International | Oct 28 2020
While short-term concerns including the US election weigh upon markets, it's increasingly important to monitor changes to policy settings across different countries in response to the pandemic.
-Importance of Average Inflation Targeting
-US versus eurozone equities
-Country by country pandemic response
By Mark Woodruff
US Election & Pandemic Investments – Part 1 (https://www.fnarena.com/index.php/2020/10/26/us-election-pandemic-investments-part-i/) examined appropriate Australian equity investments in an environment influenced by not only structural policy tailwinds but also impacted by virus concerns and US election outcomes.
In Part 2 we look at policy initiatives in both the United States and the eurozone and the relative merits of investing internationally across the various asset classes.
In the Australian context, it was considered important to develop a framework around what drives markets. The significance of profits and positioning (value versus growth) for equity markets were reinforced. The third P, namely policy, looked at how both monetary and fiscal policy affects interest rates, growth and inflation.
Now, in adopting an international perspective, we begin with recent policy initiatives in both the US and the Eurozone.
Policy Change in the US – Average Inflation Targeting
In the noise surrounding the US elections and the covid crisis, a vital policy change may have gone relatively unnoticed.
In August the Federal Reserve delivered a policy framework review. The review, which began in 2018, was commissioned to address the challenge to the effectiveness of monetary policy in the era of very low “neutral” interest rates.
The outcome was a decision to move away from a framework that ignored past deviations of inflation from target, to an average inflation targeting (AIT) regime that would try to make up for those past deviations.
In effect, it would mean allowing inflation to run above the two percent target for some time over the coming years, following several years of below-target inflation.
Aviva Investors forecasts the change in approach is likely to result in rates staying anchored at zero for even longer than previously anticipated – maybe for another four to five years.
Over the longer term, it is also considered likely to mean somewhat higher and more variable inflation and more economic and market volatility.
While the market reaction to this development has been muted so far, there is potential for this to be the most significant change in approach from central banks since the start of the inflation targeting era in the 1990s, according to the global asset manager.
When set alongside the renewed interest in fiscal policy, Aviva Investors believes it could usher in a period of steeper interest rate curves, more volatile currencies and a rotation towards value stocks.
Other central banks are also pursuing reviews, with similar outcomes likely to be delivered over the next year or so. With that in mind, it is timely to look at developments in the Eurozone.
Policy Change in the Eurozone
The European Central Bank (ECB) has signalled ongoing policy support and may yet deliver additional stimulus in the form of more quantitative easing, predicts Aviva Investors.
Fiscal assistance packages have also been extended as Europe is considered to have shown a more enlightened approach to support than some other nations. During July 2020, EU leaders agreed to a comprehensive package of measures which combined the multi-annual financial framework (MFF) and an extraordinary €750 billion recovery effort, Next Generation EU (NGEU).
Inflation is expected to stay low in coming years, according to Aviva, and it’s considered the ECB will face growing pressure to follow the Federal Reserve in the US and review and amend its inflation-targeting mandate.
From an investment standpoint, the trend toward European unity shown by a co-ordinated response to the pandemic supports European risk assets in general. In the view of Aviva, this should ensure that peripheral bond spreads remain contained.
Eurozone versus US Equities
Russell Investments believes Europe’s recovery should continue over the coming quarters, as the region is more exposed to global trade than the US and likely to benefit more from a rebound in Chinese demand.
Economic indicators have rebounded in Europe following the easing of lockdowns. While infections have been rising, hospitalisation and death rates remain low due to the shift in infections to younger age groups, as well as more effective treatments.
In the longer term, Europe has the potential to outperform in the second phase of the recovery, when economic activity picks up and yield curves steepen, says Russell. This is because of relatively high exposure to financials and cyclically sensitive sectors such as industrials, materials and energy.
Overall, Russell Investments prefers non-US equities to US equities. They believe the second stage of the post-coronavirus economic recovery should favour undervalued cyclical "value" stocks over expensive technology and growth stocks. Notably, other major markets are overweight cyclical value stocks, relative to the US.
Aviva agrees and states relative valuations and cyclical recovery favours Europe and Emerging Markets equities over the United States and Japan. This view is held despite the asset manager maintaining a relatively neutral view on global equities.
A contrary view is offered by Dr Holger Schmieding, chief economist at Berenberg, on the relative merits of the US and the eurozone. He is expecting the eurozone’s economic recovery to resemble a tick mark. This is based on the shape of the recovery to date, with the economy falling sharply in March and April, then rising relatively quickly as supply was switched on in May and June.
While the the doctor was optimistic about Europe’s recovery, when recently interviewed by global trading platform IG, he expected the US to outpace Europe in terms of growth. This is because the US economy had been propped up by generous fiscal policy and pay for furloughed workers, which has resulted in a shallower recession than the one seen in the eurozone.
(Note: a second US fiscal stimulus package will now be determined by the election result, and may not be delivered until next year.)
Having said that, the chief economist for one of Europe’s leading privately-owned banks is clear that the real heavy lifting has already been done in Europe. This is evident with the ECB signalling it is prepared to do whatever it takes to support the eurozone’s recovery. If the economy underperforms, then the ECB may need to add extra funds to its pandemic emergency purchase programme. However, for now, nothing more is needed as a recovery is already underway, says Dr Schmieding.
Daniel Lacalle, the chief economist at Tressis, is predicting an L-shaped recovery for the global economy in 2021 and also prefers the US over Europe. In a video hosted by IG Markets UK, he stated the US is likely to recover more quickly than the eurozone because it has a greater reliance on technology and intellectual property than the EU, which is more heavily dependent on financial services.
The US is also likely to benefit from more favourable demographics, while the effects of the EU’s subsidised scheme for the jobless could weigh on its economy, concludes Lacalle.
Gerard Lyons, chief economic strategist at Netwealth, is expecting a U-shaped recovery for the UK economy. When interviewed by IG, he predicted that the country will come out of recession in the second half of 2020 as the lockdown eases (currently not the case), but said that we shouldn’t expect to reach pre-crisis levels until the end of next year.
The biggest issue weighing on the economy is unemployment which he believes is only going to get worse over the next few months – particularly if the furlough scheme ends. This, he says, could result in employment figures taking longer to get back to pre-crisis levels.
However, Lyons believes that the economy could recover relatively quickly if the government is able to make tax cuts and relax social distancing. While the latter poses challenges, he believes it would be possible provided localised outbreaks can be contained quickly.
Aviva Investors considers the combined headwinds of planned fiscal retrenchment and Brexit add to the downside risks in the UK.
Aviva Investors describes Japan's second quarter GDP contraction of -7.9% as a recession within a recession. It was the third consecutive negative reading, after a consumption tax hike set off a contraction in the fourth quarter of 2019.
The asset manager sees economic output achieving pre-covid levels only in late 2022. The country is also considered partly out of synch as it went into lockdowns later than other countries.
Emerging Markets and Developing Countries
The World Bank’s outlook for different regions varies. It expects GDP to drop more significantly in advanced economies such as the US, UK and eurozone– with these forecast to fall by an average of -7% this year.
Emerging markets and developing countries, on the other hand, are forecast to fall by around -2.5% on average.
Russell Investments likes the value in emerging markets equities. China’s early exit from covid lockdowns and recent stimulus measures should benefit emerging markets more broadly.
China is already achieving levels of economic activity that exceed the pre-covid period in many sectors, reports Aviva Investors. This is led by exports (up 9.5% year-on-year in US dollar terms in August), fuelled by demand for healthcare and some catch-up after first half disruptions.
Longer term, the asset manager believes the state will aim to decouple China from its technological and energy dependencies. The details of top-down plans will be unveiled in October’s 5-Year Plan (discussions are ongoing at the time of writing).
Also interviewed by IG was Andrés Velasco, dean of the School of Public Policy at the London School of Economics. The former finance minister of Chile expects capital to flow out of equity markets as the long-term effects of the pandemic become apparent. In particular, outflows from Latin American countries are likely to be particularly pronounced.
Countries like Argentina, Ecuador and Venezuela would be particularly badly hit, considers Velasco. This is because they have been unable to implement wide-ranging fiscal policies to support families who have lost their income. However, other countries, such as Peru and Chile could fare well, as they have relatively little debt and have been able to deploy their resources to support economic recovery.
Steve Hanke, professor of applied economics at the Johns Hopkins University, agrees on the emerging economies including Argentina and Venezuela. They are considered likely to struggle as a result of volatile currencies and high levels of inflation.
In a suggestion recounted during an interview with IG Markets, he believed that one potential solution would be to replace their respective currencies with the US dollar or new currencies that are pegged to it.
Russell Investments believes Average Inflation Targeting should lengthen the expansion and delay the day of reckoning for equity markets from higher interest rates. US inflation overshoots (and therefore, Federal Reserve rate hikes) are not considered a serious risk until 2023.
Low inflation and dovish central banks should limit the rise in bond yields during the economic recovery from the lockdowns, according to Russell. As a result, government bonds are considered as universally expensive.
Aviva agrees and highlights the decline in government bond yields has made them less attractive, particularly as an effective risk-reducing element. The asset manager prefers to be neutral overall, with overweights in the United States, Italy and Australia offset by underweights in core Europe.
However, Aviva prefers to express more risk in credit markets, as opposed to equity markets, with an overweight view in global high yields and US investment grade. While credit spreads have narrowed materially in recent months, high yield still has the potential to deliver further capital appreciation. This comes with the added bonus of likely remaining supported by central banks should downside risks materialise.
Banks will be affected, suggests Aviva, but will benefit from regulatory forbearance and the central bank largesse mentioned above. Meanwhile corporates are benefitting from low interest rates and in many cases direct purchases as their bonds are included in asset purchase programs.
An example of how valuations have compressed is instructive. From a spread of 1087 basis points at their peak for US High Yield and 401 basis points for US Investment Grade, the spread has narrowed to 547 basis points and 139 basis points respectively. However, the asset management firm highlights these are still 40-60% higher than where they were pre-crisis.
In conclusion, despite record issuance, these asset classes remain attractive and the asset manager prefers the risk/reward they offer compared to equities. In contrast, Russell Investments has a neutral view on high-yield and investment-grade credit.
Daniel Lacalle, the chief economist at Tressis, considers copper may see a strong bounce under a recovery scenario.
Meanwhile, gold should still perform well due to supply/demand dynamics, while oil’s performance will still be marred by excess capacity.
For investors, monetary and fiscal policy settings are important drivers in setting an investment framework. At the present time, it’s important to monitor on a country by country basis the level and speed of pandemic response for its impact upon those policy settings.
Part 1 of this article can be accessed via: https://www.fnarena.com/index.php/2020/10/26/us-election-pandemic-investments-part-i/
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