Friday, 15th of May 2020
“A man who pays his bills on time is soon forgotten.”
– Oscar Wilde
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The recovery rally ran out of steam in the dying days of April, and markets look likely to have peaked in the first two weeks of May. Before the Friday open, the S&P 500 Index was down -2.6% since Monday morning in what would be its worst weekly performance since the sell-off in March. S&P futures do point to a modest recovery before the weekend, and the upswing could yet rescue the index from this dubious accolade, but the (short-term) direction of travel is becoming more established, and we are glad to have some equity protection in place. In Europe, market sentiment has also lost its buoyancy this week, with the Stoxx 600 Index down -4.2% as of Thursday evening. The European large-cap index has since recovered ~1%, but it remains fairly deep in negative territory. Emerging markets, meanwhile, have survived the week relatively unscathed, with the MSCI EM Index down -1.2% in dollar terms before Friday trading begins. This is hardly surprising given that the biggest constituents of the benchmark EM index are China, South Korea, and Taiwan. These three Pacific nations are closer to coronavirus recovery than their Atlantic counterparts, most of whom are in the early stages of easing restrictions.
While on the subject of East Asia, a raft of Chinese data was released this week which offers a window into the country’s post-lockdown economy. Firstly, industrial production beat expectations for April, up +3.3% YoY, after heavy declines in Q1. When you consider that this growth rate takes 2019’s (pre-coronavirus) levels as its base line, the increase is all the more impressive. Indeed, it indicates that manufacturers have perhaps got back to work faster than many feared, and with growth recorded across all major sectors (other than utilities) the industrial recovery looks to be fairly broad-based. That said, fixed asset investment is still down more than -10% YTD as uncertainty weighs on business sentiment and stalls CAPEX plans. And the Chinese consumer is still not really pounding the pavement – retail sales disappointed for April, down -7.5% YoY vs. -6.0% YoY expected. Nevertheless, these figures are quite an improvement on March, when retail sales were down -15.8% YoY. And in a sign that people want to blow off steam after months stuck indoors twiddling their thumbs, sales of tobacco, alcohol, and cosmetics are up sharply. Let the party begin! In response to the mixed economic data, the PBOC has suggested that ‘more powerful’ policies to counter residual weakness will soon be implemented. This is encouraging news for investors in risk assets and EM in particular – a rising tide lifts all boats.
What is not so encouraging is the escalation in antagonism between the US and China. Many countries are furious that China failed to share more information about the coronavirus, its origins, and the scale of the outbreak in Wuhan, leaving them unprepared for subsequent events. Once the immediate crisis abates, China can expect serious repercussions for its lack of transparency. However, in the short-term, the Donald has seen an opportunity to rescue his flagging poll numbers by needling China in advance of the election in November. (Foolishly, Trump squandered the opportunity to appear presidential during the crisis, engaging in political feuds that have damaged his ratings in key Midwestern states where unemployment is also spiking.) Like all of Trump’s most effective barbs, there is more than a kernel of truth amid the bluster on China – and ‘Beijing Biden’ and he are now engaged in a race to the bottom to be as tough as possible on the Middle Kingdom. Just this week, Trump suggested that the US “could cut off the whole relationship…[and] save $500 billion”! The Senate, meanwhile, has passed legislation that could lead to targeted sanctions against Chinese officials connected to the repression in Xinjiang and is mulling additional sanctions if China does not “cooperate and provide a full accounting of the events leading up to the outbreak”. Since China is highly unlikely to bow to US pressure, these sanctions seem to be a forgone conclusion if they pass the Senate. China, in turn, is considering countermeasures including sanctions on the most hawkish Senators personally. This is bad news for markets. China and the US seem to be falling ever further into the Thucydides Trap, with a decoupling of the two economies likely whoever wins in November. This could become a defining feature of the post-covid world.
Another will be the legacy of fiscal and monetary interventions made today. Fiscal stimulus programmes in particular (which are difficult to roll back at the best of times) are very likely to have inflationary effects unless punishing austerity is implemented in the not too far distant future. This seems highly unlikely given the political dynamics in most developed economies today. Moreover, many countries in the Eurozone will see debt burdens that proved near-impossible to tackle over the last 10 years grow even larger, and they may start to favour debt monetisation as the only way out. As a result, we expect a sharpening of North-South disputes over the summer. And, in this context, the decision of the German Constitutional Court to question the legality of the ECB’s asset purchase programme looks like the opening shot in a very serious intra-EU confrontation.
From an investment perspective, an inflationary environment with low short-end rates is likely to favour real assets, such as precious metals and real estate. Within this asset class, we favour gold at present, which can also operate as an effective portfolio hedge and benefits from uncertainty. In our view, much of the real estate sector (e.g., hotels, retail) will remain in the doldrums while lockdowns last. That said, we do like RE special situations and have a very positive long-term sector view given the inflationary low policy rates backdrop. In the medium-term, we believe that inflation is likely to punish long duration positioning in fixed income as well. However, we do not see an imminent bloodbath for bondholders or sharply steeper sovereign curves before the end of the year (not least because inflation won’t pick up until next year most likely). Indeed, the Fed, which also just began previously announced purchases of IG corporate bonds for the first time, is under significant pressure to follow the ECB and cut rates into negative territory. Nevertheless, we expect that when economies open up, ‘normal’ politics makes a comeback, and inflation expectations shift, the duration rally may finally end. You have been warned.
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