Monetary policies – A divide and conquer Covid approach?
In the aftermath of the Global Financial Crisis (GFC), central banks worldwide were applauded for their innovative monetary policies. Yet despite reacting quickly to this year’s economic crisis, COVID 19 has deepened fractures that were already emerging between the world’s three major economic powers: the US, Europe and China. This has led to monetary and government policy in these regions going their own separate ways. These three journeys can be represented as the good, the bad and the potentially ugly. So, what has driven this divergence and should investors be concerned?
Coronavirus: the great divider
In the first quarter, initial policy responses to the widening pandemic were broadly similar. Countries were locked down to stem the spread of the virus, with unprecedented economic stimulus used to shield economies and protect employment. While impactful, the lockdowns failed to fully suppress the virus and a second wave of outbreaks is being met with disparate approaches.
The US has prioritised protecting the economy and didn’t re-impose any meaningful restrictions when coronavirus cases spiked for a second time in the summer. European nations seem more willing to impose heavier restrictions, with many localised lockdowns being put into place in an effort to slow the spread of the second wave. This more stringent action will hinder the region’s recovery from an already severe economic downturn.
Even though the virus originated in China, the first outbreak was highly localised and no substantial second wave has broken out. While the initial, draconian lockdown triggered a sharp downturn in growth (and a decline in GDP), recent economic data suggests the country has rebounded quickly and China is now one of the few countries moving on to a post-pandemic economic landscape.
The potentially ugly: US presidential election
The US economy has benefitted from massive fiscal and monetary support, offsetting at least some of the impact of the lockdown recession. The Federal Reserve (Fed) has provided additional trillions in liquidity and by adopting a more flexible inflation target has signalled it will no longer pre-emptively raise interest rates to counter perceived inflation risk or fiscal stimulus. This has reassured markets by reinforcing the message that US monetary policy will remain accommodative for a long time.
For its part, the US Congress approved and President Trump signed a USD 2 trillion stimulus package the provided crucial income to the millions of people who lost their jobs. Unfortunately, a subsequent package has been held up by political gridlock between the Republican-ruled Senate and the Democrat-ruled House of Representatives. Discussions have now been shelved until after the election in November, though more limited, targeted measures are still possible.
Moreover, the election is being fiercely fought. There are several possible outcomes to consider:
It is unclear whether there will be a clear winner of the presidency on 3 November. If the result is close, President Trump has indicated he may contest the outcome, a situation that could drag on through the end of the year. This scenario could be very negative for markets in the short-term, as happened in 2000 when the outcome of the election between George W Bush and Al Gore was unclear.
Irrespective of who actually wins the presidency, a key issue is whether Congress will remain divided. As seen in the failure to agree a second stimulus, a divided Congress often results in gridlock and little legislation. This was the situation during the latter six years of Obama’s administration as well as the last two years of Trump’s. This outcome, a continuation of the status quo, would likely to still be viewed positively by markets as the economy would be left to its own devices as it recovers from the recession.
Finally, Joe Biden winning the presidency and the Democrats gaining control over the Senate, could be the most positive outcome for markets. This outcome would likely see the passage of a substantial stimulus package, which would also drive Treasury yields higher through expectations for higher growth and inflation.
The bad: Fresh lockdowns will damage the European economy
The European approach to a second wave has been very different to the US. Firstly, another round of lockdowns could see the European economy decouple even further from the US economic trajectory. Secondly, the region’s fiscal support programmes have been extended into next year and have centred on the protection of jobs and industries.
While this approach is supportive over the short-term, it prevents industry and employment from transitioning to the new post-pandemic world. And the consequent accumulation of zombie companies could be very detrimental over the long term. Reallocating financial support and labour to growth areas – a concept known as creative destruction – was proven to help industry recover in the aftermath of the GFC and is vital in enabling the economy to adapt to the much-changed post-pandemic world. But will European policymakers be brave enough to take this step?
The European Central Bank’s (ECB) monetary firepower has also come into question. With interest rates already in negative territory at the start of the pandemic, the central bank’s unwillingness to implement further cuts in March alongside the Fed and the Bank of England suggests the ECB realises negative interests may been causing more harm than doing good.
Finally, the ECB and European Union’s hard-won stimulus programmes may have helped curb market volatility, but have had little success in reviving inflation. An appreciating euro is adding to deflationary pressures and it is questionable whether the central bank has any tools left to stoke inflation or whether the European Union is able to provide further fiscal support.
The good: China’s self-sufficiency
China continues to surprise. The fact that the pandemic accelerated deglobalisation trends gave rise to assumptions that the pandemic would be especially painful for China. But this has not been the case. In fact, China is leading the path to recovery.
China is actually well positioned to take advantage of deglobalisation. While lower international trade would have been harmful earlier in China’s development, its economy is now highly focused on services and tilted towards domestic demand. And a population close to 1.5 billion1 effectively serves as its own internal market – very similar to the US’s self-sufficiency.
With comparative low (central government) debt levels and a closed capital account, China has an advantage over many other nations in that it can afford to provide further stimulus should it be required. This is not the case for many emerging markets, which do not have the capacity for more debt-funded spending or monetary stimulus, while currency instability and trade dependency create further headwinds.
Consequences for investors
Having enjoyed broadly benign market conditions for over a decade, 2020 has been unsettling for investors. Yet, while the overall vision for the near future remains cloudy, this century has taught us that disruption of any kind can lead to exciting and often revolutionary opportunities. And 2020 has certainly been disruptive.
At BNP Paribas Asset management, we look at investment from all different angles. This is why we truly believe that instability produces opportunity. While we maintain a cautiously optimistic outlook for risk assets over the medium term, we are acutely aware that the post-pandemic investment landscape could look very different. The process of creative destruction will identify those industries which have thrived and those whose demise appears inescapable. It is our job to find the best investment prospects for our clients.