The Shape of the Recovery

Guillermo Ossés

Head of Emerging-Market Debt Strategies, Man GLG

Jose Wynne

Portfolio Manager, Man GLG

A debt overhang, misplaced faith in central banks and no global V-shaped recovery are likely to leave emerging-market sovereign assets exposed to substantial downside risks, either through inflation or default.

July 2020

Introduction

As our clients and readers of our market commentary may be aware, we have been sceptical of the positive impact of the latest iteration of quantitative easing policy on risk asset prices generally, and emerging market (‘EM’) asset prices in particular. As we have previously argued, we believe EM largely suffers from fragile fundamentals, stretched valuations (for credit and rates in particular) and crowded positioning.

Our scepticism, however, has faced increased pushback. The main argument against our view is that major central banks are stuck in a framework where low and decreasing inflation could lock in a highly accommodative monetary stance for a long time to come, and where any weakness in risk assets would trigger even more aggressive easing, effectively limiting the downside. In this article, we review recent developments globally and in EM, provide an update on market positioning and discuss why we believe that the faith placed in global central banks’ puts may be misplaced.

Recorded on 24 July 2020

This Time Is Different

In March, when authorities in most developed countries implemented shutdowns across multiple sectors of their economies, policymakers and market participants believed that Covid-19 would trigger a sharp but short recession. They also believed that fiscal policy expansion would help the real economy replace lost income and monetary policy expansion would prevent market dislocations, allowing issuers to roll over their debt and economic activity to fully recover. This line of thinking underpinned the recovery in both credit and equities witnessed between early April and June.

Although we believed in late March that we would see a strong policy response to stabilise markets, we disagreed with the market optimism and suggested looking beyond the contraction in 2020 to the longer-lasting consequences of this pandemic on the global economy. Indeed, we believe that mounting evidence will soon show that expectations on a V-shaped recovery may be misplaced.

If our suspicion proves right, central banks and fiscal authorities may be forced to reconsider their generous stimulus plans. Indeed, if the pandemic leaves traces of more structural damage to the global economy, as we suspect it will, we may see fiscal/monetary headwinds going forward, as the fiscal expansion initially designed to replace the loss of temporary output faces the reality of a more structural economic damage.

Fiscal and monetary stimulus help only to the extent that aggregate demand is below its potential. This is still probably the case. As soon as demand partially recovers, if global output potential gets impaired, we believe indiscriminate policy support will prove counterproductive, even if it can be afforded. Both internal budget and monetary policy discussions in the US, and most of the G7, carry this logic. For these reasons, and given the pace at which evidence of structural economic damage is building up, we suspect that the horizon for generous policy support may be shorter than the market may think.

Our views have been challenged with the idea that risk assets should never fight the Federal Reserve. Indeed, former episodes of quantitative easing and Fed balance sheet expansions have proven a great environment for risk assets. This time, however, we do not see it that way. Once monetary policy has reached its limits, the only role for the Fed is to keep the curve broadly stable as fiscal stimulus kicks in. That implies that the balance sheet will endogenously expand as the fiscal stimulus widens. We agree that keeping the yield curve from widening is beneficial. However, to avoid the fiscal stimulus from crowding (in private spending in consumption and investment) and thus reaping the full benefits of fiscal stimulus, we believe this balance-sheet expansion is not proactive monetary policy this time around. It is for this reason that the recent leg of central bank bond purchases should not be considered as supportive for risk sentiment as in the past.

This logic suggests that if fiscal stimulus were to be tapered on the perception that potential output has been impaired, the balance sheet expansion will have to slow too. Those placing their confidence in the Fed plugging the stimulus gap and providing a put to risk assets may find it greatly misplaced.

In addition to the economic logic, we also see mounting socio-political limits that may limit support for risk assets. These are discussed towards the end of this article.

This backdrop makes the outlook for EM countries particularly challenging for the coming months. In our view, it all boils down to the shape of the recovery.

The Economic Recovery Is Unlikely to Be V-Shaped

Given the recent rise in the number of new cases of Covid-19 across multiple states in the US, we believe it is becoming increasingly difficult for the US economy to return to the levels of activity experienced before February 2020. In our view, there are two indicators proving that this economic deceleration will be protracted: the evolution of weekly jobless claims in the 40 years to 2019 (Figure 1) and the evolution of weekly jobless claims during 2020 (Figure 2). Indeed, if US employers had expected the economy to normalise in the near term, initial jobless claims would have already returned to the 200,000-600,000 range typically observed in the last few decades, in our view.

After the initial rounds of layoffs in April and early May on the back of the shutdown, we continued to see high numbers of initial claims from mid-May. We believe these are related to layoffs that are likely to be more structural and longer lasting, substantially reducing the likelihood of a V-shaped recovery.

Figure 1. Weekly US Jobless Claims (1979-2019)

Source: Bloomberg; as of end-2019.

Figure 2. Weekly US Jobless Claims During 2020

Source: Bloomberg; as of 19 June 2020.

This dynamic seems to be confirmed by Google’s Community Mobility Reports¹, which show how visitors to (or time spent in) different places have changed, compared with a baseline median value for that day of the week during the 5-week period between 3 January and 6 February, 2020 – i.e. before the pandemic extended outside of China.

Figure 3 shows that activity in the retail and recreation sector is languishing 10-20% below the baseline. This figure seems to have been plateauing in the second and third weeks of June. Public transport (Figure 4) and time spent at the workplace (Figure 5) are still 20-30% and 10-40%, respectively, below baseline levels. Indeed, time spent at workplaces have actually begun to decline again in the last few days.