Oct 13, 2020
• The markets have made progress of late despite the lack of vaccine approval
• Good US service sector suggests a broadening of the recovery
• Strong car sales and house purchases add to the confidence
• US credit markets benefit from the better news
• The risks remain – slow progress on the fiscal package and dysfunctional politics
A vaccine could help markets, but extra stimulus would be even better. A strong US economic recovery is on track, but the risk of a relapse needs hedging.
As severe as the impact of COVID was on markets and economies around the world, recovery has been quick in certain areas. That qualification is important because the recovery to date has not been universal, and some parts of the global economy will be irrevocably damaged and will have to change. Some regions will have suffered more lasting damage than others. Even so, the speed of the recovery has probably surprised even some of the more optimistic observers.
Where the general opinion until quite recently has been that for a full recovery, a vaccine is required that is safe enough and administered widely sufficient for a complete global re-opening to occur. Is this a correct assumption, or is there enough life in the recovery to discount the necessity of a vaccine? Put another way, what else will be the key driver(s) of a sustainable recovery, barring a vaccine?
Recent economic data from the US and elsewhere continue to show that the global recovery is in train, even if it is premature to call growth to revert to the trajectory on a par with the pre-COVID situation. However, some of the numbers make for encouraging reading, especially when compared to the rate of recovery witnessed after 2008. One such example is the recovery in the US labour market. The sudden stop in March this year saw the unemployment rate almost hit 15%, where the jump in 2008/09 was capped at 10%. While the recovery post-Lehman was a slow process which culminated in a breach of 4% by the end of 2019, the current recovery is proceeding at a rapid pace, with the latest unemployment reading at 8%. That is the same as in 2012, a full three years after the shock of the global financial crisis. Admittedly, there are strong reasons to suspect that it will be difficult for the current pace of the recovery to be maintained.
Among other things, a positive spin-off from a declining unemployment rate is that the ceiling in corporate defaults should be lower than the market might have expected. Indeed, it now looks unlikely that the default rate goes beyond the 14.5% or so high set in 2009 now looks quite unlikely. There have been high defaults from specific sectors (energy), but by Moody’s reckoning defaults will not exceed 10% in this cycle.
Apart from the favourable implication for corporate spreads and credit returns, at the broader macro level, it provides an avenue for much of the liquidity that has been pumped into the system to find a home.
When firms can continue refinancing themselves, spreads (borrowing costs) will continue to recede, especially in an environment where final demand has been mended, and cash flow risk is enhanced by strong operational performance. Such an outcome is more sustainable than a series of infusions and interventions from policymakers.
Apart from the labour market, the services sector seems to be in good shape COVID did indeed hit service providers very hard. The airline industry, entertainment (not the online variety) and restaurants were among the specific industries decimated by the lockdown rules. But the recovery in the broader services sector, as measured by the services ISM, has been robust. In Asia, the presumption is that the handling of the pandemic has been better than in other regions. We await data to be more conclusive about the view.
In data released last week, the US non-manufacturing ISM rose to 57.8 in September from 56.9. The index has now clocked four consecutive months above 56, flashing a recovery even more potent than some previous post-recession rebounds.
A rebound in US sales of cars and houses adds to the sense of lifting fog. Sales of new and existing homes are now running at an annualised clip of 7 million units, compared to a rate of 6.5 million before the virus struck, and 5.5 million five years ago – a pace which was viewed as healthy and normal back then. Even if one allows for a significant shift in location preference (are people leaving cities in their droves?) the numbers reflect a very healthy housing market, and suggests very little, if any, stress in the availability of mortgage credit for buyers. The same upbeat message would apply to sales of cars and light commercial vehicles (in the US little trucks are viewed as big cars in many areas). The annualised rate in September was edging above 16.2 million units – lower than the 17 million clip pre-COVID but a massive spike from the low of 9 million in April.
So, if all of this can happen without a vaccine, is the right strategy simply one of loading up on risk and watch the market continue its rebound after the September slip? Already, the S&P500 is at a five-week high and approaching the all-time high set in early September. Taking a defensive stance under these circumstances is probably not the right approach, but two main risks mitigate against a fully risk-on stance. The first is the entirely unquantifiable risk around a closely contested US presidential election. Nobody should be too surprised if the incumbent President refuses to leave, unleashes a slew of legal challenges to remain in power or even dog-whistles to the ultra-right for more than just moral support in his time of personal crisis. The period since 2016 has seen several instances of election polls being spectacularly wrong, so caution is warranted on calling a Biden victory despite most polls showing a gulf between him and Trump. Recently, online betting markets have begun to price in, with historically large odds, both a Biden victory and a Democratic lock on the Senate and hence Congress.
The second risk is more pressing and perhaps the more quantifiable: the failure of fresh fiscal stimulus to arrive on time. More pressing? Much of the spike in economic activity from May onwards described above can be attributed to a massive amount of fiscal stimulus. At the same time, the Fed was quick to take action and has expanded its balance sheet exceptionally aggressively. JP Morgan estimates that the drag on 2021 growth from a dropping off of the additional stimulus could be equivalent to 4% of GDP. It is no surprise that the Fed is urging Congress to step up with more money for help. It would be a shame to waste the good work done so far by dragging feet on the implementation of a second one.
Things are indeed looking up, but some sectors will continue to hurt and need of help, while the aggregate economic expansion is still at risk of a setback if further stimulus is slow to arrive.
Admittedly the time frame for an additional set of fiscal measures will be hostage to the round of the possible unprecedented events that may follow over the next three weeks in the run-up to election day and beyond. But after that, the course of the economy will be set, and the impact of the new spending (or lack thereof) will be a longer-term factor playing on markets.