As of September 30, 2020
The COVID-19 pandemic and resulting lockdowns led to the most severe global economic contraction in decades in the first half of 2020. But as the lockdowns were eased and restrictions were loosened, economic life moved back in the direction of normalcy. The JPMorgan Global Purchasing Manager Indexes (PMIs), a broad measure of business confidence for both the manufacturing and services sectors, dipped below 50 (which signals contraction) in February, bottomed at shockingly low levels in April and then began to recover. Both the manufacturing and services PMIs moved above 50 in July and registered levels of 51.8 and 51.9 in August, consistent with expansion in both manufacturing and services globally. Measures of economic growth also surged over the summer months, with the major advanced economies expected to post double-digit GDP growth on an annualized basis in Q3.
Nonetheless, there are already signs that the pace of growth is losing momentum. Growth in Q4 will inevitably be slower than in Q3, and major advanced economies will post annual GDP growth numbers for 2020 that are deep in the red. China’s economic recovery has been out of sync with the rest of the world as its economy absorbed the worst of the virus’s blow in February, and its economic recovery began in the second quarter when most other parts of the world were just beginning to lock down. China’s draconian lockdown was highly effective in subduing the virus. As a result, its economy suffered less damage and bounced back sooner. Thus, China’s economy is expected to post positive growth for calendar year 2020 and may have already regained its COVID-related lost output.
It remains highly uncertain when other major economies will regain pre-COVID-19 levels of economic activity. The Federal Reserve revised up its US growth forecast and expects a smaller GDP decline in 2020, projecting the US should fully regain lost output by late 2021. Consensus forecasts also expect a similar recovery trajectory for the US, while Europe and Japan are expected to take considerably longer. The path ahead could be bumpy, as the global economy struggles with the pandemic and its residual effects.
The pace of the economic recovery will depend on the answers to several critical questions. How will the pandemic evolve as the northern hemisphere moves toward autumn and the flu season and as kids head back to school? How quickly will effective medical breakthroughs emerge on the treatments and vaccine fronts? How quickly will governments and the private sector be able to scale up production of an effective vaccine, distribute it, and inoculate large segments of the population? Will the US presidential election and subsequent governing regime prove disruptive to both the economy and markets? Will there be a reescalation of US-China tensions? Will governments around the world continue providing sufficient fiscal stimulus to support their economies, or will fatigue and complacency set in? More action is needed on that front, and the cost of letting up will be many times greater than the cost of continued support.
The current downturn was triggered by the pandemic, an external shock, rather than the build-up of economic imbalances that precipitated previous downturns. Therefore, the global economy should be better positioned to bounce back more quickly today than in the years after the Global Financial Crisis. Meanwhile, economic data continue to surprise to the upside, and news about the development of a COVID-19 vaccine and treatments continues to be positive.
The Fed also announced in August that it would change its operating framework to a flexible inflation-targeting framework. This emphasizes that the Fed will target an inflation overshoot during economic recoveries, following inflation shortfalls during downturns. Thus, the Fed is likely to let the US economy run hotter than it would have in the absence of this change and likely would delay tightening policy until the economy and actual inflation has picked up a considerable head of steam. At its September meeting, the Fed indicated that it does not expect inflation to reach its 2% inflation target until 2023, at the earliest, and hence expects interest rates to remain at zero until 2023.
The biggest downside risks appear to be on the geopolitical and/or political fronts. In particular, the US Congress has been unable to agree on another round of fiscal stimulus. This is a concern, as the economy has not felt the full impact of the pandemic because policy stimulus has filled the hole. While some sort of deal may still emerge, should Congress fail to act, the loss of fiscal support would undercut the progress the US economy has made since May. In that case, the economy’s momentum could carry it a bit further, but ultimately the recovery would slow.
Following the US election, there is likely to be increased fiscal spending on health care and infrastructure (in the case of a Biden win) or further tax cuts and additional spending (in the case of Trump’s reelection).
While economists continue to debate whether the economic recovery will be V-, U-, W- or even Nike Swoosh-shaped, the equity market recovery has been V-shaped with many markets fully erasing losses from March’s severe drawdown. After surging 20% in Q2, global stocks posted solid gains in July and August, before paring gains in mid-September. Equity market gains continue to be led by the United States with the S&P 500 Index1 rising to a new all-time high of 3580 in early September before pulling back. International markets continue to lag the S&P 500, but all major markets have had very significant rallies since their March lows. The MSCI EAFE Index2 is still in negative territory year-to-date, while emerging markets have moved into positive territory, but even the MSCI EAFE Index has recouped losses that began in March.
Q2 highlighted a big divergence between the economy and financial markets and validated the idea that markets discount future economic trends, given the surge in Q3 economic growth. Meanwhile, Q3 has further crystalized that we are in a two-speed economy and two-speed market. The S&P 500, for example, is up 6.2% year-to-date and up 50% from its March low. Meanwhile, the tech-heavy NASDAQ is up more than 20% year-to-date, gaining 57% since the March low. Among US sectors, Information Technology and Consumer Discretionary are up over 20%, while the cyclical sectors, Industrials, Financials and Energy, are down for the year. (The latter two are still down significantly.)
The macro environment continues to be positive for equities and other risky assets. Economic growth continues to recover in an environment with lots of spare capacity in both labor markets and industry. Governments continue to provide massive support with fiscal and monetary largess, and there is little concern that inflation pressures will force them to step on the brakes anytime soon. The Fed’s new operating framework may push real rates further into negative territory. Meanwhile, longer-term inflation expectations have started moving in the Fed’s preferred direction, but are still only rebounding from very low levels. On the vaccine front, the number of candidates continues to grow, and regulators are preparing to consider emergency approval measures, potentially allowing a vaccine to become available by year-end. With the rebound in economic growth, earnings revisions have moved sharply back into positive territory. As a result, the earnings growth hole for the S&P 500 Index in 2020 is not nearly as deep as originally feared, and estimates for calendar 2021 are expected to surpass results for calendar year 2019.
The danger here is that markets have already moved too far in discounting the improvement in fundamentals, as broad equity market multiples have reached levels last seen nearly two decades ago during the Tech Bubble. But equity valuations look much less ominous on a relative valuation basis compared to zero, near zero, or negative yields on cash and government bonds. This, combined with the lack of appeal of commercial real estate, has led to a perception among investors that equities are the only game in town and may be sparking a TINA (“There is no alternative”) trade, especially with the Fed seeking to push real rates further into negative territory.
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- 1 A benchmark representing 500 of the largest U.S. publicly traded companies by market value
- 2 A benchmark representing the performance of large and mid-cap securities across 21 developed markets, including countries in Europe, Australasia and the Far East, excluding the U.S. and Canada