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.