RISK MAP: Cautiously Optimistic

Our updated Risk Map reflects the key themes we are working with to develop our global cross-asset views, and the topics of greatest interest from clients. In short, we remain on the risk-on camp and possibly more optimistic than consensus on the virus front, even in the US, due to in part to the favourable interplay between national vs. local/individual forces. But of course, we are more cautious of the rally at these levels and agree with the current consensus that US assets (including the dollar) will face greater headwinds relative to the rest of the developed world in the near term.

POLITICS: It’s the Virus Stupid! 

The pandemic has proven to be the game-changer for US politics. Prior to the outbreak, most observers believed President Trump would easily cruise to re-election on the back of a strong economy and record-high equity markets. An average of the betting markets suggested over 60% odds of a second term back in February. Now, those odds have fallen to around 35%, the lowest on record. Democratic presidential candidate Joe Biden starts Q3 with a sizeable lead in the national polls. More importantly, statewide polls show Biden ahead in the key swing states that Trump won in 2016 (Pennsylvania, Wisconsin, and Michigan). Finally, polls suggest the Democrats could win the Senate.

We believe Biden will hew to a centrist economic path if elected. While markets seem increasingly comfortable with a Biden victory, many remain concerned that economic policy will be dragged to the left by supporters of Warren and Sanders. Biden has outlined some broad details of his economic plans, focusing on a push to buy American goods to increase employment, encourage the development of clean energy, and foster racial economic equality. Reports suggest much of his $700 billion plan will be funded by raising corporate taxes and income taxes on the wealthiest. More noteworthy is the fact that more progressive ideas like the New Green Deal and Universal Basic Income are not centerpieces of Biden’s main economic thrust. 

Looking ahead, his choice of his Vice President and his economic team will be the true tell. Some consider Elizabeth Warren to be a frontrunner for the post of Treasury Secretary.  We do not think this would be a wise choice. This key cabinet post typically goes to someone with either Wall Street experience or high-level academic credentials in economics. Warren has neither, and given the multi-year recovery process that likely lies ahead for the US, we think a more conventional choice is warranted. 

US-China conflict is likely to remain a feature for global markets no matter who wins.  This is one of the few areas where Democrats and Republicans are united. Several bipartisan rounds of sanctions have already been passed by Congress, and more are likely to come. We suspect Biden (if he wins) would maintain a hard line on China.  However, he would be much more prone to building alliances within EM and DM to act as a  unified counterweight to China. 

After a bit of a lull, US-China tensions have erupted again as Q3 gets under way. China vowed to retaliate after the US gave it three days to close its consulate in Houston in order to protect US intellectual property, which the Foreign Ministry called an “unprecedent escalation.” The closure comes after the Justice Department accused Chinese hackers of trying to steal data related to coronavirus research. While this is just the latest in a long string of diplomatic skirmishes over the past couple of years, there has been some notable escalation in recent weeks. Yet, this seems to be a calculated risk by the Trump administration, as it seeks to blame China for a host of problems. While this may play well politically, equity markets may have a different take. 

Investors will have many other geopolitical hot spots to worry about.  China-Taiwan relations seem likely to heat up now that the Hong Kong situation has pretty much gone China's way with little seen in the way of negative repercussions for Beijing. With the US finally pushing back on China's maritime claims, the South China Sea is likely to be a hot spot in the years to come. The Middle East always offers political risk. The civil war in Libya might be considered a regional affair, but it risks drawing in larger countries that have been fighting a proxy war there, including Russia and Turkey. Finally, the pandemic has hit Latin America hard.  Chile and others were already facing heightened social unrest beforehand. If the virus situation doesn’t improve, we see risks of another regional spike in social protests. 

The pandemic has brought Europe closer. After much bickering, the EU was able to hammer out a compromise recovery package. While diluted from the original Franco-German proposal, the final package is still weighted towards grants (EUR390 billion) rather than low interest loans (EUR360 billion). The total EUR750 billion package will be funded through the issuance of bonds. Grants will come out of the EU budget, with the frugal nations receiving large rebates. Loans will have to be repaid by 2058. Some taxes will be raised to help defray the costs, including a new tax on non-recycled plastic wasted and a possible digital tax. More importantly, the more baby steps towards true joint debt issuance have been taken. 

We think markets are underestimating the odds of a hard Brexit. UK press reports that government ministers believe a Brexit deal won’t be reached. UK officials are now working on the central assumption that it will trade with the EU under WTO rules after the transition period ends December 31, though a basic deal remains possible if the EU makes more concessions in the fall. UK businesses have reportedly been told to start preparing for the possibility of a no-deal Brexit. The current round of talks have seen no progress in the contentious areas of fisheries, level playing field guarantees, governance of the deal, and the role of the European Court of Justice. The two sides are ready to meet again in August if there is any progress. Note that the EU reportedly believes that the true deadline for a deal is the end of October, which would allow time for ratification before year-end.

REFLATION: The Music is Still Playing, but the Tune is Changing

We have probably passed peak acceleration, but we expect the rally in risky assets to continue, though US assets may no longer outperform. The balance of risks is shifting, in our view, and we see more downside risks in the US compared to other areas. Investors seemed to have priced US assets as if the infection/mortality corves would flatten as they did in Europe and most countries in Asia. This view is now being challenged, and, with it, the continued relative economic outperformance. In contrast, the re-opening path in much of the rest of the world is looking smoother and with less speedbumps, which argues in favour of a rebalancing away from the US. 

We see some positive risk factors in many other regions, especially those who have managed the pandemic better, such as most of Europe and Asia. In the EU, last minute talks salvaged the €750 billion package, though it was diluted a bit by the “frugal four.” Moreover, the small risk factor caused by the German constitutional court’s challenge of the ECB’s Public Sector Purchase Programme (PSPP) is rapidly being defused. In the UK, there seems to be some positive momentum behind the Brexit negotiations. Even if this only yields a slim deal in the end, the skew for the possible outcomes seem more favourable now, if nothing else, because both sides seem ready to conclude negotiations without an extension, thus shortening the uncertainty period. Asia (or at least most of it) is ahead in the pandemic curve and seem to have the virus under control. This means that their recovery cycle will come earlier than other regions, even if dampened by US weak external demand.

One area of reflation uncertainty as we go to press comes from the US. Reports suggest the White House and Republican Senators are struggling to present a united front in fiscal negotiations. President Trump continues to push for a payroll tax cut. While that is a non-starter for the Democrats, several Republicans are also opposed. It would be bad optics, as the payroll tax funds Social Security and Medicare. It also would not benefit the 20 million Americans that are still unemployed, nor would it boost hiring. Other reports suggest the White House opposes new funding for virus testing and contact tracing, as well as extra funding for the Centers for Disease Control and Prevention. Again, the optics are bad and some Republican lawmakers are pushing back against this. 

Adding to the confusion, Treasury Secretary Mnuchin appears to have abandoned his stated limit of $1 trillion for the package.  This has set off alarm bells with some Republican lawmakers that are growing concerned about rising deficits and debt. One area of progress appears to be the possible extension of the extra $600 weekly unemployment benefits. Democrats want to extend the full benefits through January, while Republicans appear ready to agree to an extension if it were cut to $200-400 per week.  With Congress going back on recess in early August, time is clearly of the essence. Our base case is that a deal is eventually struck.

EMERGING MARKETS: Outlook

One of the many unique features of this crisis was that policy reaction in emerging markets (Ems) was similar to that of developed markets (DMs), but this does not mean the outcomes will be the same in the medium term. For just about every other period of market and economic stress that we can remember, EMs reacted by hiking rates. But not this time. In addition, EM countries implemented counter-cyclical fiscal expansion comparable to those in DMs. And to top it off, some EM central banks even engaged in QE-type policies, though these were mostly liquidity enhancing debt purchases rather than pushing the limit of zero-bound interest rates as in the US, EU and Japan, for example. That said, there are at least two big differences about this cycle: one between EMs  and their previous crisis reactions (FX reaction function), and one between EM and DM (debt funding costs).

The reaction function of EM central banks to currency moves has changed. Many countries who have been very active in FX markets defending their currencies against depreciation pressures (Brazil, Chile, EM Asia) have largely let their currencies go. This makes sense. In the absence of inflation, why not let the currency do some of the adjustment? FX intervention in most EMs has been, in our view, appropriately focused on dampening excess volatility. This resulted in a considerable depreciation in many countries REER (i.e. trade-weighted and inflation adjusted exchange rate). According to the BIS’s measure, Brazil’s exports has been 25% more competitive in the first half of the year on the basis of the currency move, along with gains of 17% and 16% for Mexico and South Africa, respectively. Most of this was due to nominal currency depreciation.

Unlike DMs, most EMs are not able to finance the post-COVID spending at zero or below. Local 5-year yields in Indonesia, Brazil, Russia, India, and Mexico, for example, are still around 5-6%. While not bad historically, it still means that the new spending will put a serious dent on these countries’ debt sustainability. The International Monetary Fund (IMF) estimates the average EM fiscal support to be around 5% of GDP, taking fiscal deficits to 10.5% of GDP for 2020 due to the predictable mix of lower revenues, output contraction and fiscal expansion. There is still a lot of uncertainty and much will depend on the speed of re-openings. It seems reasonable to assume that the recovery is likely to be more, or at least happen sooner, in Asia given the earlier onset of the virus in the region and since the region seemed to have managed its fallout more successfully.

THE VIRUS: Interplay Between Top Down vs. Bottom-Up Forces

The next stage of the pandemic is shaping up to be a delicate dance between (a) national governments pushing for normalization vs. (b) individual behaviour and local authorities working as automatic stabilizers for infection outbreaks. And this tension probably a good compromise. In the US, for example, the national policy directive by the Trump administration suggests that economic priorities now supersede medical ones. This makes sense given double digit unemployment rates and vastly reduced systemic risks to the country’s health systems. Meanwhile, several states have decided to re-instate lockdown measures, which also makes sense. At the same time, individuals are reacting in real-time to local outbreak news, as they should. In one of the worst places of the recent outbreak, namely Houston, Texas, we see mobility trends starting to reverse in mid-June, just as headlines of increased case counts pick up. Exactly as they should.

A similar pattern can be seen in other places. In the UK, for example, local authorities are re-shutting the city of Leicester after an outbreak there just as Prime Minister Boris Johnson kicks off a new phase of reopening. Same in China, where parts of Beijing were selectively shut down.

More broadly, we expect subsequent infection outbreaks to be more manageable for several reasons and for re-openings to continue. First, culture has changed, and most communities know how react to outbreaks. Second, the systemic risks to medical systems are far reduced, if any. Third, the age group of newly infected (specifically in the US) is lower, suggesting diminished risk. Fourth, the elderly and vulnerable are more protected. Fifth, there has been a vast improvement in treatment, testing, tracking, general availability of PPE, and reports of much shorter hospitalization times. To be clear, we are not minimizing the risks of what is happening in Texas, Florida, Arizona, and California, or the ongoing crisis in Brazil and India, but still think the worst of this global pandemic is likely is behind us.

CENTRAL BANKS: This is What it Sounds Like When Doves Cry

The Fed is not going anywhere in H2. Chair Powell said it best after the June FOMC meeting:  “We are not even thinking about thinking about hiking rates.” The latest dot plots suggests steady rates through 2022, but the Fed Funds futures strip shows the market is prepared for the possibility of negative rates by mid-2021. We wholeheartedly disagree, and do not believe the Fed will ever go negative. With the exception of former Minneapolis Fed President Kocherlakota, we have yet to hear any past or present Fed official call for negative rates.

If more stimulus were needed, what might the Fed do?  Some Fed officials appear quite open to the notion of Yield Curve Control (YCC).  It’s clear from the June FOMC minutes, however, that there is nowhere near a consensus yet on YCC, with most officials calling for more study. Instead, the Fed appears to be focusing on outcome-based forward guidance and asset purchases as its preferred method of reaching its dual mandate. Of course, the Fed can easily tweak its existing programs to inject more stimulus. For instance, the Fed continues to tweak its Main Street Lending Program.   

The European Central Bank and the Bank of England both expanded their asset purchases in June. We expect further expansion will be seen by both, as we believe the significantly increased debt issuance will put upward pressure on bond yields in the absence of increased central bank asset purchases. While the Japanese economy is lagging in terms of recovery, the Bank of Japan (BOJ) has signaled that it is on hold for now and allowing fiscal policy to carry the burden of stimulus.

The central banks in countries that have done well to combat the virus remain cautious. The Scandie and dollar bloc central banks have all recognized that the worst is likely behind them.  Yet they all recognize that the recovery path remains very uncertain and so none of these central banks are signaling any need to remove stimulus for the foreseeable future.

Bottom line: the global liquidity story remains positive for global financial markets.  Central bank balance sheets are likely to continue expanding, and interest rates are likely to remain near zero for the foreseeable future.

THE DOLLAR: Look Out Below!

We remain bearish on the dollar near-term, in large part due to monetary policy differentials. Simply put, we still think the relatively more front-loaded reaction by the Fed will continue to exert downward pressure on the dollar during this stage. One way to look at this is to compare the change in size of central bank’s balance sheets. Year to date, the Fed’s balance sheet as expanded nearly 70%. This compares to 35% for the ECB and 15% for the BOJ. We believe that the sheer size and absolute amount of monetary expansion is what matters for the dollar at this stage.

Until recently, we had expected many of these trends to reverse, improving the medium-term outlook for the dollar. The ECB and the Bank of England (BOE) are still likely to continue expanding their balance sheets and monetary bases, which will act as a drag on their respective currencies. However, we believe that growth differentials (rather than relative monetary policy) is more important as a medium-term driver of performance. Until recently, we felt that the US would come out of the crisis in better shape than most of its counterparts, as it did during the financial crisis.

The recent flare up in the infections calls this outlook into question. Much will depend on how the virus numbers develop in Q3 for the problem states. We note that California, Texas, and Florida account for nearly 30% of the US economy.  With reopenings there and in many other states suspended or reversed in July, we see headwinds building for the US. If the virus numbers can be pushed back down, this would surely improve the dollar’s medium- to long-term prospects. But of course, this is a premise we must constantly challenge.

From a longer-term perspective, we note that the dollar is trading around the middle of the trading ranges that have largely held since 2015. For instance, DXY has traded between 88 and 104 since late 2014. At around 95 as of this writing, DXY is basically in the middle of that range.  Similarly, the euro has traded between $1.03 and $1.25 during this same period.  At around $1.15 currently, the euro is basically in the middle of its range too. 

This exercise is simply to put things in perspective. Those analysts that are now saying the dollar is in secular decline ignore the fact that we are nowhere near the dollar’s recent lows. It may end up there eventually, but it is simply too early to push the panic button. If and when the dollar gets near those lows, then we can start to talk about a secular decline. For now, we continue to believe that the dollar is in a cyclical decline, similar to what we saw during the early stages of the financial crisis.