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Special 2020 halftime report:

Vaccines, v-shapes and other loonie ideas

July 14, 2020

At its midpoint, 2020 is already a year for the history books. But what could lie ahead for the remaining half? Never mind a possible second wave that could sweep the globe. The pandemic has unleashed a new surge of social discontent not seen in decades. Politics, especially in America, have spilled onto the streets. Borders, once free and frictionless, have suddenly become impervious, diverting the world’s collective wanderlust to more angst-driven pursuits. Whispers have turned to shouts. Fractures have deepened. Trump’s twitter account, ever adept at picking at established fault lines, has become even more belligerent. Europe’s national divisions have again been painfully exposed. The backlash against China’s economic rise has gathered momentum. And, in today’s burgeoning list of “new realities”, it is now Kanye West announcing his presidential candidacy (is anyone surprised?).

So much for summertime and easy livin’. And yet, global markets have staged a revenant-like revival since March 23 (chalking up the best 50 trading days ever in the S&P 500’s history), catching many investors flat-footed and fumbling for answers. How could this happen amidst such a tense backdrop? Are we not in the largest economic shock since the Great Depression (with most of the world on house arrest)? Many Wall Street icons have denounced the rally. Some predict new lows ahead. Meanwhile, investors are witnessing a split-screen narration of the crisis — a tussle of facts and opinions seemingly pulling in opposite directions.

All of which brings us to a key “what next?” moment in time. How to make sense of all of this? Below, we tackle the 7 most pressing questions from our clients. As always, we welcome your feedback. Our investment team, a collective of long-distance readers and researchers (with a combined 157 years of global investing experience), stand ready to respond to your questions.

Question 1: Stock market strength seems to be completely divorced from the underlying economy. What’s happening here?

By far, this is the most common question we have received over the last month. Now, to be sure, today’s fundamentals are abysmal. Global GDP and earnings have plunged. Mass unemployment has soared around the world. Many business models have been gutted and face an existential threat. Some companies will now have higher costs due to supply chain issues and health concerns. Others have ratcheted up capital buffers, lowering capital spending and expansion.

Yet, it is wrong to say that the stock market must fall to match a depressed economy. Financial markets are always anticipatory. While humans naturally think in terms of “good or bad”, markets think in terms of “better or worse”. In other words, markets are not pricing the world as it is, but the world as it may become (we often repeat this mantra around the office, reminding ourselves that markets are second-derivative thinking mechanisms).

So why have stocks soared since March 23? Some scene setting is helpful. On March 26th, we issued a comprehensive report entitled Investing In The Time Of Coronavirus. At the time, we urged investors to take on risk (our investment team substantially raised risk for all clients on March 24). “The conditions for a meaningful rally are here … investors must act now”, we wrote at the time.

We do not mention this to take a victory lap, but rather to highlight forward-looking markets at work. Why were we bullish? Not because we believed the current situation was good. In fact, everyone knew growth and earnings would collapse in the coming months. Rather, we were constructive on risk because our investment process showed such universal pessimism that upside surprises would become easier to deliver. The worst scenarios were already priced in — far worse than the “end cycle” fears that plagued the pre-virus world.

Time and again, investors who have taken on risk during our darkest days have ultimately been rewarded. Yet most investors stared into the abyss in March and concluded that the bottom was nowhere in sight. But, at the time, positive surprises could have come from several developments — the underlying economy, vaccine developments and, most importantly, policy stimulus (more on that later).

Today, the world looks much different. The Citigroup US Economic Surprise Index, which tracks economic data relative to economist expectations, just hit its highest level in history. In fact, dozens of data points are improving, whether measuring housing, auto sales or retail activity. Arrows are now pointing up and to the right.

As it is, expectations remain gloomy. Not to the extreme level of March’s under-positioning and skepticism (and, to be sure, there will always be a non-trivial segment of the investing population that only seems content predicting the end of civilization). Bank of America Merrill Lynch’s global fund manager survey sheds some light on the subject. The latest survey from mid-June reveals that a record 78% of fund managers believe that the stock market is “overvalued,” the highest in 22 years. 53% say it’s a bear market rally. The report concludes: investor sentiment remains “fragile, neurotic and nowhere near dangerously bullish”.

A final point: when people speak of “the market”, most investors think of the S&P 500, the NASDAQ or some other broad US index. Now it is true that these indices have been soaring. But this is on the back of a handful of US tech darlings (which are up 54% this year). That masks carnage beneath the surface. Some sectors in the US (financials and energy) and many stocks around the world are still more than 30 – 40% below their pre-Covid highs. European banks trade on 37% of book value. Many emerging market countries are back to the same levels as 15 years ago. Perhaps the current disconnect is not so large?

Question 2: What about a second Covid-19 wave? Isn’t that the real risk here?

Our answer in preview may surprise some here: future flare-ups will have far less impact on financial markets. This view is not based on predictions of vaccines or the virus’s trajectory (we will leave amateur epidemiology to others, financial markets are our beat). Rather, it is again based on behavioral psychology. Consider earlier this year, when the threat of a possible pandemic finally pierced the public consciousness. Back then, most had not heard of the term “coronavirus”. The terror and mystique quickly put a choke hold on financial markets as investors scrambled for clarity.

Today, a clearer picture has emerged. More is known about the virus. Equipment and protective gear are in ample supply in most places. Testing capacity has increased dramatically and contact-tracing is being ramped up in many countries. Firms and consumers have also adjusted to life in a pandemic. Working from home is now a feature of corporate life (kudos to all the parents with young children). Restaurants are delivering more. Grocery stores have facilitated curb-side pickup. Global business has adapted.

All this means changes from further outbreaks will be less disruptive than the first lockdown. Behaviour has already shifted. And the conversation has turned towards the risk and return tradeoff of draconian lockdowns and public policy. Fresh outbreaks in Beijing and, more recently, in the southern and western US states underscore this point. Even with further flare-ups, lockdowns in both cases have been more selective. An “abundance of caution” has been replaced with a more informed and less suppressive approach. That means a rerun of the severe economic contraction witnessed earlier this year (especially when the virus ravaged northeastern states) is highly unlikely.  And, importantly, market responses have been more muted — indiscriminate liquidation and financial panic has not been correlated with recent outbreaks. In the case of China, its stock market (now the best performing in the world year-to-date) has seen an almost uninterrupted rise since bottoming in late March.

Question 3: Is a V-shaped recovery still possible?

For those cut from Panglossian cloth, there is a temptation to believe that, after a short intermission, the curtain will be drawn, light will shine on the stage and the global economy will spring to life. Sport will return to stadiums. Air traffic will again fill our skies. And, for single people, the ice age of dating will quickly thaw (no doubt, with gusto). Collectively, the world will stagger blinkingly back to normal.

This view is best characterized by the letter “V”. But is this alphabet-soup debate really a helpful framework? Pandemic time runs at a snail’s pace. Our perceptions of daily movements disproportionately impact our view of the future. Was that data point you saw before lunch evidence of a U or a V? Or was it a Nike swoosh? Matching the symbol to the future economic trajectory is an exercise in futility.

A more helpful approach requires a longer term perspective and an answer to the fundamental question (which we posed back in March): is the virus a transitory shock or a catalyst to a longer running downturn? Skipping to the bottom line, we have strongly held the view that it is the former.

The key is to differentiate a temporary liquidity and demand shock from a classic recession (a longer-running change in trend driven by monetary tightening or the bursting of a major financial imbalance). To date, the weight of the evidence continues to suggest that this is more of a technical recession.

Consider past episodes. The 1930s depression was a classic credit crunch, exacerbated by counterproductive policy measures and protectionism. The bursting of the technology bubble in the late 1990s had its root in financial excesses and capital overspending. The crisis in 2008 was a perfect storm with the bursting of a major asset bubble and years of financial deleveraging afterward. What do all of these have in common? Deep financial imbalances that took years to work out.

Comparatively, the terrain upon which the virus landed is much different. Heading into 2020, the degree of leverage in the global financial system was far less than 2008. No major imbalances were evident (with some exceptions like Canada, which continues to cling to its status as a country with an epic consumer debt bubble). Households in the major economies such as the US and Eurozone had deleveraged substantially since 2008. Most of the leverage in the US corporate sector was on the financial engineering side rather than capital over-spending. And, banking systems around the world were generally healthy. Global systemic risks were in fact quite low. That makes Covid an unlikely catalyst to a longer-running downturn.

Another issue seems completely lost in the conversation. Recent statistical drops in the first and second quarter of 2020 (GDP, earnings and so on) are alarming and depressionary-like. But these are not the numbers of a classic downturn driven by market forces. Rather, they are the direct result of mandated public policy. What else could one expect in a full global lockdown? The virus is the problem, not the economy.

To be sure, the above view does not lead us to blind optimism. Yes, the second half is likely to witness a big growth rebound from deeply depressed conditions. But global demand will not revert serenely back to its previous trend line. Nor will there be an “all clear” announcement for the economy. The path to restarting the economy will be a series of starts and stops, with different regions opening on different timelines with different policy approaches. Yet, changes in trend matter most. To date, almost all incoming data points toward a steady return to growth — V-shaped or not.

Question 4: Isn’t policy stimulus just sustenance for the economy? What happens when it runs out.

Crises always create space for radical policy to emerge. Covid has been no different. Daily life has been turned upside down but so have orthodox economic ideas. Amidst a global health crisis, everything arrived fast and furiously. All of the policy apparatus that took 18 months to deliver during 2008’s global financial crisis, only took 3 weeks to arrive this time. The size and scale of stimulus this time is hard to fathom. G-20 central banks have collectively delivered 45 rate cuts this year (a total of 3,780 basis points). The Fed’s balance sheet has increased by $3 trillion. Numerous other central banks, including those from emerging markets, have made their first forays into quantitative easing (the Bank of Indonesia is now engaging in direct monetary financing of the government’s fiscal deficit).

Let’s put it another way. If Bernanke and Draghi showed up to the last crisis with squirt guns, Powell and Lagarde now wield fire hoses with unlimited liquidity. They are permanently on call. And even though they are trying to aim directly at the economy, the entire environment is getting soaked. Guess what is now most drenched? Risk assets all around the world. Expect this to continue.

But the most important policy thrust has occurred on the fiscal side. It took a global pandemic, but government spending largesse, at long last, has been decisively released. This is a huge shift. And it comes with a commingling of monetary and fiscal policy (i.e. MMT, UBI, etc. are acronyms entering public discourse and policy and will be the subject of future Ask Forstrong editions).

It was not an easy path to get here. 2008’s global financial crisis (GFC) ushered in a long era of stubborn prudence. Deleveraging, austerity and balanced budgets were in vogue. Governments flatly refused to engage the fiscal lever in a meaningful way. As such, central bankers were forced to carry the entire policy burden (grumbling the entire way and becoming the world’s lead fiscal evangelists).

Coronavirus changed all that. Even Germany — long stuck in an ideological logjam — has abruptly broke free. More fiscal stimulus was announced in April than during the entire 2008-2009 global financial crisis. And, if history is any guide, many of these temporary policies will become permanent. Once turned on, fiscal taps cannot be shut off easily. (For more on this subject, see Hello Fiscal Stimulus, We Have Been Expecting You).

The key lesson from history is that when policy turns, especially during a crisis, it turns in a big way. This was the experience during the last two booms. China’s capital spending boom, beginning in the early 2000s, and the post-GFC policy surge both led to cyclical upswings and concurrent bull markets that lasted years.

Looking ahead, we should not underestimate the power of a decisive shift in global policy. Many may protest policies which can lead to currency debasement or simply steal growth from the future. Those are worries for another time. Historically, risk assets were always in a sweet spot when policy stimulus was ramping up in a weak but recovering economy, with low inflation and high unemployment. There’s no reason to think this time will be different. The big surprise will be that fiscal packages launched so far are not only enough to stabilize the economy but will over-compensate for the loss in output.

Question 5: Have your longer-term macro views (ie: “Super Trends”) changed as a result of the pandemic?

On the surface, coronavirus has accelerated many of our Super Trends. The future has been brought forward.  For example, inflation is likely to arrive sooner in this decade than we had forecast earlier this year. Digital flows are also surging further, while industrial circulation is hastening its retreat to regional economic ecosystems — what we have called Globalization 2.0. (See the entire list of Super Trends from January 2020, Around The World In Eighty Minutes). 

But the most interesting macro question is whether this crisis produces meaningful reform in a demand-deficient world. These changes, not the short-term macroeconomic impact, will be the pandemic’s lasting legacy, diverting structural trendlines in the years ahead. To further explore this topic, we must acknowledge that Covid has simultaneously exposed the strengths and weaknesses of the three major hubs of economic production: the US, Eurozone and Asia. Understanding this tri-polar world, and how these blocs are stitched together in our sprawling, global economic ecosystem, is becoming increasingly crucial to get right. 

In the case of America’s outlook, the stakes are high. This is a country still struggling to contain outbreaks (now accounting for a quarter of the world’s recorded coronavirus deaths) and still yet to articulate a unified approach to combat the virus (agreed upon by both state and federal leaders). This stands in stark contrast to past decades. The US’s institutions and economic policy have long provided crucial stability for the world. The Fed and the Treasury have exerted a massive influence on the global financial system, especially during crises. During the last crisis in 2008, US monetary policy became a leading indicator of what other central banks would do. We all wanted to be like America. The question now is how those institutions and influence stands in relation to a profoundly divided society and political system. A fractured America cannot lead. 

For the Eurozone, many investors have long been skeptical of the region’s social model. Yet, as the Eurozone emerges in much better shape than the US, its strong public health systems suddenly seem appealing. Still, the basic weakness of the region is an architectural flaw: a monetary union that lacks a shared fiscal capacity. Here there is much hope for a policy breakthrough. The crisis has again revealed that a fiscal union is necessary to offset macroeconomic shocks in individual nations and thus prevent contagion from spreading to the broader region. What’s more policy cohesion can work to generate more inclusive and balanced growth for each member country. Italians know this. The French seem to know this. And now the Germans, at long last, have admitted this (and may be also recognizing that their export-led growth boom of the last 15 years may not be repeated without reform). 

In that vein, a new Franco-German initiative has proposed an EU-jointly funded €750bn recovery fund (which will require a larger EU budget for the first time since 1988). This puts the EU on a path towards a fiscal union. The policy signal is unambiguous: the Eurozone is on a steady path to integration and a more growth-oriented fiscal policy (buh-bye austerity!). This big turn in EU policy means it should compete better with the US as a destination for capital and lead to a structural re-rating of Eurozone stocks which have chronically traded at a steep discount to America. (For a more comprehensive view on this, see my colleague David Kletz’s recent piece Make Or Break Moment For Europe).

Lastly, let’s deal with Asia. More strengths than weaknesses have been revealed recently. Pandemic responses in most Asian countries (notably South Korea) have been well-ordered and rational. What’s more important for capital markets, however, is that monetary and fiscal policy fire hoses were not needed. In the period February – May, the US’s combined monetary and fiscal response amounted to an eye-watering 44.4% of GDP. By comparison, China’s was just 14.7%. Similar levels were witnessed across Asia. That leaves further policy flexibility in the region to fight future downturns. Financial markets have taken note. This is the first crisis where Asian stock markets have outperformed their developed peers with less volatility. Looking ahead, Asian countries like China, South Korea and Taiwan tick many of the boxes for regions that will attract capital. This list includes those that have: (1) managed the health crisis well, (2) benefit from low oil prices, (3) have decently healthy banking systems, (4) have large domestic markets with rising consumption and (5) have plenty of policy room. 

Question 6: What are the key portfolio risks for the rest of the year?

Two key risks have increased during Covid. In fact, both are blinking bright red right now. First, concentration risk. Consider that US assets were the stars of the bull market out of 2008 — a Michael Jordan-like era of uninterrupted stock market leadership. American stocks and bonds soared during this period. In the global currency market, through which more than $5 trillion normally swirl every day, traffic was one way: out of every currency in the world, into US dollars.

Looking back, American domination does make sense. In environments of subdued global growth, US stocks and the senior global currency tend to thrive. The makeup of the US stock market, with its larger weighting in growth stocks, is also a factor. Growth can command a premium with a sluggish backdrop.

Yet, US assets have soared even more this year during Covid, building into a dangerous crescendo that leaves plenty of room for underperformance. The US stock market is now priced for perfection. The dollar is about as overvalued against its G7 peers as it has been for 30 years. The five largest stocks in the S&P 500 now account for nearly a quarter of the index. And everyone is in on the trade.

Much of this is related to investors piling into the “stay at home” trade which has chased many technology companies higher. But this is almost certainly a case of investors overestimating permanent changes during a crisis. Yes, we are all live on Zoom now. And, yes, many will work from home. But many more things will return to normal. And deep structural shifts cited above argue for changing trend lines, even faster growth in the coming years.

What’s more, investment leadership changes result from a crisis. This may be happening right now, with the US stock market showing relative weakness over the last few weeks. In comparison to US growth stocks, many equity markets are priced as if the pandemic will be with us for years. Expectations for many regions outside of the US are abysmally low (with record flows in 2020 out of globally-oriented funds), valuations are far cheaper and ex-US growth stories are starting to attract capital. Combined with America’s waning leadership (diminishing its attractiveness as a destination for foreign capital), a major rotation is likely underway.

The second risk relates to income. As if low interest rates were not a problem in the pre-virus world. Now, they are public enemy number one for retirees and savers. What to do to combat low rates and financial repression? Ironically, equity markets have become a better source of income than bond markets. Yet the underlying risk of equity is clearly higher. Piling into equities to generate yield would lead to inappropriate risk levels for many income investors.

Another approach (which our investment team actively pursues in our income-oriented strategies) is to become more eclectic and global in one’s quest for reasonable income. This means scouring the world’s asset classes for decent yield. This can be found in emerging market bonds (who have not blown their public balance sheets like the West has and provide a juicy yield), US high yield bonds (which have the tailwind of the largest underwriting of corporate risk in history), real estate investment trusts (many of which trade on far lower multiples than Canadian or US listings) and, yes, dividend paying stocks from developed markets (Euroland is a particularly fertile hunting ground). The biggest benefit here is that investors do not have to compromise the only free lunch in investing — diversification. With many yield-oriented asset classes still deeply on sale, it is now possible to generate a higher income in the post-virus world. Crucially, exposures to Western government bond markets should be minimized.

Question 7: Who will win the election… Trump or Biden?

Experience has taught us that it’s best to leave the room after making any political predictions. Toss the grenade and walk away. This is especially true of the reality TV show that has become American politics. The US is now more polarized than any other major country.

Still, let’s indulge the topic. First, it is becoming clear that Biden is steadily gaining in the polls (even if one’s heart sinks that this was the best candidate a nation of 330 million people could come up with). If Biden does win, fears of higher taxes, more regulation and an avalanche of welfare programs would initiate a fall in US stock prices. If Trump wins, then the investment and social climate could get even more hostile. Ramping up trade wars, inflaming social divisions and more erratic foreign policy would almost surely define the next four years.

Given that neither of these scenarios are clearly bullish to investors, the above uncertainties are now weighing on the US stock market. Investors should be watching developments closely. And they should be bracing for the possibility that Kanye will be president in 2024 — the most unlikely person to be voted in since, well, Donald Trump was (and, for the record, that would make Kim Kardashian the First Lady).

Conclusions

The first half of 2020 seems like a work of fiction. Surely the plot was made up and we will all wake up from a bad dream? As it is, we continue to live in an era of new realities, jagged pills and rough edges. 2020 will be an important demarcation line in our collective memories for some time. Where were you when the entire world went into a total lockdown?

But, in financial markets, policymakers show no signs of slowing down stimulus. The music is still playing. Prudent action in this environment is to build portfolios that can survive and withstand the shocks of a modern world — and to keep a sharp eye on the disc jockey. Our investment team will be doing just that for clients. In the meantime, let’s all breathe now (just not on each other).

TYler MORDY

President & Chief Investment Officer

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