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De-globalisation, inflation and earnings deterioration

15 May 2020

GAM Investments’ Charles Hepworth discusses growth forecasts, the impact of fiscal measures and the outlook for risk assets.

It is now clear that the Covid-19 pandemic will severely impact growth across all regions. Indeed, latest forecasts by the International Monetary Fund (IMF), suggest a 3% hit in annual percentage terms to world output, or GDP. Notably, the IMF suggests that emerging and developed Asia – which includes China and India – may be the only region to see growth (albeit a mere 1%) in 2020 before bouncing back aggressively (8.5%) in 2021. This is a significantly brighter growth outlook compared to the IMF’s view of advanced economiesi (average -6.1% contraction in 2020 followed by 4.5% growth in 2021). Emerging markets (EMs) were already eating the share of global GDP away from developed markets (DMs) before the viral crisis and this environment only increases that rate. Consequently, valuations and growth rates in the developed world could be pricing in too optimistic a scenario.  

That said, we simply do not know how long the coronavirus will continue to have a negative impact on the global economy. As analysts across the board struggle to get to grips with forecasting, medical research seems to suggest that a second Covid-19 wave is likely at some stage. Despite small clusters of infections, we have not seen any direct evidence of this so far in China or South Korea where respective responses seem to have effectively neutralised the viral transmission progression. As China activity picks up, an increase in China ex-Hubei infections is a concern. Ultimately a second wave of infection rebounding, potentially in the both the northern and southern hemispheres, is the unknowable and largest risk.

In the meantime, the impact on Q2 GDP growth, particularly in DMs, is likely to be severe. It is unclear whether markets have fully priced this in now or are just re-pricing the unlimited stimulus; the fiscal policy response is large and unprecedented and will likely continue. In the US, the response is equivalent to 10% of GDP, while in France and the UK credit guarantees are worth 10% to 15% of GDP respectively. The virus was, in the first instance, a negative supply shock from China. Policies to limit movement have now transformed this into a big demand shock. The role of current fiscal policy is to stop this initial double shock from snowballing into something much larger. However, fiscal policy cannot reverse the impact of limited movement. It can only keep the economy together until the infection rate slows enough to allow mobility to increase. Therefore, the global economy requires both a large fiscal stimulus and, crucially, no second round of infections. Looking back to the Spanish flu outbreak over 100 years ago, it was not the first outbreak that killed many millions, but the second more deadly one that followed six months later.

Outlook for assets

Earnings should continue to deteriorate into the second quarter, so it is a little surprising to see the US equity market holding up so well, relatively speaking.  We have heard the argument that this is due at least in part to the higher growth technology companies that comprise the index. This may be true but when five companies in the index account for a fifth of overall make-up, the situation is potentially becoming unbalanced. Earnings will continue to erode, in our view, and the US prestige moniker of ‘Fortress America’ might come into question. In the UK, we believe a combination of cease and desist dividend orders from policy makers and the current economic slowdown will certainly impact equity fortunes.

In the fixed income space, the safe havens of US treasuries really do not offer much if any upside as far as we are concerned. We are more attracted to the unloved areas at present and, in our view, DM credit markets will suffer compared to EM credit markets. Meanwhile, gold still continues to help provide hedge protection and so far this year it has certainly provided that protection, rising over 17% year-to-date in sterling terms.

Ultimately, until we have some visibility on growth, we remain cautious on risk assets. Equities have re-priced the stimulus effects (monetary and fiscal) but we now need to see earnings evidence from companies. The virus has done more to advance de-globalisation than President Trump could ever do and we believe de-globalisation (reshoring, closer supply chains) is now a guaranteed outcome of this episode. This could translate into higher inflation long term as the world economy becomes less efficient. However, currently disinflation and deflationary forces remain the medium-term outlook.

iSource: IMF. As at May 2020. Advanced economies group includes US, Germany, France, Italy, Spain, Japan, UK, Canada.
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