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Episode 26

The long road from lockdown

Published on: April 28, 2020 • Duration: 17 minutes

This week we look at the speed with which economies can emerge from lockdown and the ability for consumers to recover. Many investors are now realizing that recovery will be a slow process, but price distortions in the US market may be giving a false sense of hope. 

  • [00:00:04] Many economies are now turning their attention to exiting the lockdowns. But what does that mean for economic activity, and does this alter the expectations for fiscal and monetary stimulus? That's The Big Conversation. So a lot of countries are now talking about coming out of, or least easing some of their lockdown criteria. Italy is expected to start coming out in one week's time with lots of caveats, that obviously if there's a recurrence, they will be straight back into a severe lockdown. New York's planning on too, Germany is already coming out, and the U.K., although still lagging, there's certainly a lot more talk. And because these numbers are just so shocking and because this is clearly a downturn that is so severe, this is the reason why people now rationally saying that we've got to come out of lock down, there has to be now be a balance between the risks of the the disease itself versus the risks of destroying the economy because these numbers are so bad. So these numbers are just exceptionally poor. And as a result of that, people are trying to at least, governments are trying to say, look, we need to come out of this lockdown. We need to kick our economy or else the cure is worse than the disease. I think this is very much now the very heart of this reopening debate that we're seeing pretty much across most of the Northern Hemisphere. 

    [00:01:21] But you can see it when you look at these services, PMI data from Europe and also the US, but particularly Europe, where we saw France service PMI down around the 10 level. And for the overall composite of Europe, it was about 13. Normally, we never see numbers below the 40 regions, so these are absolutely stunning numbers. We're also looking at the US and the jobless rate. And obviously we've seen those initial jobless claims. They've been absolutely huge, not quite off the chart but the nearest thing you can get to that. And they've been persistently poor -five times the previous peaks on an ongoing basis now for four or five weeks. With many thinking that in the US, the overall unemployment level could reach 16 percent. And I think it was more like 10 to 12 percent in the great financial crisis. So when people say unprecedented, these are unprecedented numbers. But as I said, I think the assumption is because the fall itself was so hard and so fast, the expectation is that we will get a rapid rebound. And I think we need to look into what is the reality of that rebound going to be like? In fact, what is the reality of reopening going to be like, and what are the opportunities within that? This week, we've got some of the central banks, the Bank of Japan, which today they have now announced some unlimited bond buying, so they've effectively joined QE infinity, although some would argue that they were already there in many ways. We've seen the Fed on Wednesday and then the ECB on Thursday and I think Europe is a particularly interesting case and it's one where I think there are going to be opportunities for other regions versus Europe because of the inability of Europe to really come up with a clear and fast package. What we've mentioned before is that a lot of the response will come down to the impact on the real economy versus in what many ways we're seeing in financial assets, where in some financial assets are doing remarkably well. We've mentioned this in previous episodes, and I think it's worth reiterating again. When we look at the oil price, and obviously last week was a sensational week for oil markets, particularly in the US. The oil price this morning is down around about 7 or 8 percent once more. This is the WTI version. And there have been some issues around that with the expiry last week, and the WTI futures contract obviously went into negative territory and then sold off I think more dramatically on the Tuesday when the price discovery had already shifted to the June contract because it was the May contract in which we saw all the fireworks, particularly last Monday, with the price going deeply into negative territory i.e. people paying others to take oil away. Part of this is due to the fact that WTI is a physically settled future, one where you take delivery of the underlying commodity, so an oil tanker turns up at your door. You can take exchange for physical as well on Brent, which is the global benchmark, but you can take a cash alternative there. So it's not always physical delivery. And this is why we've seen a little bit more activity in WTI because of its landlocked status and again, some other minor oil indices in North America which had already gone into negative territory. But what this reflects, and particularly what we saw last Tuesday with the sudden rollover again in oil prices in that price discovery month of June, is that the real economy remains very much out. The demand is not there. But obviously, the supply is still being pumped out and those cuts are now coming. We can also see the difference between not just the real economy, which is in oil, which is in employment, which is in the macro data that we're getting versus the financial economy. We can also see the difference between many of the US financial assets, particularly equities versus other markets. We talked about the S&P. The S&P has rebounded. It's between 50 and 62 percent. We've called this a common or garden rebound. It's very much in line with all the rebounds that we've ever seen from major market sell offs. When you look at Europe and many of the other global equity markets, they've not been quite as impressive, particularly Europe. If we look at the Stoxx600, the rebound so far in Europe has barely been to the 38 percent retracement level. These are simply guides just to give us an idea of how strong a rebound and how good the performance is. But the real question here is going to be, is the consumer going to bounce back? So it's all very well seeing financial losses bounce back because of that support from central banks where there is a transmission mechanism from that liquidity into financial institutions and then into the into the market. And of course, the rebound that we have seen even in the US, has been on significantly lower volume and poorer breadth from the sell off that we saw. But it's really all about the consumer. This has been a hit to the consumer, as we saw from those PMI figures. The service PMI figures in Europe and the US, much more so than manufacturing. The problem for manufacturing, if manufacturing returns, but the consumer doesn't, who are the manufacturing nations manufacturing for? Where is the demand coming from for those goods? It's much easier to restart a business than it is necessary to restart aggregate consumer demand. And so therefore, there is a risk that we could get some deflation out of this in that if we start building up inventories once more, but without the consumer really coming back to the game, then down the road, whilst we might see in manufacturing areas and manufacturing industries some feeling that normality is starting to return, albeit to a lower level. If you're producing goods but the consumption side is not picked up, then you're going to have a glut just like you have in the oil market. So are financial assets really reflecting this are they just reflecting central bank largesse and obviously the expectation of some fiscal stimulation? But I think one of the problems for that fiscal side, the stimulating of demand is, as we've seen in both the UK, to lesser extent in Europe and some European countries such as Switzerland have been quite efficient, funnily enough, at doing this and in the US, we're not seeing the fiscal packages getting through to the real consumers and the real small businesses in the way that we'd want to, such that the smaller end of the corporate spectrum is very much under a lot of pressure. But that's where the majority of new jobs are found, and that's where actually the majority of all labor and employment is found. So if these are areas which are still in need of being unblocked then the expectation of consumers to bounce back is going to be very, very much limited. And I think that is going to be the absolute key for the rest of this year and for financial assets. Remember, in a lot of economies, for he consumer and services are the biggest section, even in heavily industrialized economies such as China, the consumer is still around about the same, if not slightly more, just edging the manufacturing side of things in Europe and the US manufacturing at least true manufacturing industry is between 10 and 20 percent of most economies. So if the consumer remains in self-imposed lockdown, and in many cases it's still actually the social distancing is still part of the fabric of the government's itself and what they're putting out. But if we see this very, very much social distancing taking place within the services sector, then it has to be a very, very slow return to normality. In fact, can we even call it a return to normality? Certainly we're coming out of a lockdown. And I think this is really then goes on to how much can central banks and governments step into that breach? And this is where we're seeing some very interesting differences or potential opportunities between different regions. And the central bank response is something which I've talked about quite a lot in previous episodes. In fact, back on the 20th of March, I said we're going to need a bigger bailout. And actually, it's three days later when the Federal Reserve announced another 2 trillion plus package, particularly targeting corporate bonds and junk bonds. We've seen central banks have a response. This is the monetary side. We've got the monetary, which is the central bank liquidity, and then we've got the fiscal, which is generally going to be debt spending and then that's going to be financed by the central banks. But we've seen a response from the Fed and their balance sheet expansion, as we've talked about before, has been quite dramatic with some estimates now for the Fed's balance sheet potentially reach 10 trillion by the end of the year. Some others say 9. But whether it's nine or 10 doesn't really matter. These are huge numbers. The ECB response is still very much a classic response from Europe where the potential is there, but the ability to reach that potential is hindered by the number of people who have to agree. It looks like the ECB is going to descend back into offering loans for regions which need the money the most rather than socializing the overall debt i.e. it's not going to be northern countries paying for southern countries just yet. And that's still going to be a very existential sticking bloc for the forseeable future, which will be a drag on the European response itself. But we've also started to see the PBOC, the People's Bank of China. They've started to increase their balance sheet. So we've had a significant increase year on year and the absolute level of their balance sheet. Now, obviously, if you actually then change this for GDP, these are much, much smaller numbers. But in absolute terms, there has been a relatively large response from the PBOC. But they and they've been relatively reticent up until now. But I think as the market reopens and the economy reopens, but it reopens at a much slower pace, then all the central banks are going to be coming in, and as we mentioned, the Bank of Japan has just moved towards unlimited QE as well. In last week's episode, we actually talked about the opportunities in emerging markets. We highlighted three particular currencies Brazilian Real, Mexican Peso and South African Rand. Since then, we've had quite a big move in US Dollar versus the Brazilian Real to the upside. So U.S. Dollar strength, Brazilian Real weakness. Now, there are some idiosyncratic political issues around that, but it's a bit like in 2007/2008 there were a lot of issues that swept through individual countries. Iceland's problems were not the same as Ireland's problems. Ireland's problems were the same as Spain's problems. Spain's problems eventually weren't the same as Greece a few years later, weren’t the same as Cyprus. Actually, they were all the same problem – it was leverage in the first place. It was excesses that have caused those. Today we've got similar things where a lot of the so-called is idiosyncratic or individual risks that we see globally actually will lead the same release valve, which is that the currency will weaken or the economy will slow down. And the emerging markets, which are based around commodities in a world where commodities are in a bust and demand is in a bust, even if we come out of the lockdowns to some way, shape or form. These currencies are still going to remain under pressure. But what about other regions? And I think Sterling is an interesting one to look at. And Sterling is an interesting one, because the UK had already committed to quite a significant fiscal boost in terms of the election at the end of last year and then getting through Brexit. So this was prior to Coronavirus. We were talking on this program about the potential for the UK to be one of the first movers in the fiscal space. That's still the case today. And if we look at this with Europe being looking like it's dragging its heels, I think the UK's fiscal impact will be putting pressure on sterling. Now, why is that different from the US? Well, the US is the reserve currency. People demand dollars and the US looks like a safe haven, whereas the UK will probably see a natural adjustment. More fiscal measures relative to GDP versus Europe and going earlier should put pressure on sterling versus the euro. And it might be a better way of playing these fiscal moves rather than trying to play the euro against the dollar because the dollar is benefiting from that safe haven status and the fact that the more the Fed does, the more attractive all those Fed backed ethics become as we come out of lockdown. How fast we will get back to normality, I think is the key question. I think most people now accept it's going to be a long time before we see at least consumption return to normality. And all we need to do is take some of the examples, such as Singapore. Singapore appeared to have this very much under control at the beginning, and in some ways they still have it under control in terms of how their economy is operating, but they're now in lockdown once more until into June with now the highest rate or the highest number of cases in Asia. But it's one of the smallest populations within Southeast Asia. So it just shows the difficulties of opening up and opening up too early. And this means that there will be some long term balance sheet impairment. In fact, the leadership within Singapore has been very pragmatic about the outlook, the potential for reopening borders. And they've said very clearly that this is not going to be a return to normality anytime soon. The balance sheets have been impaired at the corporate level. They've been impaired at the household level, and they've been impaired at the government level. We've seen dividends falling or expectations for dividends are going to be significantly lower, particularly in the US and Europe. Corporates are wanting to hold cash. They will be required to hold cash, which therefore means there will be fewer buybacks. Goldman Sachs believes there'll be 50 percent less or fewer buybacks in the US over the next 12 months. And buyback was really the only game in town that was the main difference between how the US has performed and other markets have performed. And then the governments are going to have to look at how to rebuild their balance sheets in the future. Now, some people say that we have QE Infinity and MMT forever, but before we go down that route fully, there will probably be an attempt to claw back some of the expenditures that most governments are going through. And that's going to be through things like taxation. So some of the cash rich companies, which are tech companies, some the cash rich companies which use their money for buybacks, they will probably be earmarked or they will be earmarked for taxation in the future, which probably means that they will think of different things to do with their income streams, which might be such as, and it may might be things such as M&A. And there's always going to be this battle between the corporate and the household. And there's probably stories in every region where corporates and certainly large corporates, have been gaining or winning out in terms of collecting money off governments, which is households and small businesses have not. So is it very much that inequality playing out once more and that's going to be very much in the political forum over the next few months. All these are going to be drags on growth, drags on the economy. And whilst some equity markets might look like they're doing incredibly well, the reality is that these are going to be drags on income. And if we're taking away the bedrock for support, which is pension flows and buybacks and then dividends in certain parts of the world like Europe. Then that support for the equity market will be diminished relative to where we were prior to February and the spread of COVID-19. And that therefore means that it is unlikely that equity markets can drive higher unless, and this is the big caveat, unless central banks really do go absolutely ballistic. And the way to think about that is we should expect the S&P to roll over around these sorts of levels based on history. But if it doesn't, then it breaks new all time highs. And we should put a ridiculously high number on the S&P, 4000 maybe 5000, because earnings don't matter. The only thing that matters in that environment, if it comes about, is what central banks are doing in terms of pumping liquidity into the system. Free floating assets will be the places to express your macro opinions. When we say freely floating assets, those are assets which are not distorted by central banks and therefore still a play on the macro. And this is why EMFX would be one of my favorite spots to do that, because they are still relatively free to move and express some of the vagaries that are going through the global economy. Distorted assets such as corporate bonds, US equities, they may be relative outperformers, but as long as you're playing those to play governments rather than play fundamentals, that's absolutely fine. And those are some relative opportunities. And I think relative trades will be the way forward. Sterling should be on the back foot relative to Europe, simply because it's a first mover and will be able to do the fiscal. But the real plays here are going to be a emerging market bonds and emerging markets FX under duress for an extended period of time. The demand for dollars is still out there. And despite the fact that we've seen such an incredible move from central banks and particularly the US Fed, in some ways it may be remarkable that how many of the signs of stress have only just dipped gently back towards normality. None of these have actually moved in a dramatic fashion, despite the drama that has been put into the markets by the central banks. This is going to play out over the long term. It's going to be slow growth for the rest of the year. 

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