Flattening Out the Wrong Curve?

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Is the US recovery flattening out? Latest data suggests that instead of the hoped-for V, the third quarter may see the beginning of a W pattern–or perhaps an undulating curve like a sine wave– as COVID-19 surges and ebbs around the country, but is not decisively contained. However it is described, the impact of a faltering economy is the same for the millions of Americans still losing their jobs and staring at the disappearance this week of the extra benefits that have held up spending, especially for lower income families. Add to that, geopolitical tensions that are flaring again between China and the US, and the outlook is concerning. It’s not surprising that equities stumbled last week after rising for the previous three. The saving grace for markets? The Fed still has their back.  
Will the pandemic hurt diversity in finance, as childcare and virtual schooling impact women more than men? Listen to the latest episode of Finance Forward with Lisa Shalett, investor and former Goldman Sachs partner, discussing these issues with Afsaneh Beschloss and Caroline Atkinson.

Uncertainty surrounds the outlook for the global economy, with patterns diverging around the world. One thing seems clear: signs of progress– or setbacks– in curbing the pandemic have become a leading economic indicator. China was the first in and first out of recession, with its GDP up in Q2 and expectations for further recovery in the second half of the year. Europe was next hit badly by disease. Second quarter data coming this week will still look terrible, as most nations responded aggressively with shutdowns. But Friday’s European PMIs, in contrast to those in the US, suggest that the measured reopening in recent weeks is leading to a gradual recovery across the region. And steps to keep workers employed have held down jobless totals. In the US, the failure to curb COVID-19– with 4 million cases now recorded since the first infection identified in January and infections rising in a majority of states– is filtering into the economy. New jobless claims were up in the week to July 18 and PMIs released Friday showed a continued contraction expected this month in the services sector, that accounts for the bulk of US employment.

Observations and takeaways
1. This is not a normal recession; is that why politicians can’t agree on next steps to bolster recovery?

From its beginnings in February, the “corona recession” that swept across the world has been different from any other. The differences have complicated projections for the future path of the economy, confounded decision-makers used to operating traditional economic and financial policy tools to guide the economy, and led to a big disconnect between markets and the real economy. More than six months into the crisis, it is worth looking at some of those differences to judge what may come next.  
 
Most obviously, this recession sprang from an unusual source– a little understood and rapidly spreading health crisis. The costs of initial government responses– switching off most economic activity and locking down most workers– were swift and unexpectedly large. This was  especially true in the US, where millions of workers suddenly lost their jobs, many lost access to health care, and lines appeared across the country of families queuing at food banks. The specter of another Great Depression loomed. Hardly surprising that there was an enormous backlash and pressure for re-opening the economy.
 
But, as we have learned to our detriment, there is not a simple trade-off between economic livelihoods and public health and lives. By reopening when COVID-19 was still spreading and pervasive in many places, the US may have gotten the worst of both worlds: a sharp recession, which will leave scars in terms of business closures, bankruptcies and disrupted lives, and continued disease, that will be difficult if not impossible to eradicate, in the absence of effective treatments and vaccines.  
 
That puts more focus on finding and distributing innovative medical treatments. Here the story is much better, as Microsoft founder and philanthropist Bill Gates laid out on CNN last week. 

Scientists are hopeful that medical treatments will improve further in coming months, with new drugs and drug combinations being developed both to fight the virus itself, as antiviral remedies have been shown to do to some extent, and to tamp down the ill effects of the body’s own immune response that leads in some patients to blood clotting, breathing difficulties, kidney problems and other systemic health issues in the later stages of disease. Vaccines are likely to take somewhat longer to be widely available and successful in quelling the pandemic. But with scientists pursuing over 200 vaccine candidates, backed with billions of dollars of government and philanthropic money that will help to manufacture and distribute vaccines that pass trials, the prospects are good.
 
Unfortunately, even under the most optimistic prognosis for medical success, the US has months before it of pandemic-induced uncertainty. 

We have seen that while the US public health response to the crisis can be described as anywhere between disappointing and disastrous, other policy action has been quite effective. Extraordinary fiscal stimulus enacted back in March supported the millions thrown out of work in the US, and dwarfed that put in place by other countries. The Fed’s actions took away the risk of financial implosion and calmed markets in the US and around the world. 
 
With the virus still around, it is critical to have more fiscal support for struggling businesses and individuals. That may not have been clear when Democrats passed an additional $3 trillion in stimulus in May. But by now, politicians have little excuse for delay. It is disappointing that the expected unveiling last Thursday of an agreed set of Republican proposals was pushed into this week. It may take further weakening of financial markets to speed up the politics.
 
Fiscal help is particularly critical given another unusual feature of this recession: its differential impact on service sectors of the economy. A typical recession hits manufacturing and industrial production and employment first, along with interest sensitive industries such as construction, housing, and investment. Services– which account for the bulk of employment in the US as in other advanced economies– provide a buffer. Not this time. The fact that many service businesses are small, without easy access to credit markets and even banks, with low paid and vulnerable employees, means that monetary easing may be less effective than fiscal aid.


2. School is good for children it turns out; but balancing its benefits against today’s health risks is not so easy. 

The debate about reopening US schools has become politicized.  That is not good for the nation’s children, parents, or teachers. Other school employees, including bus drivers, teachers’ assistants, catering staff, and administrators are also affected. Opening schools will mean they have jobs. But those jobs bring the risk of becoming infected and of infecting others at home. For many, the latter may be their biggest concern. Improved testing and tracing and availability of better masks, protective equipment and cleaning products would go some way to protect educators. Schools do not have budgets or ready access to obtain this support. Even more effective– as well as more costly– would be building upgrades to improve ventilation and airflow.  
 
Evidence is now building up about the impact of school opening from other countries. Unfortunately, the story is not simple. A large scale study in Korea showed that children can catch and spread the virus, although children under 10 are about half as contagious. In Israel, a spike in cases was blamed on schools reopening prematurely. But in Europe, notably in Germany and Denmark, schools have reopened successfully without triggering renewed outbreaks– beginning with the youngest children who are most in need of social interaction to learn and least able to follow virtual instruction. Importantly, these countries reopened when the virus was contained at much lower levels than in the US. They also have had better policies on distancing, cleaning etc.


The most sensible approach is also complex, as there is not a one-size-fits-all response. For college students, a recent College Reaction-Axios poll finds that most are ready to return to campus in the fall: 76% of students plan to return to campus if they have the option, and 66% said they’ll attend in-person classes if they have the option. As schools, local officials, colleges and universities contemplate what to do, experts believe that local conditions should drive decisions. Incidence of COVID-19 in the community, the importance of school in students’ lives– perhaps for providing nutritious food, and the ability of students to learn and to socialize virtually if schools are closed– are all important factors in determining how to balance the difficult trade offs. The most useful– and urgently needed– federal action would be to provide the considerable funds needed to support education, whether through improving buildings’ safety or ensuring that all students have access to affordable online teaching.  
 
Schooling and child care options are another channel for an unequal impact from the COVID-19 recession. We wrote last week about growing concerns that women will suffer from a partial reopening of offices with continued heavy reliance on parents for homeschooling. Economist Betsey Stevenson put it well: “The impact of the child care crisis on women’s outcomes is going to be felt over the next decade.”


3. The Takeaway for Investors

With earning season in full swing, markets were mixed this week. The week in US equity markets started unsurprisingly with technology and growth stocks outperforming, but ended in late week volatility with another value rotation looking possible. Global markets experienced similar swings with China continuing its risk-off sentiment as opposed to the highs the CSI 300 and Hang Seng Indices reached earlier in July while Europe advanced on positive coordination across the Eurozone. Investors continue to look for opportunities as well as safe havens across credit and equity markets globally. 


US Dollar, Inflation, and Precious Metals: Markets have begun to reflect expectations that policymakers’ reflationary policy will take hold, countering the extremely deflationary impact of the COVID-19 lockdowns. 10-year yields on US Treasury Inflation Protected Securities (TIPS) finished the week at -0.91%, close to the all-time lows seen in 2012. The Treasury also auctioned $14 billion of 10-year TIPS this week at a yield of -0.93%, the lowest ever yield at auction. With the nominal 10-year Treasury yielding 0.59%, this implies an expected annual inflation rate of 1.5% over the next decade.
 
Inflation expectations have been climbing steadily since the breakeven rate bottomed at 0.50% at the height of the liquidity squeeze on March 19th, but remain well below the Federal Reserve’s inflation policy target of 2.00% – a target that policymakers would like to exceed. According to minutes from the June meeting of the Federal Open Market Committee (FOMC), committee members discussed providing forward guidance that included a “modest temporary overshooting of the Committee’s longer-run inflation goal.”



This shift in expectations that has sent real yields tumbling is weighing on the US dollar and boosting alternative stores of value such as precious metals. The US dollar has been losing ground since March 19th as funding pressures have eased, with the US Dollar Index (DXY) declining -8.1% to its lowest level since September 2018. According to recent studies, the dollar remains near its most expensive levels in 20 years, leaving more room for the dollar to fall. We expect the move to be exacerbated by other secular trends coming to an end – e.g., relative economic strength deteriorating due to poor crisis management and a commitment by the Federal Reserve to hold rates near zero for the foreseeable future. Both these factors will support the relative attractiveness of other markets as alternative havens for foreign capital. 
 
Gold and silver prices gained 6% and 16%, respectively, this past week and are now 30% and 94%, respectively, off their March lows. With Treasuries all along the curve set to deliver a negative real return at maturity, zero yielding assets that can retain their inflation-adjusted value are looking relatively attractive.
 
The question going forward is whether the normalization of implied inflation expectations will continue to be driven by falling real yields or rising nominal yields. Going back to the beginning of April, breakeven rates have risen 58 bps as nominal bond yields have hardly budged. After seeing unprecedented levels of volatility in the Treasury market in March, volatility has completely evaporated with 10-year yields spending two-thirds of the time since April in a 10 bps range between 0.60% and 0.70%. While the FOMC still seems reticent about joining Japan and Australia in implementing yield curve control (YCC) policies, the market may be signaling that it’s more likely than committee members are letting on. If that’s the case, we can expect recent trends in real yields, the dollar and gold to continue.

European Markets: After a much anticipated summit lasting over four days, the EU reached consensus on a recovery fund that could be a game changer for European equities. Look out for more positive catalysts in the coming weeks that may continue to favor Eurozone equities – especially with the volatility in US and emerging markets. Europe’s clear, swift and coordinated response to the COVID-19 crisis combined with a fiscal policy across countries may become even more appealing to global investors looking for incremental return with less risk and cheaper valuations.  With a more stable monetary union and an attractive Euro, European equities are not to be an overlooked opportunity set.

Chinese Markets: In China the end of the week saw investors trying to reduce risk exposure ahead of potentially more uncertainty across headlines this weekend. The latest news on the orders from China to shut the Chengdu US Consulate as retaliation for the US shutdown in Houston introduces another complexity in China-US relations and markets. China A-shares and Hong Kong indices saw a plunge as the Shanghai Composite Index finished below the 3,200 level. The STAR 50 Index was down -7.0% and led declines. Subsequent selling in Hong Kong China markets have been across the board but recent out-performers and mid cap names have seen the most selling pressure. Out of 2,440 stocks within the Shanghai & Shenzhen Composite Indices, only 284 stocks were in positive territory at the end of the week. 
 
Also of note for investors is the announcement from Hang Seng Indexes, the city’s leading index compiler, highlighting the creation of a new benchmark that will track the 30 largest tech firms that trade in Hong Kong. The Hang Seng TECH Index is expected to debut next week. The announcement of Alibaba’s spin off of Ant Financial  and its historic Hong Kong-Shanghai dual IPO listing along with the establishment of the “HK Nasdaq Index” are a positive for Chinese tech conglomerates. Alibaba, JD.com, Tencent, and Meituan stocks all reacted favorably despite the correction this week in Chinese markets. 
 
EM Bonds: Equity markets in emerging markets are not the only source of opportunity as investments in long sovereign bonds and receiving rates in emerging markets is becoming a short term play on interest rates. Investor preference has been for high real–yielding countries that generally have limited fiscal deficits (South Africa is the exception) and are in a benign inflation environment. The preference to be long in places where central banks are in an easing cycle due to slowing economies and low inflation has been favorable for receiving rates or long fixed income predominantly in Mexico, India, South Africa, Russia, and Indonesia.  Brazil had been a staple long, but given the huge economic and political problems in Brazil– as they approach zero real rates and largely at the end of the cutting cycle– investors have been reducing or eliminating much of their positioning in Brazil.
RockCreek Update
The RockCreek team continues to work seamlessly and efficiently remotely. While remote, our team has been staying connected with morning coffee sessions, book clubs, guided meditations, and more. 
 
Over the past few weeks, the RockCreek team has hosted a few guests on our daily investment calls to share insights on their areas of expertise. We recently hosted Heard Capital Founder and CEO William Heard to discuss his firm’s investment philosophy, and Elizabeth Park President and Founder Fred Cummings to discuss the financial sector and outlook on banks. We look forward to sharing highlight clips of more discussions in the coming weeks.
 
We hope you, your families and teams continue to stay safe and healthy throughout these uncertain times. We are always eager to learn of more ways in which we can help uplift communities during the crisis, please let us know if you are aware of any opportunities and ways in which we can get involved.

–Team RockCreek

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