6 June 2021

Typically, investors must juggle numerous factors while making their global asset allocation decisions. In this regard, the next 12-18 months may be more straightforward. By now, no one doubts massive monetary and fiscal stimulus will produce a sharp, V-shaped 6% global recovery in 2021, with China and the USA leading the way at 9% and 7% respectively.

But, two not so simple questions still must be answered. As the fiscal stimulus recedes, will the Covid crisis have “scarred” the global economy — leading to weaker long-term GDP growth potential — as occurred following the Global Financial Crisis (GFC)? Alternatively, did the pandemic produce a frontloading of several key structural themes — digitalisation, automation, robotics, cloud computing, peer-to-peer commerce, etc. — leading to a period of sustainably stronger economic growth? Secondly, what are the consequences of US President Biden’s massive fiscal stimulus? What are the implications for US inflation? How will the US Federal Reserve respond? Will the markets repeat their 2013 “taper tantrum”? What are the implications for non-US financial markets and the US dollar? I will consider these issues using a bunch of my favourite Charts! I also provide below my market forecasts through 2022.

Post Covid: Scarring or a New Dawn?

Each nation’s ability to recover from the pandemic’s damage will depend on three factors: the effectiveness of the early public health response to the outbreak, the scale of the monetary and fiscal stimulus, and the success of the vaccination program. As a result of Asia’s initial success in containing the virus, China, Japan, and Korea have already recouped the output lost during the recession (more on their vaccination programs and renewed Covid waves later). At the other extreme, Latin America may take 5 to 10 years to recover lost GDP. In Europe, France, Italy, Spain and the UK (despite its large fiscal stimulus and successful vaccination campaign) may not fully recover until the end of 2022. Meanwhile, Germany and Scandinavia will be back to pre-Covid levels in 2021. Despite its early mishandling of the pandemic, the USA has already recovered, reflecting its massive fiscal and monetary response.

With the exception of Latin America, therefore, the post-Covid economic recovery has been stronger and quicker than following the GFC, most noteably in Europe and the USA. Does this imply there has been no “scarring”? Not so quick. Large-scale fiscal stimulus, of course, have lead to bloated public sector budget deficits, and a sharp increase in government debt (Chart above). Already, the USA and UK are contemplating large tax hikes to begin to come to grips with the budgetary fallout of the crisis. To be sure, fiscal restraint will be a potential economic headwind for many years, as occurred after the GFC. Perversely, however, the task may be so large as to force governments to proceed slowly with fiscal belt-tightening, and to attempt to grow their way out of the problem. The Chart illustrates the USA and Japan may be most at risk, while emerging Asia is best-positioned.

We economists are simple people. We assess long-term scarring based on trends in productivity, capital spending, and labour supply. Long before the GFC, productivity was slowing around the globe (Chart above). In the aftermath of that crisis, however, labour efficiency decelerated even more sharply, which contributed to the tepid economic recovery. Will history repeat itself post-Covid? High debt and prolonged periods of high unemployment often dampen output per hour. Unlike previous recessions, however, US productivity remarkably accelerated during the recent deep downturn (next Chart). This suggests the accelerated adoption of digitalisation, automation, etc. may already be paying off.

Meanwhile, capital spending was contrained following the GFC, with key advanced economies (e.g. USA and Eurozone) lagging Asian rivals (next Chart). However, fiscal programs in both the USA and Europe (each roughly $2 trillion) aim to boost public investment in infrastructure, digital assets, broadband, and climate initiatives. Rather than post-GFC austerity, sharply higher private sector and goverment capex may boost productivity and long-term GDP prospects this time. It’s fair to note, however, that high corporate leverage and proposed hikes in business taxation may be constraints.

In addition, entering this upturn US private sector balance sheets are far healthier than following the GFC (next Chart). In the previous cycle, consumer deleveraging was a major growth headwind. Now, the US household savings rate is very high, and the American consumer is set to lead the recovery.

A healthier consumer, stronger business investment, and upside productivity surprises should limit the post-Covid scarring, especially compared to the GFC. Therefore, even though US grow will slow in 2022 (following this year’s torrid 7% pace), GDP growth in the advanced economies may exceed 4% again in 2022 following this year’s 5% gain. To ensure this favourable outcome, US policy should focus on encouraging people back to work. The decline in the labour participation rate was a major growth impediment following the GFC (next chart).

Is Inflation Temporary? Will Markets Have a Another Tantrum?

How much inflation will the continuation of robust growth cause? Despite April’s 3.1% core PCE inflation reading, markets remain willing to accept the Fed’s suggestion that higher inflation is temporary. While rising commodity prices grab headlines, raw materials account for only a small share of business costs. The price outlook, therefore, hinges on labour market developments, especially wage growth.

To be sure, the record-high level of US job vancancies indicate worker shortages already exist, but these problems do not appear wide-spread at present; rather, focused largely on a couple of sectors. The following Chart illustrates compensation growth (and unit labour costs) remain steady so far, reflecting still high unemployment. The spike in core inflation, therefore, should be temporary. Nevertheless, I still project underlying price growth at 2.5% in 2022 — higher than earlier trends and the Fed’s 2% target.

How will the Fed and markets respond? The Fed’s shift to an average-inflation target (AIT) suggests they will move cautiously. Using the 2013 tapering experience as a guide, I expect the Fed to slow their monthly asset purchases towards towards the end of this year, with the size of its balance sheet not peaking until next summer or later. In 2015, the first Fed rate hike did not occur until a year after the balance sheet peaked. Thus, I expect first US rate hike in Q4 2022.

All of this year’s rise in US bond yields reflects rising inflationary expectations, which are now in line with my 2022 forecast. The next phase, therefore, will be led by higher real yields, reflecting strong growth and big budget deficits. I project 10-year yields at 2.75% by the end of 2022. In the past (including during the 2013 “taper tantrum”), US equities were cheap compared to bonds, despite lofty P/E ratios. However, this is no longer true. As the equity risk premium is near record lows, stock markets now will be more vulnerable to rising bond yields (MS provided the next Chart). While I am by no means bearish, it’s hard to see where the upside comes from. My 3,900 S&P 500 target for 2022 reflects EPS at 210 and a P/E of 18.5.

Europe: Outperformance at Last!

After a multi-year period of underperformance, European equity returns have exceeded those in the USA this year, and this trend should continue. Despite the economic slump caused by last winter’s painful Covid second wave and the mismanagement of the vaccination rollout, Europe’s recovery is finally gaining momentum (see composite PMI Chart below). Indeed, I expect European GDP growth will exceed America’s in 2022.

As Europe is earlier in the economic cycle, corporate earnings have room to run. While US EPS are well above the peak of the previous cycle, Europe’s are 40% below the earlier peak (next Chart).

Likewise, being earlier in the cycle Europe does not confront meaningful inflation risks. I expect the ECB to remain on hold through 2022. Moreover, even as bond yields rise (yield curve steepens), Europe’s high Earnings Yield Ratio provides an ample cushion, unlike in the USA.

Not to forget to mention the relatively very attractive valuations. (Morgan Stanley provides the Charts).

Biden Dents the Case for Emerging Markets, But….

President Biden’s massive American Rescue Plan has numerous consequences for EM economies and markets. On the positive side, the ARP will promote stronger global growth and higher commodity prices. On the other hand, the prospect of higher US interest rates and a potentially firmer US dollar (more on this later) tend to be headwinds, especially for Asian stock markets.

What should we conclude from these cross-currents? Despite benefiting from their FIFO status (first into and first out of recession), Asian economies still have considerable excess capacity. As a result, Asian corporate EPS remains well below the peak of the previous cycle, unlike the USA (Chart above). Consequently, EPS is likely to remain stronger than elsewhere, and benefit from America’s additional fiscal stimulus.

The prospect of higher US bond yields, however, is troubling. Asia’s Earning Yield Gap does not provide the same cushion as in the past, although Asia’s relatively high dividend yield does provide some protection (see Chart).

Likewise, the Chart above illustrate Asian equities are fairly valued relative to world markets.

Emerging markets confront other risks. Recent data suggest that while surging Covid cases may be peaking in hard-hit India and Brazil, infection rates are rising elsewhere in Asia, especially Malaysia. As the vaccination rollout has yet to reach most emerging nations (Chile is an exception), health and economic risks remain.

I am concerned also by China’s heavy-handed market interventions (Alibaba is just one example), which could impede innovation and confidence. Despite booming 2020 GDP growth, China confronts numerous economic headwinds: deleveraging, over-investment, climate, demographics, etc. Without additional fiscal support, especially for consumers, I expect GDP growth to falter towards 5% in 2022.

Increasingly, Emerging Markets must be considered on an individual basis, and less as an asset class. Idiosyncratic risks will always arise, e.g. Turkey, Brazil, etc.

Putting, the pieces together, I would remain overweight Asian equities relative to the USA , but I prefer Europe.

FX: Biden and Tapering

• I am fundamentally negative on the overvalued US dollar (see the earlier table for explicit forecasts). However, as fiscal stimulus often leads to currency appreciation (especially if accompanied by tigher monetary policy), the ARP may slow the greenback’s depreciation. However, bloated US twin deficits create serious medium-term risks. The undervalued Japanese yen’s weakness has been a bit surprising.
• UK sterling is now approaching fair value. While further appreciation is likely, UK equities offer better value.

• Rising US yields complicates life for EM currencies, especially where external borrowing requirements are large (Chart above). Turkey has lost credibility and has huge external financial needs: TRY will continue to decline. In Latam, Chile’s successful vaccination program and booming metal prices will continue to support CLP. Brazil’s relatively healthy external balance sheet and the BCB’s pre-emptive tigtening of monetary policy will allow deeply undervalued BRL to ride the commodity wave for now. Lack of sustained fiscal and micro reforms, however, create medium term risks. Similarly, despite Mexico’s structurally weak economic prospects, the very cheap MXN will be supported by high oil prices and a larger-than-expected current account surplus.
• Asia’s healthy external balance sheets should limit the impact of rising US bond yields, but I expect some weakness in MYR, PHP, THB, INR, and IDN. The RMB remains supported by relatively high inflation-adjusted policy rates, and strong GDP growth (for now).
• The RUB is support by tighter monetary policy, sound external finances, and rising oil prices. But, the lack of reform, weak growth prospects, and sanctions leave RUB fundamentally at risk. South Africa’s swing into current account surplus has supported the undervalued Rand, to the surprise of many! However, the nation’s low levels of FX reserves leaves ZAR vulnerable once Fed tapering begins.