Market Outlook – Third Quarter
A sustained recovery in markets will probably have to wait until there is more confidence that the coronavirus pandemic is under control globally and a serious second wave of infections hasn’t happened. We expect our Investment Clock model to reflect the eventual re-opening of the world economy by moving from its disinflationary “Reflation” zone, with weak growth and falling inflation, and into its equity-friendly “Recovery” zone, as growth improves with lockdowns being eased – but the timing of this move is uncertain.
We intend to make full use of our active tactical asset allocation risk budget to add to equity exposure when we judge the time is right. Our investment process has weathered difficult markets in the past and we added significant value over the 2007-9 Global Financial Crisis.
We believe a disciplined and active approach to both risk control and tactical asset allocation will be crucial in portfolios, as markets respond to the current crisis and the economic recovery when it comes.
Survey data, high-frequency data and now increasingly the hard data too, continue to show that developed economies are in the ‘recovery phase’ of this crisis. Albeit this is the somewhat mechanical bit as economies are allowed to open up and you get a bit of pent-up demand set loose as well. Some of the recent data points have shown much stronger than expected improvements. This, however, doesn’t tell us much about the next stage of the recovery that economists generally expect to be much slower.
Social distancing, scarring (including permanent job losses, business closures and balance sheet damage) and residual fear of the virus (including as it relates to job security) will all influence the strength of that recovery and government policy still has a crucial role to play in all of them. June business surveys improve substantially: Data in the past week or two has included several June business surveys and these have mostly seen solid improvements, with some notable upside surprises in European business surveys and US regional business surveys. However, the headline composite PMI business survey indicators for the US, eurozone, Japan and the UK remain below 50.
Taken at face value, remaining below 50.0 would normally signal that these economies are still shrinking. However, mapping PMIs accurately to economic activity levels is somewhat hazardous after such a big shock to GDP (the survey asks whether things are better/worse, rather than by how much). Nevertheless, if you look at the commentary in the PMI surveys – social distancing has eased, helping many firms reopen and firms are more optimistic, but many companies also report weak demand as customers to remain cautious. That is – so far – consistent with economies taking time (likely, several quarters) to get back to ‘normal’ levels of activity after a sharp initial recovery phase.
US data continue to suggest a strong start to the early stage recovery, but virus data more worrying: May retail sales, durable goods orders and some housing data have bounced significantly more than expected. However, US COVID-19 numbers have, in the meantime, become more worrying. The increase in virus cases in some states is likely to worry consumers, including the prospects of social distancing being reversed and the impact on job security.
Meanwhile, Congress and the White House have still not agreed on a package of economic support measures to replace those set to roll off this summer. US government policy interventions have so far done a good job in shielding household balance sheets (and therefore spending power) from the crisis. Reduced/disrupted fiscal support and the progression of the virus both have the potential to curb US recovery momentum. Here in the UK, data also signal a solid start to the recovery phase but also a weak underlying labour market and an economy still in need of policy support: May retail sales were also an upside surprise, rising 12% in May. They are still 13.1% below February levels, but that’s a solid start to the recovery phase, especially since it was only mid-June that saw ‘non-essential’ retail stores reopen.
Just as in the US, however, the UK’s early-stage recovery has needed – and still needs – plenty of policy support. Government borrowing was also somewhat higher than expected in May and the levels of government debt as a percent of GDP, on the headline measure, moved above 100% for the first time since 1963. PAYE data meanwhile show the number of paid employees fell by 449K March to April.
Early May estimates indicate another drop of 163K. Job vacancies in May fell to a record low. The furlough scheme is set to start unwinding from August, but this is a labour market that is far from out of the woods yet. That was recognised by the Bank of England who extended their asset purchase programme, though reduced the pace. They have become more concerned about long term damage from the crisis.
How the labour market evolves from here will be a key driver of their decisions going forward including, potentially, a decision around negative rates.