Global Market Environment - CIO Update

Covid-19 is likely to have a considerable impact on the second half of the year. Dovish central bank policies have mitigated the pandemic’s economic fallout, but with monetary policy being so dominant, it has maintained the gap between growth in the real economy on one side and equity and bond valuations on the other.

The economy and monetary policy

A slow economic recovery could be bad news for credit markets
We are currently being held between both upward and downward pressures being exerted on financial markets. The pandemic’s negative fallout has been almost cancelled out worldwide by dovish monetary policy and the slow recovery in economic activity. The global economy is indeed recovering, but there are signs it may happen more slowly than expected. Meanwhile, the job market is improving only modestly. Against this backdrop, the US Federal Reserve has warned of significant risks. Small and mid-sized companies are being hit in particular and have so far failed to create a sufficient number of new jobs.

However, both consumption and home-building have recovered very rapidly. This was initially driven by pent-up demand, and over the near term the pace is likely to slow. Consequently, a slow economic recovery could have a negative impact on financial markets over the medium term and, in particular, on the high yield bond market.

Healthcare systems will probably be able to cope better with Covid-19
Covid-19 remains under control in many countries, even in those that have reopened their economies. However, there are increasing numbers of local outbreaks and the pace of second wave infections is greater than expected. The situation could worsen considerably in the coming weeks, particularly in the US, but also in many developing countries. The good news is that it is unlikely that healthcare systems will be overwhelmed or that economies shut down again completely. This is the case in the US at least, as lessons were learnt with the first wave of infections: safety measures were also improved and two effective drugs were discovered. A second wave, however, could slow the recovery down even further (especially in troubled sectors such as leisure and aviation). This could undermine consumer confidence.

Monetary policy remains essential to financial market performance
The aggressive monetary stimulus seen in recent months has lost some momentum, as the growth in US money supply has slowed. Consequently, the expansion of the US Federal Reserve’s balance sheet has slowed down to the current high levels we see (see chart). This suggests that the Fed is slowing its asset purchases.

Nonetheless, we do not yet expect a major change in policy direction by the Fed. If necessary the Fed could even expand monetary support with no limit: for instance, in the case of market turmoil. This is an important reason why, in our opinion, the relatively high financial market valuations will be partly justified for some time to come. Moreover, the Fed’s very expansive monetary policy will spill over into other regions, as long as the US dollar remains stable or even weakens.

Source: Board of Governors of the Federal Reserve System

 

Inflation: Investors should be alert
One factor driving uncertainty is inflation. Accommodative monetary policy and monetary stimulus will only work until inflation begins to rise. As a consequence, central banks would then be forced to rein in their liquidity injections, which would have negative consequences for the economy, the government bond market and financial markets. At present, there are no significant inflationary pressures, but many prerequisites are in place for that to change.

Interest rate trends and valuations

We see no short or medium-term issues from the expansion of debt in many countries. Central banks are buying up newly issued government bonds, which has kept interest rates from rising. They are even moving in to take more control of the yield curve.

Additionally, we may see the use of helicopter money over the medium term, i.e. the direct and sustained funding of government spending by the central bank. There have already been various lighter versions of helicopter money used in past years. Helicopter money would also be an effective way to control interest rates.

The combination of potential inflation and expensive government bond markets could at any time trigger a temporary uptick in interest rates. However, for the reasons we have mentioned, we see little risk. A slight uptick on the long end would lead to a steeper yield curve, which would subsequently provide a positive signal for economic growth.

We see the sustained relatively high equity and credit market valuations as only partly justified, given the slow economic recovery and the resumed strong spread of Covid-19. There is still a discrepancy between fundamentals and market prices that is being driven strongly by central bank monetary support. But there is no sign yet of an actual bubble.

Summary and positioning

The equilibrium remains highly fragile and increasingly subject to disruption. In particular, the slowing pace of money supply expansion and the burgeoning second wave in the pandemic are potential risks for the economy and financial markets.

There are currently no strong trends in financial markets. Commodities are trending slightly downwards, while government bonds are moving moderately upwards. This is part of the overall balance between upward and downward market forces. Things could, however, change very quickly. That is why we are keeping close track of trend signals and other leading indicators.

We remain neutral across our strategies, while slightly underweight risk exposure in troubled bond issuers and small illiquid securities. However, we also remain on the lookout for opportunities, even in sectors that have been under stress or located in emerging markets.