Pyrford International July Monthly Commentary

The global economy experienced a welcome bounce in activity over the last couple of months following an easing of lockdowns. Investors continue to take confidence from the continued aggressive monetary and fiscal policy support, providing justification to look through inconsistent macro data, instead of focusing on the prospects for a global recovery. However, many countries still find themselves struggling to shake off the spread of the virus. We see an increasing divergence in the growth trajectories of major economies, a result of the various strategies adopted in the fight against the virus.

The economic rebound in the US has not come without costs. Data earlier in the month surprised on the upside. Retail sales increased by 7% in June following an 18% jump in May as consumers returned to shops and restaurants. Similarly, manufacturing and non-manufacturing PMI’s increased to 52 and 57 respectively, indicating a sharp expansion in business conditions. Finally, the housing market staged an extraordinary bounce back following the initial shock. Buoyed by record low mortgage rates and fiscal stimulus which has boosted disposable incomes, mortgage purchase applications are now above pre-COVID levels.

It didn’t take long however, for the second wave of infections and deaths to spread across the US, particularly in the sunbelt states of California, Arizona, Texas and Florida though arguably they are still in their first wave. The daily number of infections posted new highs in July with the death count also rising. This has prompted a number of states, representing 80% of the population, to either pause or reverse plans for reopening. The premature reopening of the economy now threatens a severe hospital crisis as well as a reversal in the growth trends seen in May and June. In contrast to the backward-looking indicators mentioned above, certain leading indicators have provided a more real time picture of the health of the economy. Consumer confidence, as measured by the University of Michigan Consumer Sentiment index, has fallen from 78.1 to 73.2 – just two points above the lows in April. More significant was the weekly initial jobless claims number which came in higher than expected at 1.3m.

Unemployment now stands at 11% as the US approaches a ‘fiscal cliff’ which urgently needs to be addressed to avoid a deeper and more prolonged recession. Specifically, the $600 a week unemployment benefits, as part of the CARES act, are set to expire at the end of the month. Unless Democrats and Republicans can agree on a second-round fiscal package, millions of unemployed Americans will be left exposed. At the time of writing, Republicans have announced a $1tn stimulus plan that would cut emergency unemployment benefits. Agreement still needs to be reached with the Democrats who view $1tn as insufficient in the face of a stalling recovery. Given the severity of the economic crisis it is expected that a compromise will be reached. The risk is that the stimulus measures will disappoint at a point when equity valuations have moved further back into expensive territory.

China is the only major economy to register growth in the second quarter. GDP growth came in above expectations at 3.2% for the last 12 months. Following a -9.8% contraction in Q1 of this year, GDP grew 11.5% in Q2. Ignoring the skepticism surrounding official Chinese data releases, these figures are confirmation of a remarkable V-shaped recovery by the first country to be hit by the virus. Under the surface, we observe an uneven recovery with production growing faster than consumption. Industrial production grew by 4.8% over the last 12 months and investment in real estate and infrastructure rebounded by 8% and 6% respectively. Retail sales, however, continue to be a drag on the economy falling by 1.8% in June, likely a result of an elevated unemployment rate and a weakened household balance sheet following the initial shock to income.

However, there are at least two roadblocks in the way of China’s impressive recovery. Firstly, devastating floods, which began at the beginning of June have hit 27 provinces affecting over 45 million people. Fortunately, the damage does not appear as severe as the 1998 floods, which caused an estimated economic loss of around 3% of GDP. Secondly, there is the ongoing spat between the US and China. The tit-for-tat continued this month with the closure of the Chinese consulate in Houston. In retaliation, the US consulate in Chengdu was also ordered to close. So far, the impact has been more symbolic than economic. Of course, the tensions must be viewed in the context of an upcoming election. With a build-up in anti-China rhetoric, Trump draws some attention away from the deteriorating situation within his own country.

July was an historic month for the EU as policymakers agreed on a recovery deal after 5 days of negotiations in the longest summit in 20 years. This marks the first instance of debt mutualisation among the 27 EU countries. The European Commission will issue common debt to finance a €750bn recovery plan, €390bn of which will be in the form of grants. Ultimately, the southern economies emerge as big winners from the deal. The grants will be disbursed to those areas most affected by the virus. The rest of the recovery plan in the form of loans will offer an attractive source of funding with lower interest rates and light conditionality.

The positive news out of Europe on both the policy and virus front has briefly initiated a conversation on the reversal of US outperformance, a persistent trend over the last decade. Europe has certainly experienced a deeper crater in economic output, a result of stricter lockdown measures. However, with the virus tamed for the most part (cases have picked up in the Catalonia region as well as in Belgium) Europe could expect a smoother recovery, relative to the US. Indeed, it’s very early days to determine whether this trend can be sustained. What is certain, is that European policymakers have displayed greater unity and urgency compared to their performance following the GFC.

 

In summary, we remain sceptical about the pace and breadth of the economic recovery. The main risk facing markets is not government restrictions but fear of the virus and how this impacts behaviour. Attempts to reopen sectors will fall short of returning to previous levels unless genuine progress in combatting or managing COVID-19 is achieved. We have seen this play out across southern US states, which have struggled to reopen sectors against a reacceleration in infections. Other US states, most European economies and most Asian economies have demonstrated the ability to manage the infection better with rates ticking lower, increasing the prospect of an economic recovery.

Markets have attempted to distinguish between these uneven recoveries with economies that have managed reopening better than others seeing investor support. That said, a return to pre-lockdown economic activity will not be realised until a vaccine is found. Equity prices do not reflect this with overly optimistic investors ignoring the grim reality.

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