As The Tri Polar World Turns - Take a Break Bro
MACRO THEMES
Time seems to be slowing down, just a bit. It's a welcome relief after the past few months of breakneck speed. Speed is Covid-19’s signature: speed of spread, of policy response, market reaction & in the future speed of science response & perhaps speed of economic recovery. A period of market digestion is healthy; we remain optimistic on risk assets based on continued policy support, economic recovery, reopenings, low rates & gushing liquidity, cash rich & underweight investors, science & more.
Much doubt remains as to where we are headed. This is a good thing for risk assets. BofA reports 64% of investors continue to see a U or W economic recovery while a smaller majority believe the current market (ACWI) up move, now roughly 35%% off the low, is a bear market rally. With policy support assured, renewed lockdowns remain investors’ principal risk factor. (See Chart 1).
Chart 1: Investors More Bearish than Bullish
Source: BofA
And that risk resides primarily in America. The slipshod nature of the US policy response to Covid-19 is coming home to roost as several states have sharply rising case levels & hospitalizations which are likely to require reimposed restrictions. This could have asset allocation implications; investors may exit the US, increasing flows to non US markets that lack both renewed outbreak risk as well as the political risk implied by the upcoming election season. For example, to compare Beijing with roughly 100 new cases to the US with 20k new cases each day is missing the point. To be forewarned is to be forearmed.
HEALTH
The health news across much of Asia and Europe is quite good. Reopening continues with no sign of large scale outbreaks. The EU has restarted travel within its borders (another sign of Covid-19 driving TPW’s regional integration) while in Asia some small outbreaks in SK and Singapore have been brought back under control. These examples provide lessons learned for Europe & the US who are following behind Asia in the Covid-19 queue. China has moved forcibly to address a cluster in Beijing, again providing signposts for how others might respond to similar outbreaks.
And there will be more clusters, outbreaks etc, the world has not defeated Covid -19, rather various nations have reduced its ferocity somewhat, ensuring national health systems won't be overrun. Defeat requires a vaccine. The US remains in a league of its own (though Brazil has just passed it in terms of daily new case levels), still identifying 20k new cases a day though nationwide hospitalizations, deaths and ICU occupancy rates are all down significantly from the late March, early April peaks. As befitting a continental sized country, some states in the North East are doing very well, while those in the South are battling rapidly rising case counts. See Chart 2 A & B.
Chart 2A: US & Brazil in a Covid League of Their Own
Source: Cornerstone Macro
Chart 2B: US Setting Up for State-Local Lockdowns
Source: Pantheon
Importantly, these responses to clusters/outbreaks suggest that the complete shutdowns that many nations implemented in the Spring are unnecessary & thus highly unlikely in the Summer - Fall, even with a 2nd wave. As Sec Mnuchin said, it's too damaging to shut down the economy again. This is important given that 2nd wave concerns represent a principal investor risk even though immediate investor attention has shifted from case levels to economic data points. In the US it seems as if even mitigation is a challenge and the hope seems to lie in vaccine discovery. While we continue to expect the speed of the science response to be a positive for risk assets US federal Govt apathy is worrisome.
The gap between states reflects the bifurcated nature of the US response. Interestingly, BofA notes it has not seen any impact between states in last week’s credit card spending data, now running only 5% below yr ago levels. As a New York City resident I am happy that we will move to Phase 2 reopening Monday (outdoor dining yeah!); the possibility that other US cities might have to reimpose restrictions is jarring but unlikely to slow or reverse the economic & financial market recovery underway. And that is the key point.
ECONOMICS
The record level of the Citi US ESI (see Chart 3) shows how tough it has been to forecast economic entrails in the Covid Age. Given the unique nature of the global condition there is very little history to fall back upon - something to keep in mind for those who like their stats. One stat that did strike us was the end of the longest expansion in US history (128 months) followed by what will surely go down as the shortest recession ever (March to May). The past few weeks have brought positive economic data across the US spectrum from unemployment levels to income gains, from retail sales numbers to new home purchase mortgage applications, all way better than expected. This is true globally as well though the magnitude of the surprise is higher in the US.
Chart 3: US Economic Data Surprises to the Upside
Source: Bloomberg
In our 2H Outlook (link) we suggested investors focus on the demand side given it represents 70% or so of advanced economies. China’s reopening showed that production can come back quickly but demand is more uncertain given the role confidence plays in deciding to go out and shop, dine, be entertained etc. Recent US and EU data (income, savings) demonstrate the capacity to spend exists more so there than perhaps in China; the China demand story may not be as applicable elsewhere. (See Chart 4)
Chart 4: German Current Conditions Remain Weak but Expectations Soar
Source: Bloomberg
We continue to expect demand will recover faster than most expect & believe it could run into disjointed supply chains and create a whiff of inflation. This in turn could lead to a backup in long duration UST rates. Disinflation, deflation, even stagflation have been mentioned as possibilities but the potential for a demand surge coupled with supply chain interruptions leading to some inflation is almost completely unexpected. Actually, consumers expect inflation as evidenced by survey data but economic forecasters & bond investors do not.
Over the coming months we foresee continued reopenings, improving demand & falling inventories (already low in both wholesale and retail terms) which could spur production and create a mutually reinforcing economic growth cycle. Throughout the Tri Polar World, there is growing appetite for infrastructure spending: a possible $1T plan in the US, Europe’s Joint Recovery Fund and Green Deal and growing signs of renewed infrastructure spending in China. The direction of the global economy is clearly up - the question now is the magnitude of the recovery. Fall should bring some economic clarity, even if the politics remain murky.
POLITICS
The US Presidential election is the world’s main political focus for the rest of 2020. As we move into summer, the prospects for the Presidency as well as for the House and Senate will garner more attention. The recent Black Lives Matter (BLM) protests across the US have resulted in falling poll numbers for the President. Current polling suggests that the combined impact of Covid-19 on older voters & the BLM protests effect on younger voters is damaging the President & the Republican Party. Odds of a Democratic Party sweep are growing which suggests investors will start to pay more attention. Such an outcome would imply policy shifts towards a bigger Govt role & greater focus on wealth distribution, though tax hikes are unlikely to be job one. (See Chart 5)
Chart 5: Swing States Favor Dems – a Blue Sweep in Nov?
Source: JPM
In Europe the political parlour game is trying to decide who will give way in the discussions surrounding the Joint Recovery Fund. It's clear that there are states for whom frugality is critical while others, led by France & Germany, note the need to act boldly to counteract the economic effects of Covid-19 and to perhaps steal a march on other regions. We anticipate agreement between the two groups in the next month or so and expect to see Europe taking on a growing regulatory role in both tech and climate. For example, tying stimulus spending to Green Deal implementation makes a lot of sense. We noted in a recent RealVision interview (link) that the 2020s could be Europe’s Decade.
Asia faces multiple brush fires ranging from angst among the two Koreas to high altitude disputes between China & India. It is unlikely either will matter very much in the weeks ahead. The dispute to watch remains between the US and China. President Trump needs a punching bag for his re-election campaign and China offers the closest fit. For its part China is happy to engage in a verbal tit for tat but not much beyond that. The recent back and forth over Hong Kong previews the coming months. We continue to expect a War of Words rather than a new Cold War.
POLICY
Rolling Thunder continues to be our global policy catchphrase and it has been quite accurate - virtually no global coordination, but a true rolling thunder of individual country and perhaps (EU) regional responses to date. Global monetary policy continues to be uber accommodative with Chair Powell reiterating no plans to raise rates for several years. The ECB continues to act aggressively to support its banking sector with a healthy $1.5T takeup of its latest TLTRO offering providing ultra cheap, 3 yr loans to banks to lend to the broader business community or buy Govt debt (note periphery bond rally).
As Chart 6 shows there has been a large fiscal response, particularly in Europe, something which doesn't get enough attention, especially here in the US. There has also been a robust fiscal response in Japan and other Asian countries which likewise gets subsumed under the China focus. For its part, China has been somewhat reticent with its policy largesse as the downside of its post GFC spigot opening strategy remains fresh. Nonetheless, there is a steady amount of support that doesn't fit under a big new program rubric but is still effective in underpinning China’s economic recovery.
Chart 6: Rolling Thunder of Stimulus Around the Globe
Source: Charles Schwab
Given it's an election year in the US we have every expectation that a Phase 4 stimulus package will be approved, the question is when. Time is running short for it to be done prior to Congress going on its summer break (7/31). There is likely to be some movement as the WH has indicated the $600 per month UE benefit top up is likely to be phased out at the end of July. We continue to believe investors are protected - either the economy picks up or policy makers will do more.
There is a fair bit of tech related policy action taking place that's worth paying attention to, especially as Tech remains the most crowded segment of US equity markets. Regulatory scrutiny in the US is growing (the two bipartisan points in DC: bashing tech and China) but Europe might be more important as it carves out a role as the tech regulatory superpower. The digital tax dispute and the apparent US decision to walk away from global talks on it is worth paying attention to. Fresh sources of tax revenue are going to be a global high priority in the years ahead.
Bottom line: policy, both fiscal and monetary, across the globe, can be expected to remain accommodative throughout the 2H of the year.
MARKETS
There have been two market “tells’ since we published our 2H Outlook; the first was when several famous US investors called the US equity market very overvalued and unattractive, which when coupled with some worrisome Powell and Dr. Fauci comments, led to a quick 2-3 day, 7% pullback. The tell was in what was bought off the bottom: Cyclical, Value & Small Cap stocks and Credit. This led us to infer that while many investors missed the bottom, they were determined not to miss the Rotation - Reflation Trade.
The 2nd “tell” was just last week, a very similar 7% pullback with the bulk coming in one ugly day for the S&P. The next day, both Asia & Europe traded pretty well - down but not huge suggesting to us that equity leadership could be switching from US to non US DM markets led by Europe and Japan. It's rare indeed when the US falls 5%+ in a day and the ROW equities don't follow suit the following day. We have commented before on how we like to let the markets tell us rather than we tell the markets - well these two examples are exactly what we mean. They also both tell us to: Buy the Dip. Pullbacks are healthy and in today's machine driven age where markets go right to pain points, they come (and go) fast.
We continue to think we are in a new bull market with the Rotation Trade to new leadership in early innings (actually over 50 markets worldwide are in bull markets - defined as over 20% off their recent low). Tremendous global liquidity, very low (negative) rates, a recovering global economy, underweight & cashed up investors are all supportive.
Risks remain centered around broad regional/national lockdowns, lack of policy follow through, especially on the fiscal side, irrational investor exuberance (nowhere close today - notwithstanding the Robinhood bros in the US - just look at the Money Market mountain). Fall brings adverse seasonality together with rising US political uncertainty.
We remain focused on non US DM, Cyclical sectors and Value factors (esp Financials), small caps and selective EM equity. Within fixed income we expect steepening yield curves in the US and Europe and favor Credit over Govts, HY over IG as well as EM $ debt, Preferreds and TIPs. We believe the USD has further downside and Commodities have significant further upside, especially the base metals and miners. We continue to like gold and gold miners. (See Chart 7)
Chart 7: Cyclical Leadership in Early Innings
Source: Charles Schwab
We have questioned whether Covid-19 would upend US financial asset dominance much as it upended everything else around the globe. It now looks like a combo of poor responses to both Covid-19 and the BLM protests coupled with what is likely to be among the nastiest electoral seasons in memory might do the trick. NDR reports that the S&P does most poorly when an incumbent Republican loses.
We noted the non US equity tell above; some confirmation came from last week’s flow data as four of the top ten ETF inflows were to non US equity - a data point that has not been seen for some time. In addition, JPM notes the short base in Europe remains quite extensive, unlike in the US, Japan or EM where much has been covered. JPM also notes that non US equity has not discounted as much of the economic rebound as US assets have which makes sense given their cyclical nature. Once that confirmation comes through however, cyclical exposure is what can drive outperformance. (See Chart 8)
Chart 8: Time to Look Abroad?
Source: Charles Schwab
In Fixed Income the story remains pinned short ends and gradually stepping yield curves especially in the US. We continue to expect the 10yr UST to trade back towards 1- 1.25% as supply expands, consumption picks up and supply chains struggle to meet demand, raising the prospect of inflation. A recent JPM quant survey found only 16% expected the 10 yr above 1% by YE while NDR reports FV is 90 bps above current levels. We look for the 10yr BUND to trade close to zero from -.38% and highlight the powerful rally in peripheral spreads. Credit markets remain robust with US IG issuance breaking all records as companies look to build cash levels and take advantage of record low rates. Corporate bond ETFs have already taken more inflows (roughly $46B) than in all of 2019. (See Chart 9)
Chart 9: UST Yield Curve Steepening Ahead
Source: BofA
It's surprising how little traction the Fed’s commitment not to not raise rates till 2023 has received from either FI or equity investors. What kills economic expansions/bull markets? Central bank tightening - that's now been taken off the table for the coming 30 months or so. The Fed moved fast in March because it had the GFC playbook in hand - more importantly today, the Fed will be slow to raise rates because it remembers how that undercut the post GFC economic recovery.
Currency markets have likewise heated up somewhat with the USD displaying signs of weakness. Exploding dollar liquidity (up 40%y/y) & ballooning twin deficits support further weakness. Reducing exposure to a safe, defensive asset like the USD in favor of more cyclical exposure makes sense, especially as the yield pick up has dissipated. The A$/Y cross continues to suggest global growth pickup while the Euro moves towards the mid to upper teens vs the USD. EMFX has been mixed. (See Chart 10)
Chart 10: USD Rollover?
Source: Bloomberg
Gold and copper both have had good runs of late - we expect this to continue as the Fed keeps real rates negative & signs of economic activity pick up… inventories are quite low across many base metals and broad commodities remain the asset class that has recovered the least from its March lows. Oil seems to have found a new range. We remain quite constructive on commodities.
I hope you find this monthly piece of value and look forward to engaging with you on a monthly basis as we move through 2020.
Jay Pelosky, CIO & Co-Founder
TPW Investment Management
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