The biggest threat to a quick recovery is a second wave of the virus

In May, several countries began to ease lockdown restrictions in an attempt to restart their economies. The economic discussion has firmly shifted from an assessment of the damage inflicted by Covid-19 related lockdowns, to questions surrounding the speed and strength of the recovery following reopening. The biggest threat to a quick recovery is a second wave of the virus later this year prompting new restrictions. Yet, even if the virus is controlled, there are a number of existing economic headwinds for investors to grapple with.

Over the course of the month, we saw an escalation in US-China tensions. First, the US tightened regulations on Huawei, who is accused of acquiring semiconductors that are produced using American technology and software. Less than two weeks later, China proposed a new national security law over Hong Kong, which reignited protests
in the region. The White House responded with threats of sanctions. In addition, a directive was issued to the federal employee pension funds to not invest in Chinese firms as the war between the two superpowers moves from trade flows to capital flows. For now, the economic damage of the renewed tensions has been limited and, importantly, the ‘Phase- One’ trade deal signed at the beginning of the year is still intact. Kristalina Georgieva, the IMF Managing Director, has warned against another trade war that would weaken the economic recovery at a critical juncture when many economies are looking to get back on their feet.

We maintain our view that protectionism, in the form of tariffs or otherwise, are bad for business. They raise costs for an already bruised consumer, misallocate resources and lower much needed incomes for countries that rely heavily on global trade. Australia for example, is paying the price after pushing for an independent inquiry into the origins of the coronavirus, much to the anger of Beijing. China responded by banning imports from four meat processors and a week later, slapped Australia with an 80% tariff on all barley imports. This follows a forecast by the RBA of a 10% contraction in GDP in the second half of 2020, plunging Australia into its first recession in over three decades.

Turning to Brexit

The British Pound continued to weaken and is heading for a fourth consecutive month of depreciation against major currencies as the important milestone of end June rapidly approaches. Negotiations with the EU are ongoing though there are few signs of progress. The end of June is the deadline for when the Brexit transition period can be extended and there is no indication that the UK will look to extend the transition further out from the end of 2020. Should the transition period not be extended negotiators will have months to agree a trade deal, a process that typically takes years. That said, we’ve seen in previous negotiations how discussions are pushed to the eleventh hour so expect a volatile second half of the year should the transition not be extended.

The battle for the survival of the Eurozone continues, with significant developments over the course of the month. On the 5th of May, the German Federal Constitutional Court (GFCC) dealt a blow to the ECB’s Public Sector Purchase Program (PSPP). The GFCC claimed that the ECB, through the PSPP, was pursuing its objective (inflation close to or below 2%) but ignoring the other economic effects of the program (such as the effects on personal savings, the rise in asset prices and public debt etc.) and therefore ‘manifestly disregards the principle of proportionality.’ The ruling serves as a powerful reminder to investors of the very real legal constraints faced by the ECB. With this ruling, the ball was placed in the court of the elected politicians to offer a fiscal solution to the crisis. A Franco-German initiative emerged, proposing a EUR 500bn Recovery Fund (later increased to EUR 750bn), consisting of mostly grants and disbursed to those countries most affected by the crisis. The initiative constitutes the most significant step toward fiscal integration since the birth of the union. However, shortly after the announcement, the proposal met with opposition from the ‘frugal four.’ Austria, the Netherlands, Denmark and Sweden object to the handing out of grants and propose a ‘loans for loans’ package. Ultimately, the package can only be implemented with unanimous agreement from all EU27 members. We await the news from Brussels as EU leaders begin debating the proposals this week.

The importance of consumer spending

Another necessary pillar for a strong recovery is a bounce back in consumer spending. Interestingly, many have forecast a spike in private savings rates across the developed world as incomes have largely been preserved, whilst expenditures have seen a much bigger collapse. In its latest Spring Forecast, the European Commission predicts that European households will save a record 19% of their income this year. Oxford Economics forecast this rate to be close to 15% in the US, where the household savings ratio has been below 10% for the last 30 years. The BOE have also noted a surge in UK bank deposits in March. It is unclear how much of this is ‘forced savings’ due to fewer spending opportunities in lockdown, versus precautionary savings stashed away in the fear
of troubles ahead. For all three of the above economies, household consumption forms the largest component of GDP (52% in the EU, 68% in the US and 63% in the UK). These governments will be hoping that the rise in savings does not form a longer-term trend.

Retail sales data in April illustrates the immediate damage resulting from the collapse in consumer spending. In the US sales were down 16.4%, almost double the figure for the previous month. In the UK, sales fell 18.4%, Canada 10% and the Euro Area, 11.2%. These economies can take at least some relief from China’s experience of reopening, where retail sales have fallen only 7.5% compared to 15.8% the month before. These data points correspond to a record drop in retail prices as much of the developed world fights deflation. US core inflation, which excludes food and energy prices, was down 0.4%, the largest one month decline since records began in 1957. The monthly change in total CPI was -0.8% for the US, -0.4% for Switzerland, -0.2% for the UK, 0.3% for the Euro Area and -0.7% for Canada.

Against this economic backdrop, markets continue to be pushed and pulled between government support packages and concerns on a spike in coronavirus cases as lockdown measures are rolled back in many economies. The market is also weighing $6 trillion of stimulus packages against the potential for a significant deterioration in earnings with some forecasters expecting a contraction of 50% this year. Nonetheless, market moves in the month reflect the view that earnings growth will recover over 2021 despite continued uncertainty on the duration of a recovery and the impact of unprecedented government borrowing. As we’ve discussed before, such swift and sizeable rescue packages were a necessity, but they come at a price. A legacy of greater debt and challenging demographics suggests global growth will remain subdued for many years. Moreover, in economies that have relaxed lockdown restrictions business activity has improved but remained tentative and a long way off pre-lockdown levels. Consumer behaviour is understandably cautious in ramping up discretionary spending given the significant risk of redundancies in sectors worst hit by the lockdown measures. Consumers will remain cautious when given the choice of returning to bars, restaurants, theatres etc. and furlough schemes are not indefinite. As furlough schemes retrench, discretionary spending will be hit with the real prospect of a further spike in unemployment.

Our View

Investors are looking through the pandemic and disappointing earnings announcements to 2021 to justify pushing equity valuations higher despite the reduction in corporate profits and dividend payments. We admire the optimism but it is premature. The economy and the stock market have totally disconnected and, with familiar geo-political issues returning to the fore, opportunities for continued volatility through the end of the year remain.

Disclosures

Past performance is not a guarantee of future results.

All investments involve risk, including the possible loss of principal.

This report is for general information purposes only and is not intended to predict or guarantee the future performance of any investment, investment manager, market sector, or the markets generally. We will not update this report or advise you if there is any change in this report. The information is based on sources believed to be reliable. We do not represent or warrant that the report is accurate or complete.

This presentation may contain targeted returns and forward-looking statements. “Forward-looking statements,” can be identified by the use of forward-looking terminology such as “may,” “should,” “expect,” “anticipate,” “outlook,” “project,” “estimate,” “intend,” “continue” or “believe” or the negatives thereof, or variations thereon, or other comparable terminology. Investors are cautioned not to place undue reliance on such returns and statements, as actual returns and results could differ materially due to various risks and uncertainties. This material does not constitute investment advice. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investment involves risk. Market conditions and trends will fluctuate. The value of an investment as well as income associated with investments may rise or fall. Accordingly, investors may receive back less than originally invested.

Pyrford International Ltd. (Pyrford) is a registered investment adviser and a wholly owned subsidiary of BMO Financial Corp.

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