In this report we elaborate on a few topics from our latest Risk Map. The map outlines the key themes we are working with to develop our global cross-asset views, and the topics of greatest interest from clients. In short, we remain on the risk-on camp and possibly more optimistic than consensus on the virus front, even in the US, due to in part to the favourable interplay between national vs. local/individual forces. But of course, we are more cautious of the rally at these levels and agree with the current consensus that US assets (including the dollar) will face greater headwinds relative to the rest of the developed world in the near term.
VIRUS: The Interplay between Top Down vs. Bottom-Up Forces
The next stage of the pandemic is shaping up to be a delicate dance between (a) national governments pushing for normalization vs. (b) individual behaviour and local authorities working as automatic stabilizers for infection outbreaks. And this tension probably a good compromise. In the US, for example, the national policy directive by the Trump administration suggests that economic priorities now supersede medical ones. This makes sense given double digit unemployment rates and vastly reduced systemic risks to the country’s health systems. Meanwhile, several states have decided to re-instate lockdown measures, which also makes sense. At the same time, individuals are reacting in real-time to local outbreak news, as they should. In one of the worst places of the recent outbreak, Houston, we see mobility trends starting to reverse in mid-June, just as headlines of increased case counts pick up. Exactly as they should.
A similar pattern can be seen in other places. The UK, for example, local authorities are re-shutting the city of Leicester after an outbreak there just as PM Boris Johnson kicks off a new phase of reopening. Same in China, where parts of Beijing were selectively shut down.
More broadly, we expect subsequent infection outbreaks to be far more manageable for several reasons and for re-openings to continue. First, culture has changed, and most communities know how react to outbreaks. Second, the systemic risks to medical systems are far reduced, if any. Third, the age group of newly infected (specifically in the US) is lower, suggesting diminished risk. Fourth, the elderly and vulnerable are more protected. Firth, there has been a vast improvement in treatment, testing, tracking, general availability of PPE, and reports of much shorter hospitalization times. To be clear, we are not minimizing the risks of what is happening in Texas, Florida, Arizona and California, or the ongoing crisis in Brazil and India, but still think the worst of this global pandemic is likely is behind us.
REFLATION: The Music is Still Playing, but The Tune is Changing
We have probably passed peak acceleration, but we expect the rally in risky assets to continue, though US assets may no longer outperform. The balance of risks is shifting, in our view, and we see more downside risks in the US compared to other areas. Investors seemed to have priced US assets as if the infection/mortality curve would flatten as they did in Europe and most countries in Asia. This view is now being challenged, and with it, the continued relative economic outperformance. (See our recent piece on the US here). In contrast, the re-opening path in much of the rest of the world is looking smoother and with less speedbumps, which argues in favour of a rebalancing away from the US.
On the other hand, we see some positive risk factors in many other regions, especially those who have managed the pandemic better, such as most of Europe and Asia. In the EU, we expect the €750 bln package to go through, even if diluted by the “frugal four.” Moreover, the small risk factor caused by the German constitutional court’s challenge of the ECB’s PSPP is rapidly being diffused. In the UK, there seems to be some positive momentum behind the Brexit negotiations. Even if this only yields a slim deal in the end, the skew for the possible outcomes seem more favourable now, if nothing else, because both sides seem ready to conclude negotiations without an extension, thus shortening the uncertainty period. Asia (or at least most of it) is ahead in the pandemic curve and seem to have the virus under control. This means that their recovery cycle will come earlier than other regions, even if dampened by weak external demand.
DOLLAR and CENTRAL BANKS: A Gentile “V”
We remain bearish on the dollar near-term, in part for the aforementioned reasons, but also due to monetary policy differentials. In addition, we still think the relatively more front-loaded reaction by the Fed’s will continue to exert downward pressure on the dollar during this stage. One way to look at this is to compare the change in size of central bank’s balance sheets. Year to date, the Fed’s balance sheet as a share of GDP has expanded by nearly 14 ppts, compared to 11 ppts for the BOJ and around 8 ppts for the ECB and BOE. The Fed’s balance sheet is still the smallest as a percent of GDP (33%), especially when compared to the BOJ’s (116%), but in our view the rate of YTD growth (70% for the Fed vs. 33% for the ECB and 14% for the BOJ) and the absolute amount of monetary expansion is what matters for the dollar at this stage (see our recent report here).
Eventually, however, we expect many of these trends to reverse and improving the outlook for the dollar. The ECB and BOE are likely to continue expanding their balance sheets and monetary bases, which will drag on their respective currencies. Moreover, we believe that growth differentials (rather than relative monetary policy) is the ultimate driver of performance. Despite the recent flare up in the infections, we still think the US comes out of the crisis in better shape than most of its counterparts, as it did during the financial crisis, improving the dollar’s medium- to long-term prospects. But of course, this is a premise we constantly challenge. Much will depend on how the virus numbers develop in Q3 for the problem states – and just as important, how the politics around this infection wave shapes up.