Markets scenarios & risks - July 2020

Assessing the recovery path post Covid-19

The pandemic has altered the picture we had at the end of 2019. Covid-19 has sent us into deep, global economic contraction bottoming out in the end of 2Q2020. A rebound will take place in 3Q2020. Thanks to policy boosters, we will progress into a sequencing recovery with divergences across and within regions. We expect EMs to converge to pre-crisis GDP levels in 2Q2021 while for AEs we have to wait the end of 2022.

In this environment, growth, rates, inflation, monetary and fiscal policies are strongly interconnected. The potential mismatch of one could affect the overall results. We expect ultra-accommodative monetary policies to persist, leading to stable and low interest rates worldwide. Strong demand from central banks will cap yields, while the recalibration versus the short end of the curves will ease tensions in the long end. In fact, governments are financing the emergency with short-dated issuance. Central banks’ purchasing programs and state guarantees are supporting spreads, in an attempt to safeguard default rates, at least in the short term.

Carry amid low yields is boosting the appeal for credit. Monetary policies are lifting equity markets, but the decoupling from fundamentals is increasing downside risks. We are more cautious than the consensus and we expect EPS to drop and then to bounce back in 2021. The collapse of interest rates differentials and the secular US deficit are building the case for a bearish USD in the medium term. Be cautious.

Methodology

• Scenarios

The probabilities reflect the likelihood of financial regimes (central, downside and upside scenario) which are conditioned and defined by our macro-financial forecasts. We use the k-means clustering algorithm to our enlarged macroeconomic dataset, splitting the observations into the K cluster, where K represents most of the variability in the dataset. Observations belong to one cluster or another based on their similarities. The grouping of the observations into the k clusters is obtained by minimizing the sum of squared Euclidean distances between observations and clusters centroids i.e. the reference values for each cluster. The greater the distance, the lower the probability to belong to a given regime. The GIC qualitative overlay is finally applied.

• Risks

The probabilities of risks are the outcome of an internal survey. Risks to monitor are clustered in three categories: Economic, Financial and (Geo)politics. While the three categories are interconnected, they have specific epicentres related to their three drivers. The weights (percentages) are the composition of highest impact scenarios derived by the quarterly survey run on the investment floor.

1. EUR

The appetite for EUR/USD has been rising too fast and too far. We confirm our 1.07/1.10 short-term target and our 1.14 medium-term target.

• Support for a stronger EUR since May has been driven by: (1) lower political risk perception (EU Commission’s proposal of a Recovery Fund; lack of strong response by the US towards the China New Security Law in HK, and a commitment on both sides to keep the Phase One Deal alive); and (2) the rebalancing the growth premium towards the Rest of the World thanks to revamping fiscal expansion.

• Although we acknowledge EUR tail risk has fallen substantially, we remain of the view that the current movement has overshot some short-term drivers. Moreover, the differential in EPS 12M growth expectation has continued favouring the US, and physical commodities (our preferred proxy for growth) haven’t bounced back consistently. We prefer EUR vs. GBP (while hedging Brexit risk) and expect a correction vs the USD.

• Financial conditions have eased but they remain fragile. We are struggling to see banks, which have been provided with ample USD liquidity (TED, LIBOR-OIS Spreads are back to normal levels) circulating it to the system. FX will continue to be the asset class pricing in this risk and supporting USD.

2. Inflation

We expect short-term low-inflation, if not disinflation, risk. Then higher mid- to long-term inflation is likely, but hyperinflation isn’t.

• A negative output gap and slack in the labour markets will overcome short-lived price spikes on selected items or the oil basis effect. ECB has a 0.9% target for 2022

• Debt overhangs amid prosecution of monetary and fiscal monetary fusion might lead to higher inflation rates in the medium to long terms.

• Central banks will be managing price dynamics systematically to avoid secular stagnation, in case real rates do not decline sufficiently to balance private sector savings and investment. CBs might possibly revise their mandates and allow temporary overshoots to avoid premature tightening.

3. Potential market catalysts

(+) A positive combination of falling virus cases, rising PMIs, and continuous policy support leading to rising growth expectations
(+) Consolidation of commitment and political capital in the Eurozone, with the European Council approving the EU Recovery Plan
(+) US labour market improvement
(+/-) US elections in November, year-end Brexit deadline
(-) Widening gap between China and EM
(-) German Constitutional Court’s early-August deadline for the ECB’s PSPP proportionality assessment

The ECB’s TLTRO successfully added net €550bn of liquidity, on top of the €400bn already injected since March through weekly LTROs. Since the outbreak of the covid-19 crisis, almost a €1t of additional liquidity has been injected thanks to long-term financing. The high take- up represents a positive test for the effectiveness of monetary and fiscal policy in supporting SMEs and easing financial conditions.