The recession triggered by the Covid crisis seems less serious than expected and the economic recovery is partially already underway: the role of central banks is fundamental in supporting at least the markets, if not the real economy. Situation analysis, numbers of the crisis and the recovery, economic forecasts.
They will likely be surprised at the International Monetary Fund to see the speed of economic recovery after the shock caused by the COVID-19 pandemic. If at the time of the publication of the World Economic Outlook in June the IMF forecasts had seemed rather pessimistic (almost -5% of global GDP in 20201), today, after a summer of better than expected macroeconomic data, the scenario outlined by the ‘IMF seems fortunately averted, at least for the moment.
As an example for a comparison, Pictet AM’s estimates, recently revised upwards, predict a contraction in global GDP of around -4% for this year, followed by a sharp rebound in 2021 (over + 6%). The much desired V recovery scenario seems to materialize, at least in the forecasts, and the minimum point seems even less deep than initially assumed.
This is a scenario that favors the economic recovery of Emerging Countries, in particular those in Asia, favored both by better management of the health emergency (with the exception of India, which has recently plunged back into chaos) and by less dependence on their economies from the service sector, the most affected by the crisis: the tertiary sector represents, in fact, only 50% of the GDP of these countries, compared to 70% for developed countries.
In fact, services show a more difficult recovery dynamic, everywhere, as they are more linked to the mobility of people: despite the fact that in August the real-time indicators of daily activity in the services sector started to rise again, these are still far below pre-Covid levels.
In the manufacturing sector the recovery was decidedly faster, exceeding even the rosiest expectations: globally, PMI took 5 months to return to expansion territory (beyond the 50 threshold), a path that during the last major crisis of 2008-2009 had been completed in 13 months. It should therefore come as no surprise that China is currently the only country that has returned to GDP levels at the end of 2019, clearly also due to the fact that it was the first to enter a state of emergency and then to exit it effectively.
However, the improvement in the economic context does not allow us to let our guard down. The risk of a second wave of Covid-19 infections remains and is very real. Around the world, the number of infections has risen in recent weeks, requiring the authorities to remain vigilant and balance the economic aspects of the pandemic with the social and health ones. On the medical front, in any case, today we have elements that allow us to face the health emergency with greater preparation than in the past.
The vaccine is still an unknown, but there are more effective treatments: there is the awareness that the virus will still circulate and that the rules must be respected to contain it.
Monetary and economic policies
The liquidity injected into the economic-financial system by central banks around the world, combined with a mix of supportive fiscal measures by governments, has on the one hand protected the real economy but above all supported financial activities: it is known that excess liquidity (that not absorbed by economic activity) feeds equity and bond valuations.
However, it should be noted that the peak of liquidity injection seems to be behind us, above all due to the slowdown in the expansionary maneuvers of the Fed and PBoC which, as is done with a patient showing signs of recovery, are starting to reduce the amount of care administered . But the central banks themselves have developed a real tonic for the financial markets: the guarantee of a persistently accommodative monetary policies.
The lack of initiative shown by the ECB at its meeting on 10 September, in which no monetary easing measures were taken to counter the strength of the euro, may have been partly disappointed, but it is also true that support for the region’s public and private debt has never ceased. The QE and the PPEP are confirmed and perhaps even strengthened because in Europe part of the budgetary policy support, that provided by the Commission (Next Generation EU), will arrive only in the course of 2021.
But the substantial change in monetary policy took place on the other side of the Atlantic Ocean. The Federal Reserve will wait longer before raising interest rates, even if inflation rises rapidly (once productive resources are fully utilized, i.e. around 2022), especially if after prolonged periods of low inflation like the current one. The rate hikes expected up to last year now seem even more distant, officially postponed by at least two or three years.
In fact, the Federal Reserve has announced a new monetary policy: a new definition of the inflation target has been adopted, again at 2% but no longer just prospective (ie indifferent to the past) but based on the average inflation level (“average inflation targeting “) over a period that also includes the surveys of past months.
The move announced by the US central bank has further implications, primarily for the labor market. Partly set aside the binary objective consisting of price stability and maximum employment, employment takes on an even more central role in the definition of overseas monetary policy. A certainly encouraging sign in a historic moment in which the unemployment rate in the United States, after reaching a peak of 15%, stands at 8.4% according to the latest non-farm payrolls data at the beginning of September.
Situation of the financial markets and forecasts
In the economic scenario outlined, clearly improving but still extremely uncertain and in any case recessive, the unbridled rush of the stock markets from the lows of mid-March seems to confirm the effectiveness of the treatments administered by central banks and governments. In fact, the reduction in real rates down to -1% (-0.5% since June) on US 10-year TIPS is due to an increase in inflation expectations (break-even) with the same nominal yields to maturity. This has driven all financial valuations, allowing the continuous expansion of multiples (price / earnings ratio) despite a slight increase in equity risk premiums (earnings’ yield – bond yield).
The partial withdrawal of liquidity by the Fed is probably a contributing factor to the recent market correction, which particularly concerned the tech sector, driving the rally up to now and on which investor positioning was very concentrated, triggering a phase of taking profits. The limited scope of the market movement makes it difficult, at the level of portfolio construction, to identify assets capable of effectively protecting: the classic decorrelators, such as bonds, VIX and yen, have in fact reacted in a modest way to the reversal of the last sessions, imposing highly tactical management of equity exposure.
On the other hand, valuations on Nasdaq had reached anomalous values. Although earnings reviews for the index companies had been rising for months (more decisively than the rest of the US market and anticipating European exchanges), inflating the denominator of the tech sector’s price / earnings ratio, this had been pushed to stellar levels by the rush of the lists. From this point of view, the recent correction, largely confined to tech, can be understood as a pause for reflection with which we wanted to eliminate an excess. It should not be the beginning of a bear market, at least as long as real rates remain in abundantly negative territory, dragged below -1% by the rise in inflation expectations.
From now on, despite the Fed’s turnaround has removed important brakes, it is likely that these expectations will not depart significantly further from the current inflation level (less than 1%). If, as it seems, central banks do not move nominal rates, real rates will remain more stable, acting as support but no longer as drivers of the equity rally: other health and / or economic levers will also be needed in order for it to continue its running.