Market Themes Update
In this piece we revisit some of the themes discussed in our Q3 Risk Map and flesh out our views on some emerging themes. In short: (1) we are on the optimistic camp regarding the risk of a virus second wave; (2) we are more worried about the campaign than about who will be the next president; (3) we expect trade tensions to rise, but not enough to disrupt markets; (4) we expect the bear steepening trend in yields to continue, but not for too much longer; (5) and dollar weakness is likely to continue as delays to stimulus add to the virus headwinds in Q3.
VIRUS: MORE BENIGN SECOND WAVE
Evidence so far suggests that the Covid-19 “Second Wave” has been far more benign. The simplest way to look at this is comparing infections rates and deaths. Countries where the infections had troughed around June and are now increasing have not seen a corresponding increase in deaths. We believe there are several reasons for this, including more widespread testing that catches less severe case, better treatments, preparedness of national health systems, and protection for the most vulnerable population.
This reinforces our view that the interplay between “top down vs. bottom-up forces” will produce a favourable outcome. In short, this new stage of the pandemic will be shaped by a tension between (a) national governments pushing for normalization vs. (b) individual behaviour and local authorities working as automatic stabilizers for infection outbreaks. As long as we don’t see political forces pushing for national-level action (apart from travel restrictions), we believe markets should be able to navigate through the rest of the pandemic, hopefully until we get a vaccine.
US ELECTIONS: Campaign More Dangerous than the President
We are more concerned about Trump taking increasingly drastic actions ahead of the November elections and failing to agree on more stimulus than we are about who will be the next president. Markets seem to be comfortable with a Biden presidency, as are we. Picking Kamala Harris as his VP just reinforces his centrist credentials, though there is still some uncertainty about how prominent of a role farther left figures such as Elizabeth Warren will play. The main risk is Trump’s reaction to a further decline in polls, and trade policy seems like the easiest path towards building political capital (see below). In parallel, the budget negotiations are becoming increasingly tense, in true brinkmanship form. We – and markets – still expect some deal to be reached, but the odds look a lot smaller now. At the very least, it will likely be delayed until September and so there will be a hit to incomes in Q3.
TRADE WAR: Fade Tensions, but Mind Tail Risks
Our base case is that the trade conflict with China will remain in rhetoric/symbolic sphere, but the risks will probably rise. As we have often noted, US public opinion towards China has continued to worsen for both Democrats and Republicans. Having anti-China as a bipartisan issue ahead of the general elections opens up a lot of potential risks as both the presidential and Congressional candidates try to “outhawk” each other in the foreign policy space. But this doesn’t exclude the risk of escalating trade conflict on other fronts, such as the lingering Airbus-Boing subsidy dispute.
RATES: Higher, But Still Capped
We suspect that investors are not too concerned about inflation in the near term but are still willing to pay up to hedge because the risk of being wrong could be very high. We are also in this camp. It’s hard to get too worried about price pressures given the current levels of excess capacity, slack in the labour market, and the secular deflationary forces (such as technology).
Yet we see the potential for the bear steepening of yield curves to continue. Incoming supply, bearish treasury bets, and a pick-up in market measured inflation expectations (TIPS, 5yr 5-yr breakeven) are all good reasons to expect the upward pressure in yields to continue. But more importantly, there is a lot riding on the low-for-long assumption for yields. Higher inflation, especially if accompanied with rising nominal yields, could be devastating for asset prices, and could ultimately lead to a Covid-Taper-Tantrum event. To us, this is the single greatest risk to financial markets in the medium term and, even if unlikely, it’s one that investors must hedge.
Although we see room for further increases, we think yields will be eventually capped – one way or another. Yields of, say 1.0-1.5% in the 10-year Treasury would probably be enough to lure investors back. But of course, the presumption here is that the Fed’s credibility remains intact, even under the new regime of accepting temporarily higher inflation. Lastly, yield curve control (YCC) is still on the table as a viable option.
The Fed’s aggressive easing and ultra-dovish stance were the start of the current dollar weakness, along with the unwind of risk-aversion trades. Then the failure of the US to contain the virus, even as the rest of the world has, only made things worse. This suggests a rare period of US economic underperformance compared to Europe in H2. Forward-looking data out of Europe suggests a robust recovery is in the works, though subject to periodic hiccups due to viral flare-ups. Japan is in the laggard camp with the US, as the Abe government also struggles to contain the virus and restart the economy. We believe it is relative growth rates that are the main driver for currency markets. As such, the US economic underperformance should translate into dollar underperformance.
We must stress that we are not in the secular dollar decline camp. Rather, this current bout of dollar weakness is due largely to cyclical factors that should eventually revert to mean. That is, the US will eventually get the virus under control, pass another big stimulus bill, and return to more robust growth. This seems like a proposition for Q4 and beyond, as Q3 is looking increasingly like a lost quarter for the US.
Lastly, dollar weakness against the majors is likely to help EM currencies. However, we warn of continued divergences within EM. Weaker credits such as Turkey, South Africa, and Brazil are likely to underperform, while stronger credits in Asia are likely to see stronger currencies. In other words, we remain in the differentiation camp.