The challenge of Covid-19 is that it is two crises at once. While medical personnel try to contain this public health scourge, central bankers and economic policymakers have been fighting on the economic front. So far, large fiscal and monetary stimulus have staved off deeper economic woes and there are green shoots of recovery emerging.
But even if the virus is under control, the economic fight will be far from over. The severe economic shock from the pandemic, combined with macroeconomic paradigm shifts in motion since the Global Financial Crisis in 2008, has seen policymakers — who were for decades trained in the way of the free market — become less resistant to economic intervention.
At the heart of the previous economic orthodoxy was Austrian economist Joseph Schumpeter’s idea of creative destruction, which suggests that unviable businesses deserve to fail and be displaced.
However, in advanced economies, the severity of the pandemic has delivered a severe shock to corporate balance sheets all round. To rescue these firms, governments have provided relief to businesses like tax breaks, cheap loans and subsidies.
As necessary as such policies are, Economist Intelligence Unit (EIU) analyst Waqas Adenwala observes that a significant debt overhang has resulted, thereby requiring deleveraging and restructuring. Low interest rates have kept unviable businesses afloat, dragging down overall productivity. Yet, withdrawing support from unproductive firms could lead to high political costs due to short-run labour market upheaval.
“We believe that governments will prefer a scenario of low productivity growth, underinvestment and high debt overhang, which potentially will lead to a lot of zombification of firms,” says Adenwala at an EIU webinar discussing the effect of the pandemic on the global economy, in which high debt and low growth can be expected.
There is hope, however, that a more active state-driven industrial policy could spur productivity in strategic sectors and stave off zombification. Governments can invest at a loss longer than private sector firms in potential high-growth sectors such as the green economy. Yet in the long-run, structural unemployment could worsen as automation and digitalisation accelerate, demanding the frontloading of social welfare as labour markets adjust.
Other long-run trends include unfavourable demographic trends in advanced economies facing population decline. Agense Ortolani, Europe analyst at EIU, notes that a shrinking, ageing population is associated with a smaller workforce, reduced productivity and higher social spending costs. Developed economies with such unfavourable demographic structures could face poorer long-term growth prospects than more fertile emerging economies.
But, there are policy options, such as relying more on immigration, initiating labour market reform, and boosting research and development to improve productivity, Ortolani says. Still, given the political costs of such policies, developed economies may instead accept a smaller population and lower growth, focusing instead on maintaining a high GDP per capita.
Fiscal and monetary policies
Governments of developed economies like the US and the EU, however, are feeling the pinch from higher spending during Covid-19. While public debt has spiked, Ortolani believes that given modest debt servicing, the debt outlook for European governments is still relatively sustainable at the moment.
“Inflation will jump a bit here as the Covid-19 recovery gets underway,” says Ortolani, though EIU’s core assumption is that inflation will stabilise in the medium term. Interest rates are therefore likely to remain low for the next five years, and thus debt will remain manageable. But with central banks potentially having to tighten monetary policy in the face of prolonged inflation, there is a fine line between inflation management and public debt management.
EIU senior Europe editor Matthew Sherwood sees ultra-low interest rates becoming a norm in advanced economies. While the Bank of Japan (BOJ) seems permanently locked into a loose policy stance, unconventional monetary policy will be a feature of the Fed and European Central Bank (ECB) in the coming years. But strong fiscal policy from the Biden administration will lift US growth sufficiently to allow for the Fed to rein in quantitative easing from 2022, with a view to raise interest rates in 2023.
With the need to rebalance the public finances, Adenwala expects governments to levy higher taxes on companies, capital gains, and pollutive industries.
But with interest rates already at record lows before the pandemic, the EIU sees the risk of secular stagnation emerging as central banks are no longer able to reduce real interest rates. EIU warns that this could lead to a persistent shortfall in demand, causing a “new mediocre” of low growth and low inflation. While aggressive fiscal stimulus could be a solution, there is also the risk of widening macroeconomic imbalances.
Equally concerning is also the potential loss of central bank independence — a cornerstone of central bank governance. Central banks are traditionally seen as dispassionate guardians of price stability guarding against the politicisation of monetary policy. But Sherwood says that the pandemic has seen central banks interpreting this mandate broadly.
For instance, central banks have used direct instruments to facilitate the flow of credit to households and businesses while allowing governments to borrow at ultra-low rates. Sherwood also notes that central banks have also undertaken policy intervention in individual sectors through targeted lending and corporate bond purchases. Such actions, he says, blur the line between fiscal policy and monetary policy.
“With inflation having been near zero, central banks have shifted their focus from inflation targeting strategies to implicit and sometimes explicit support for government fiscal policy,” Sherwood explains. He sees this new mandate increasing scrutiny of central banks, promoting a backlash from financial markets.
Fixed income and FX
The Fed’s commitment to accommodative monetary policy coupled with liberal fiscal policy have so far kept the US dollar relatively weak. Still, DBS FX strategist Phillip Wee expects the greenback to recover in 3Q2021; the USD Index (DXY) has tried in vain every week in May to push below 90. A positive showing on the US monthly job’s report could see 10-year treasury yields move within 10 basis points higher or lower than 1.60% as the Fed Open Market Committee inches towards internal debates on tapering asset buying.
Wee expects the euro to be capped at 1.22 to the dollar with downside risks to 1.20; the ECB is not expected to slow its pandemic emergency purchase programme at its June 10 meeting. “ECB officials want to maintain favourable financing conditions, which have tightened on a stronger euro and higher EU bond yields, to support the recovery from the pandemic,” he explains. ING senior rates strategist Antoine Bouvet sees German 10-year “bund” yields rising to 0.2% in 2021 from –0.1% currently, with EU corporates and sovereigns constructive on tighter spreads.
Lombard Odier’s global head of FX strategy Vasileios Gkionakis expects Brexit headwinds to batter the sterling, seeing GBP–USD settling between 1.38 and 1.40 by year-end. “The main risk to this view is an earlier tightening of monetary policy by the Bank of England,” he notes. Isobel Lee, head of global government portfolios at Insight Investments, told Bloomberg that she is underweight on UK government bonds, projecting economic expansion following an aggressive vaccine rollout.
At its last policy meeting on April 27, BOJ left monetary policy unchanged, with Shigeto Nagai, head of Japan economics at Oxford Economics, seeing current rates persisting for years to come. Despite a sharp drop in BOJ’s Japanese Government Bond (JGB) purchases, 10-year JGB yields continued to decline in April alongside US yields to around 0.08% as of early June. With the USD/JPY increasingly correlated with the DXY, Heng Koon How, UOB head of markets strategy, sees the pairing heading towards 107 closer to end2021 amid USD weakness.
Developed market equities
In the equity space, investors are increasingly asking questions about the valuations of US stocks. Mike Wilson, chief investment officer and chief US equity strategist for Morgan Stanley, sees upside for the S&P 500 being capped for the year as the US economy enters a mid-cycle transition. With price earnings multiple for the S&P 500 typically falling by around 20% during this period, the mere 5% reduction as of May 24 suggests plenty of room for a further reduction.
Wilson favours reflationary beneficiaries like financials and materials over consumer discretionary, as well as consumer staples, healthcare and parts of communication services over technology plays. Ian Samson, multi asset portfolio manager at Fidelity International, sees US small caps benefiting most from Democrat fiscal stimulus, urging investors to focus on value plays.
European equities are seen to have a strong 2Q2021 given substantial improvements in vaccination and upcoming fiscal support. A key edge for European equities, says JP Morgan global market strategist Gabriela Santos, is their “sizeable valuation discount” relative to the US while offering exposure to cyclical recovery and inflation hedges. Europe is now vaccinating a higher share of its population than the US per day (0.8% vs 0.6%) and provides the biggest cyclical bang for the buck, with 55% of its market consisting of cyclical sectors.
“Europe’s exposure to financials and cyclically sensitive sectors such as industrials, materials and energy, and its small exposure to technology, give it the potential to outperform in the post-vaccine phase of the recovery when economic activity picks up and yield curves in Europe steepen,” says Russell Investments in its 2Q2021 report, projecting the MSCI EMU Index to outperform S&P 500 in 2021. There is also value on the FTSE 100 — the worst-performing European equity market in recent years — as UK corporate earnings rebound after falling 35% in 2020.
Lombard Odier’s chief investment officer Stéphane Monier is meanwhile bearish on Japanese equities due to low profitability and high valuations. This is notwithstanding “corporate reforms, supportive demand and strong balance sheets” amid continued Covid-19 challenges. “In yen terms, the TOPIX [Tokyo Stock Price Index] has returned 7% year-to-date, and 2% in US dollars, reflecting the weakening Japanese currency against the dollar,” he warns.
But Shuntaro Takeuchi, portfolio manager at Matthews Asia, argues that Japanese markets are in fact trading at discounted valuations. The P/B ratio of the MSCI Japan Index was 1.52 in April while MSCI World came in at 3.20. Japan’s strong exposure to global industrial production is also seen to benefit from growth bottoming out and rebounding from the pandemic.
Christophe Braun, investment director at Capital Group, sees Japan’s innovative growth sectors like electric appliances, precision instruments, automation and mechatronics potentially riding on the post-Covid wave of digital disruption. Yet the strong balance sheets of Japanese companies also “add to the attractiveness of Japanese stocks in terms of valuations."
