomes have been averted by central bank and government intervention. That said, volatility levels remain higher than they were pre-crisis, and they appear to be more sensitive to geopolitical developments than they were pre-crisis when the volatility collapse could be attributed more or less to QE alone. The same is true of skews.
In summary, markets appear to be pricing in an outcome closer to our single-most-likely ‘good recovery’ scenario, as opposed to the bulk of economic commentary, which is more downbeat and closer to our ‘bad recovery’ scenario.
Election Update
SECTION 3
November’s US Presidential election is set to be one of high stakes, polarized viewpoints and an unprecedented mass mail-in voting process due to social distancing measures. Many expect polls to narrow over coming weeks, which is likely to bring uncertainty to markets up to Election Day, and possibly beyond, in the case of an unknown outcome. Historically, when a party change in the White House is expected, the S&P 500 shows weakness through September and October1, and we believe this season will be no exception. However, the main factor driving market sentiment through fall is the path of Covid-19 and the expected timing of a vaccine. If our “Good Recovery” scenario persists and we avoid an unmanageable second wave of the virus, market participants will focus more closely on hot button topics of taxes, law enforcement, unemployment and 2021 fiscal stimulus.
Predicting the effects of election outcomes is more straightforward for some sectors than others, and if the last election was any guide, the consensus view of broad market reactions can be wildly off-base. The sectors we expect to be most susceptible to election volatility are Health Care (affected by messaging around drug pricing and affordable access to care) and Technology (affected by messaging around trade and privacy regulations, likely to come from both candidates). Although the Presidential race is certainly one of consequence, the Congressional election arguably has the potential for as much, if not more, impact on markets going forward. Fiercely contested issues such as corporate tax levels, health care and fiscal spending through the recovery are items that require Congressional support and face stark party divisions. Despite volatility that could ensue due to election uncertainty, we do not believe it is a reason to take a defensive stance or try to position portfolios to “win” based on election results. Maintaining proper protection for risky assets is always prudent, but staying present in markets during the recovery process is also a key factor in reaching investor goals.
A major policy difference concerns the corporate tax rate. Rightnow estimates for the 2021 S&P earnings are $165. Everything else being equal, an increase of the corporate tax rate from the current 21% to 28% would shave SPX earnings by10%, meaning the new baseline is roughly $149. That is a top line result and the companies which pay the full corporate rate will be more affected than those that pay a lesser rate. Inorder to implement a new corporate tax rate though, a Bidenadministration would need Congress and presumably aDemocratic Senate because tax law can only be passed by Congress. There may be some partial counterweights to higher rates in a Biden administration in that the removal of China tariffs could help offset some of the hit to corporate profitability that would come from higher taxes. Trade policy is controlled by the administration without the need for Congress to act. If all tariffs were removed, an estimated $9 per share would be added back, for a net earnings expectation of $158 per share for 2021.1
Charts are provided for illustrative purposes and are not indicative of the past or future performance of any BNY Mellon product.
All investments involve risk, including the possible loss of principal. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.
FORECASTS
Projections or forecasts regarding future events, targets or expectations, are only current as of the date indicated. There is no assurance that such events or expectations will be achieved, and actual results may be significantly different.
RISKS
Equities are subject to market, market sector, market liquidity, issuer, and investment style risks, to varying degrees. Bonds are subject to interest-rate, credit, liquidity, call and market risks, to varying degrees. Generally, all other factors being equal, bond prices are inversely related to interest-rate changes and rate increases can cause price declines. Commodities contain heightened risk, including market, political, regulatory, and natural conditions, and may not be appropriate for all investors. High yield bonds involve increased credit and liquidity risk than higher-rated bonds and are considered speculative in terms of the issuer’s ability to pay interest and repay principal on a timely basis. Investing in foreign denominated and/or domiciled securities involves special risks, including changes in currency exchange rates, political, economic, and social instability, limited company information, differing auditing and legal standards, and less market liquidity. These risks generally are greater with emerging market countries. Small and midsized company stocks tend to be more volatile and less liquid than larger company stocks as these companies are less established and have more volatile earnings histories. Currencies are can decline in value relative to a local currency, or, in the case of hedged positions, the local currency will decline relative to the currency being hedged. These risks may increase volatility. Alternative strategies may involve a high degree of risk and prospective investors are advised that these strategies are appropriate only for persons of adequate financial means who have no need for liquidity with respect to their investment and who can bear the economic risk, including the possible complete loss, of their investment. The strategies may not be subject to the same regulatory requirements as registered investment vehicles. The strategies may be leveraged and may engage in speculative investment practices that may increase the risk of investment loss. Investors should consult their financial professional prior to making an investment decision.
INDEX DEFINITIONS
US Consumer Prices (CPI) Index measure of prices paid by consumers for a market basket of consumer goods and services. The yearly (or monthly) growth rate represents the inflation rate. The 10Y US Treasuries Average Yield of a range of Treasury securities all adjusted to the equivalent of a ten-year maturity. The CBOE VIX Index (VIX) is an indicator of the implied volatility of S&P 500 Index as calculated by the Chicago Board Options Exchange (CBOE). The Majors Dollar Index (USD) measures the value of the US dollar relative to a basket of currencies of the most significant trading partners of the US including the euro, Japanese yen, Canadian dollar, British pound, Swedish krona, and Swiss franc. The MSCI EM Index (Emerging Markets Equities) tracks the total return performance of emerging market equities. The S&P 500 Composite Index (S&P 500) is designed to track the performance of the largest 500 US companies. Europe STOXX 600 Index represents the performance of 600 large, mid and small capitalization companies across 18 countries in the European Union. Bloomberg Barclays US Corporate High Yield: covers the universe of fixed-rate, non-investment grade corporate debt in the US. Bloomberg Barclays US Corporate Investment Grade: designed to measure the performance of the investment grade corporate sector in the US 1-mth. 1-year forward swap: the avg. interest rate for 1-mth. in 1-year forward. GDP: gross domestic product is the total monetary or market value of all the finished goods and services produced within a country’s borders over a given time period. Fed funds Rate: the target interest rate for overnight lending and borrowing between banks. Purchasing Managers Index (PMI): An economic indicator derived from monthly surveys of private sector companies. A level above 50 indicates expansion compared to the prior month and below 50 contraction.
STATISTICAL TERMS
Skewness in statistics represents an imbalance and an asymmetry from the mean of a data distribution. In a normal data distribution with a symmetrical bell curve, the mean and median are the same. Probability-weighted mean is similar to an ordinary arithmetic mean, except that instead of each of the data points contributing equally to the final average, data points are weighted by the statistical probability for a particular scenario outcome. Duration is a measure of a bond’s interest-rate sensitivity, expressed in years. The higher the number, the greater the potential for volatility as interest rates change. Z-score: number of standard deviations from the mean a data point is.
Other
R: the number of people Covid-19 is transmitted to per person. QE: quantitative easing.
BNY Mellon Global Economics and Investment Analysis team
Shamik Dhar
Chief Economist
Lale Akoner
Market Strategist
Alicia Levine, PhD
Chief Strategist
Bryan Besecker, CFA, CAIA
Market Strategist
Liz Young, CFA
Director of Market Strategy
Sebastian Vismara
Financial Economist
im.bnymellon.com
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IS-142708-2020-09-28
