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The repercussions of the COVID-19 pandemic continue to dominate the global economic outlook. Countries are locked in a race between ending fiscal income support and searching for a vaccine. Yet, the vaccine’s arrival may not be the panacea many expect and could herald a premature end of policy accommodation. If the search is not successful, many economies face a fiscal cliff by year-end when most income support will expire, imperiling the recovery.
During the May-July period, the MSCI ACWI returned a solid 13.4% as many countries began to lift mobility restrictions, businesses reopened and economies began to recover. Although the pandemic engulfed many EM countries during the period, the MSCI EM outperformed the overall index with a 17.8% gain. This largely reflected the successful policy response to the virus in China, Korea and Taiwan, which account for two-thirds of the EM index.
As restrictions were eased, clusters, new peaks or second waves of outbreaks appeared, hampering the recovery that was getting underway. The initial outbreak had hit the Eurozone, the UK and Japan particularly hard (in terms of the contraction in activity in Q2), but it is the speed of the recovery that will ultimately matter more. Here, the early indications are particularly good for core Europe (with several recent activity readings already above the pre-pandemic level), point to a lagging recovery in Japan and suggest a middling performance in the US.
While the recovery is naturally incomplete at this juncture, it is also likely to follow a shallower path than expected prior to the pandemic. It is particularly at risk in the US where a premature end to the emergency support measures could halt it in its tracks. Negotiations in Congress on the next phase of support are thus key in order to avoid a fiscal cliff. A similar threat exists in Japan, which struggles to get businesses to shut for fear of income loss.
The emergency packages are intended to provide a temporary remedy until the pandemic is vanquished. This can only be achieved by acquiring widespread immunity, either naturally or via a vaccine. Given current infection rates, it would take a very long (and economically unsustainable) time to achieve general population immunity. Hopes therefore rest on the development of a vaccine.
Yet, a vaccine does not necessarily represent the fork in the road that leads to one of two binary outcomes. Indeed, it appears that a vaccine may afford some protection for some time, but not be able to eliminate the disease completely (such as polio). This would mean a need for repeat injections, which raises questions of affordability and of scalability. It is also not clear whether it would benefit all (ethnic and age) groups equally and what the long term or side effects may be. In turn, this could limit public acceptance and the widespread adoption of the vaccine. Some commentaries have suggested that the vaccine may limit the severity of the infection but not be able to avoid it altogether. While a boon to many potential sufferers, a vaccine would therefore not be the panacea it is commonly perceived to be. The result is that economies may need to operate at 75-90% of pre-pandemic levels in their attempts to offer sufficient safeguards to people.
Our new allocation reflects these considerations. As a result, we have downgraded the US to neutral, as we see the recovery at risk from insufficient policy support. Conversely, devising an effective vaccine that overcomes the above-mentioned hurdles could prompt the Fed to become less accommodative. At the same time, it would remove some of the upside from internet/tech stocks which have been the key drivers of the US stock market (excluding them leaves the market on par with its DM peers). Finally, we also see a risk to the US dollar from the convergence of US real yields to German ones, in negative territory.
On the other hand, we upgrade the Eurozone to overweight. Despite recurrent, localised outbreaks authorities have learnt to respond well and a swift recovery is underway in part of the region. What is more, thanks to the European Recovery Fund, a two-pronged policy approach is now at hand that overcomes the previous problem of insufficient fiscal capacity amongst the more indebted member states.
*The publication reflects asset performance up to 31 July, 2020, and macro events and data releases up to 12 August, 2020, unless indicated otherwise.
The information contained herein is obtained from sources believed by City of London Investment Management Company Limited to be accurate and reliable. No responsibility can be accepted under any circumstances for errors of fact or omission. Any forward looking statements or forecasts are based on assumptions and actual results may vary from any such statements or forecasts.
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