Markets continue to make new highs despite the underlying economic outlook remaining severely challenged.
Another relatively quiet week saw US equities post new record highs, with the Nasdaq now up 30% since the start of the year. Speaking at the Jackson Hole meetings, Federal Reserve (Fed) representatives announced widely anticipated changes to its policy framework.
Revisions to the Fed approach will mean that the FOMC won’t rush to tighten policy pre-emptively if inflation remains at target just because of strength in the labour market or broader economy.
Furthermore, in allowing inflation to modestly overshoot its target in order to correct for periods when it has undershot, so it is hoped that the decline in inflation expectations over the past couple of decades can be arrested.
The corollary of this may mean that no hike in Fed Funds occurs before 2023, or even until 2025, depending on the strength of the recovery following the emergence from the Covid-induced recession.
On the back of these announcements, Treasury yields moved slightly higher with the yield curve bear steepening. However, with economic data painting a mixed picture, it would seem premature to us for rates to rise very far against the backdrop of elevated unemployment.
From ‘U’ to ‘K’ recoveries?
Away from these adjustments to policy framework, much of our recent dialogue with central bankers has focused on the increasing level of concern that monetary policy is driving asset-price inflation at a time when the underlying economic outlook remains severely challenged.
The different experience of Main Street versus Wall Street has led to a description of a ‘K’ shaped economic recovery, noting the degree of divergence in the respective trajectories.
Ultimately, this speaks to the limits of monetary policy to deal with the challenges facing the economy. In this week’s public comments from former Fed Chair Janet Yellen, there appears a growing pushback from central bankers that more needs to be done to address this situation via the fiscal policy channel.
In ongoing deliberations regarding additional fiscal stimulus in the US, or with respect to the imminent end to furlough payments in the UK, there appears a risk that fiscal support is being rolled back too soon.
However, if this leads to another economic dip, it is not clear what central bankers can be expected to deliver. Overreliance on monetary policy risks creating social tensions by widening the wealth gap between the small percentage of asset owners and the rest of the population facing higher unemployment and shrinking incomes. Yet buoyant financial markets may provide a disincentive for those responsible for fiscal policy to act with any great urgency.
Weaker economic data could spur greater action and it will be interesting to see whether next Friday’s payrolls report challenges this complacency. Though for the time being, it may appear that the trends we have been witnessing for the past several months could continue to play out in the absence of a new catalyst capable of creating a revision to the market or policymakers’ mindset.
Divergence in Europe
Central-bank thinking may mean that the bar to additional monetary stimulus is higher than some in the markets are given to perceive. However, it is hard to see central banks turning more hawkish in their comments any time soon.
In the US, the Fed is likely to be as passive as it can be in the next couple of months in the run-up to November’s election. Meanwhile, in the EU a pick-up in Covid-19 infections and additional measures curtailing economic activity means that risks are skewed more to the downside, especially in the Southern European countries whose tourist season has struggled to ever get started. This may put more pressure on the ECB to be dovish at its September meeting, yet we detect strong internal resistance to the idea of extending or adding to existing asset purchase programmes in the months ahead.
It also seems likely that there will be substantial divergence of performance across the Eurozone, with upward revisions to growth estimates in Germany and other countries in the north standing in contrast with further downgrades in Greece, Portugal, Italy and Spain.
For now, we believe that bond markets in the European periphery are well supported by the financial repression driving investors towards higher-yielding assets in a negative-rate world.
However, as we look ahead into 2021, it appears that there is scope for increased political divergence within the Eurozone and for increased populism at a national level, should the economic recovery fail to lower unemployment relatively quickly. This may limit how far spreads can tighten in the interim. In this context, we are inclined to continue to look for opportunities to reduce remaining exposure on any strength.
Uncertain outlooks call for greater selectivity
Corporate bond spreads have been little changed over the past week as levels of new supply have started to pick-up ahead of the seasonally busy period during September, once summer comes to an end. Refinancing activity in the high yield market has helped to lower prospective default rates in 2020, with potential insolvencies deferred into 2021 or 2022.
By this time, it is hoped that a vaccine will have passed testing and been deployed, such that economic activity can return towards end-2019 levels, meaning that the Covid-19 recession is able to pass over without nearly as many corporate restructurings as have been witnessed in past economic cycles. However, this may yet prove to be a complacent view should demand fail to normalise as quickly.
Moreover, the scale of economic destruction during 2020 seems likely to leave many lasting scars and in sectors such as commercial property, retail or business travel, the outlook could be profoundly different to what we saw prior to the pandemic.
Being selective with respect to sector and issuer selection is likely to remain extremely important. We would also expect divergent performance to be more pronounced once the tidal wave of central bank liquidity and asset purchases starts to dry up.
News from Japan
FX and emerging markets traded sideways during the past week. EM credit has been consolidating recent positive performance, whereas weakness in EMFX has been slow to reverse.
In the UK, the EU and UK remain far apart with respect to a Brexit trade deal and this has led to some hope that Brexit will be delayed beyond the end of this year.
However, this seems unlikely to us given the ideological commitment on the part of those in the Johnson administration. This may yet be a tactic to make Brexit hardliners more willing to compromise but we suspect that before we reach such a point, the reality of a no-deal scenario needs to be stared at more closely – cue stories with respect to shortages of food and essential medicines in the UK come Christmas time.
Elsewhere, the resignation of Prime Minister Abe in Japan on health grounds came as a surprise to markets. However, we doubt that a change of leadership in Japan will lead to a change in the policy framework and so this may not be particularly significant with respect to yen markets.
US politics remain in focus
This week saw the Republican convention, with the platform dominated by members of Trump’s own family. Attempts to discredit Biden and stoke fears with respect to law and order in the wake of rioting – following yet another outrage after the distressing shooting of Jacob Blake in Kenosha – appear to be helping to support the Trump base.
The gap between Trump and Biden has now narrowed to a few percentage points and it is also striking to recall that Hilary’s lead over Trump was actually bigger than Biden’s lead over the President at this exact stage in the campaign four years ago.
In this context, it would be wrong to write off Trump just yet, even if it appears very tempting for much of the liberal media to do so, as is particularly true in countries in Europe, where the election of Trump as president confounded commentators in 2016 and has been a source of disbelief ever since.
Maintaining a focus on facts and data will be important during an ideologically charged campaign – albeit one which seems to hold limited relevance for financial markets for the time being.
The payrolls report at the end of next week is likely to provide focus going into the Labor Day long weekend. With the UK on holiday on Monday, we might expect another impacted week before the proper ‘back to school’ ramp-up in activity resumes the week after. More broadly speaking, it seems like much attention in September will also focus on whether rates of viral infection can be contained with kids back in the classroom and increasing numbers returning to the workplace.
Optimists will hope that any bad news on increased numbers of infections won’t lead to a corresponding climb in the rate of hospitalisations and mortality and hope that good news on a vaccine is just around the corner.
In the US, newsflow on the virus has been somewhat better in the past couple of weeks, just as it appears to turn worse across Europe. Yet this may, in turn, breed complacency and subsequently lead to disappointment. These remain uncertain and unprecedented times and maintaining a somewhat cautious stance as a benign summer draws to a close feels warranted for now.
Turning back to US politics, it will be interesting to see whether stock-market gains can continue to give Trump a bit of a boast in the polls.
Mind you, Joe Biden could always remind voters that the S&P 500 Index stood at just 9.2 points in the month when he was born and has rallied 37,200% since then. If that makes him sound a bit old, then it is worth reflecting that Tesla stock has nearly climbed by that much since 2013 (the year that Biden celebrated his 70th birthday). Go Joe!