The early-cycle playbook

There are two types of forecasters: those who don’t know and those who don’t know they don’t know. Making predictions about how tomorrow may differ from today is obviously tricky. The thing is that there are so many cross-currents that, when one has it all figured it out, something else happens. These are the all-important ‘unknown unknowns’, as Covid-19 reminds us. But, barring unexpected turns of events, think about how the ‘known unknowns’ are shaping the outlook: a vaccine is coming through – allowing economic reopening – and policy will stay very expansionary. This suggests to us that we’re early cycle, with a nascent recovery and risks of overstimulation. This is important for investors, as forward stock returns are higher when the economy is weak but getting better than when it’s strong but getting worse.

Virus drag | Starting to ease: The Covid-19 situation has improved over the last couple of weeks: confirmed case growth has begun to decline in most countries; positive testing rates appear to have peaked; the number of new fatalities seems to have flattened in several places. Although hospitalisation rates remain near their April highs, governments are loosening the lockdown restrictions for the upcoming holiday season. While we still expect the European economy to contract outright this quarter, this is likely to be a temporary setback, and in any case a lesser blow relative to the plunge in GDP following the large-scale lockdowns earlier this year.

Vaccine boost | On its way: Several vaccines are approaching approval. In the US, we expect the first available doses to go to high-risk groups from December onwards, followed by widespread vaccination starting in April. Based on supply data from the leading manufacturers and attitudes towards vaccination from consumer surveys, we expect large parts of the population to be vaccinated by late in the second quarter: the US and probably also the UK could be almost halfway through by April, Europe and Japan by May. This should allow many sectors of the economy to open once again, and stay open, and, therefore, spark a strong bounceback in activity from next spring.

Here’s why this matters:

Overstimulation: The mantra of monetary and fiscal authorities worldwide is ‘better dovish than sorry’. They’d rather ease the policy stance a bit (or even a lot) more than tighten it prematurely and make things worse, by possibly putting the economy back into recession. This means that, while the cycle is likely to improve over the next six to twelve months, ample central bank liquidity and government support are likely to stay for quite a while. This should continue to result in strong asset-price inflation, smaller rises in bond yields than usual in the early cycle and US dollar weakness as safe-haven flows lose importance.

Recovery: An economy that’s likely to get better, courtesy of medical breakthroughs, and risks of policy overstimulation mean that assets that tend to do well when growth picks up should probably gain to a greater
extent. Some sectors are currently distressed because they’re closed: this is the first-ever recession by decree, as lockdowns are a political decision. When the next decree, this time on reopening, is announced, they’ll obviously benefit. Smaller companies are likely to outperform larger, more global ones, and lower-quality credit instruments should see stronger demand too, given a more benign default cycle.

Meanwhile, watch China…

In a category of its own: China’s recovery keeps broadening, with the purchasing managers’ indices showing the services sector closing the gap with the manufacturing sector. This bodes well for the global economy. The PMIs have fallen sharply in Europe, though not as much as earlier this year. The lockdown measures to contain the spread of Covid-19 are impacting the domestic economy. The US is in between, but on the whole rather resilient so far: some softening in the ISM surveys is likely this week, but at levels consistent with growth. The jobs report should show continued job creation, but at a slower pace than previously. The markets are also likely to be on the lookout for any Brexit news.

Daniele Antonucci | Chief Economist & Macro Strategist