UE-EN Institutional

Coronavirus vaccine developments are extremely welcome news

The US, UK, Euro Area and Japan all look to be headed for a very weak end to Q4, with some potential weakness dragging into Q1 of next year.
November 2020

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The global economy hailed a series of positive developments on the vaccine front at the start of the month. Pfizer-BioNTech were first to announce successful Phase 3 trials of their vaccine with 95% efficacy. The Moderna and AstraZeneca-Oxford vaccines also reported positive results. No vaccine has yet received regulatory approval for mass public use. Also, there remain several manufacturing and logistics related obstacles in the way of mass distribution. Perhaps most challenging for the new President-elect Joe Biden and other global policymakers, will be addressing public scepticism against the vaccine. A recent Gallup poll, conducted at the end of October, indicated that 58% of Americans who participated in the survey were willing to be vaccinated. Despite these challenges, the news is overwhelmingly positive and extremely welcome for the major economies who are battling second and third waves. Particularly, the US, UK, Euro Area and Japan all look to be headed for a very weak end to Q4, with some potential weakness dragging into Q1 of next year.

All four economies responded to record increases in infections with varying levels of new restrictions. Nations across the UK entered various forms of lockdown in November, joining several EU economies in closing all non-essential stores. Although restrictions in the US were less strict, the economic effects as expected have weighed on consumption predominantly in the services sector. The latest Markit Services PMI for Europe contracted to 41.3, 7 points lower than the level in July. Retail sales in the US grew by 0.3% in October, a sharp deceleration from the 1.6% growth in September and consumer sentiment indicators for the major economies have collapsed again to levels seen at the end of Q2 this year.

Correspondingly, inflation data for October was depressed. Japan returned to deflation registering -0.4% growth in consumer prices compared to a year earlier, the lowest level since 2016. The UK, EU and US CPI grew by 0.7%, 0.2% and 1.2% respectively over the last year. We note, however, some important conclusions in a recent IMF study on the difficulties of capturing true inflation during the lockdown. The CPI basket, which most economies use to measure inflation, is sticky and fails to reflect sudden changes in spending preferences. Specifically, during the lockdown consumers spent more of their income stockpiling food (food prices increased) and less of their income buying plane tickets (travel costs collapsed). The CPI basket fails to reflect this change and therefore overestimates the deflationary impact of travel costs and underestimates the inflationary impact of rising food prices. The IMF concluded that global inflation is close to 0.4% higher after these adjustments.

Economic and financial developments in China

We continue to monitor economic and financial developments in China, which in many respects are in stark contrast to the situation in most developed economies. China’s recovery since the first lockdown has continued to remain robust. Industrial production, which has benefitted from fiscal subsidies, grew 6.9% in October compared to last year. Private consumption, which initially acted as a drag on the economy in the first half of the year, has now picked up. Urban unemployment has fallen to 5.3% and retail sales grew 4.3% compared to a year earlier, the strongest growth since December. The external sector has been exceptionally strong. China recorded a current account surplus of a $110bn and $94bn in Q2 and Q3 this year. Exports grew 11.4% over the last year, largely a result of strong demand for medical equipment and work from home technologies.

On the policy front, the PBoC has not printed money in the same fashion as developed market central banks. Last month, PBoC Governor Yi Gang explained his view against excessive monetary stimulus in a PBoC affiliated magazine, China Finance: ‘in the long run it will inflate debt and asset bubbles, distort economic structures, influence income distribution and increase systematic risk.’ We certainly agree. In avoiding excessive money printing, China has again signalled its commitment to maintaining a managed exchange rate regime. This monetary stance has resulted in a growing rate differential between the other major economies. China’s 10-year bond now yields 3.3% versus 0.9% in the US, -0.6% in Germany and 0.3% in the UK. Expectedly, investors searching for a positive yielding ‘lower asset risk’ have gobbled up Chinese domestic debt this year.

However, there is a limit to how high rates can get before financial risks begin to emerge. Earlier in the month investors were caught off guard by a series of defaults among a few state-owned enterprises (Yongcheng Coal & Electricity Holding Group as well as Tsinghua Group were among the notables). This has led over 20 Chinese companies to delay plans to issue new bonds. Furthermore, the credit events in the corporate sector have affected domestic demand in the sovereign bond market, even though foreign demand remains strong. This has resulted in even greater upward pressure on yields. Finally, commercial banks, who hold 49% of onshore domestic bonds, are experiencing a surge in demand for cash. 3-month shibor, the interbank lending rate for Chinese banks, has doubled over the last 5 months to 3%, now higher than the level at the start of the year. The gradual tightening of the financial system has prompted the PBOC to inject a net $30 billion in the form of reverse repos, similar to Federal Reserve operations at the end of last year. China has continued to avoid a major crisis in their efforts to tackle the excessive build-up of debt post-GFC. Time will tell as to how successful their efforts will ultimately be. For now, we await the next PBoC meeting at the end of December for any shifts in strategy.

Positive market reactions as optimism increases

Turning to markets, investors reacted positively to the vaccine news and the suggestion of a smooth transfer of power in the US, largely looking through the stark reality of a resurgent wave of coronavirus cases. November saw exceptional equity market returns with the MSCI AC World returning around 13%. From the lows in March, the MSCI AC World has rallied about 60% and is trading close to all-time highs.

The Pfizer vaccine announcement was rightly hailed as another form of stimulus, with long-term interest rates widening and equity markets rediscovering the worst hit cyclical industries that sold off in the wake of lockdown restrictions. Following the announcement, investors moved out of government debt with the 10-year yield on US Treasuries trading at levels last seen in March.

Momentum stocks that have benefitted from the changes in behaviour induced by lockdown such as PayPal, Zoom and Netflix were among the worst hit. The widening of yields has slightly tarnished the appeal of growth stocks given most valuation models will now be applying a greater discount to earnings growth. Value stocks, often in economically sensitive industries, found themselves drawing the attention of investors causing them to lead equity markets following the positive vaccine news.

In the UK, Sterling appreciated on news that a trade deal with the EU was close to being approved and on optimism that a vaccine will support the beleaguered services-driven UK economy. The hospitality sector is fragile as nations across the UK remain in a second lockdown until early December. With regards to Brexit, officials on both sides of negotiations have sounded upbeat with a positive outcome largely priced into Sterling.

Conversely the US Dollar weakened through a combination of low rates and positive vaccine news. Positive vaccine news has led to expectations that an economic recovery will arrive sooner than previously anticipated causing the US Dollar to lose some of its safe haven appeal.

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