The Second Wave: Can Its Impact Be Contained?

A second wave of coronavirus is crashing over the European economy. New lockdowns are being put in place from the UK to France, Spain and Italy, clouding the economic outlook across the continent. Daily infections are climbing again in the US as well, reaching a record high this weekend. The rise has put a damper on market spirits and maybe also on recovery this quarter. But no widespread US restrictions are expected to follow. And predictions of a Blue Wave in the November 3 elections are raising expectations of a big fiscal boost before too many months pass. We saw the power of government spending to lift the economy in the spring and early summer. Market hopes for a repeat may offset traditional concerns about higher taxes and regulations if Democrats sweep the board next week. Meantime, this week’s big economic numbers won’t tell us much. In this strange stop-start year. GDP releases will show tremendous strength on both sides of the Atlantic, but looking backwards, to Q3.
Last time we showed this chart, the message was very different. Europe contained the spread of Covid-19 over the summer and industrial production picked up while the US suffered a renewed surge in infections and recovery slowed. The US summer surge peaked in mid-July at 75,000 new infections in a single day. New US infections this weekend reached 85,000 a day. But this time there is a surge in Europe as well. What today’s data show is just how quickly a relaxation of restrictions, reopening of schools, increased travel and social engagement can lead to an uptick in infections.

A weak fourth quarter for Europe now seems likely as a result. Restrictions appear to feed more quickly into sentiment and output than in the US. Friday’s PMI figures for Europe were already disappointing. Germany’s manufacturing production was an exception — helped by the revival in export markets in China and the rest of Asia. The Eurozone composite PMI fell back into contractionary territory falling to 49.4 from 50.4 in September. Services were particularly affected with Germany also falling back into contractionary territory while France remained below 50 for the second consecutive month. Since then, Covid-19 has worsened across the continent. In Germany, which has been praised for an effective Covid-19 response, new daily cases this weekend topped 11,000, close to double the previous high in April and still rising. No surprise that the latest reading of IFO Institute business climate index showed a drop in October for the first time since March. France, where President Macron has called for a tough response and curfews now affect 46 million people, has seen new cases jump to more than 40,000 a day — five times as high as the April peak. Other large economies — the UK, Spain, Italy and the Netherlands — are all experiencing a surge. Reinforcing public health messaging is not the only step that governments are taking. In the UK, Chancellor Sunak rolled out his third economic package in a month last week, with new measures to support jobs and businesses.
Observations and the takeaway for investors:
1. Glass half full: for 2021

Even the most optimistic analysts have given up on congressional passage of another fiscal stimulus before next week’s US election. Whatever happens in the election, a harmonious lame duck session that would speed a big spending bill is also unlikely. But looking to 2021, the latest polls suggest that an empowered Democratic majority may be in place to agree on new support for the unemployed, for states and local governments and for small businesses, as well as the start of a major program of public investment. Over time, of course, some of this spending would be offset by somewhat higher taxes on corporations than today’s 21 percent rate (reduced from 35 percent in the 2017 bill) and on the very wealthy. And a full economic recovery will also depend on curbing Covid-19 much more effectively than we have managed so far. But there is reason to look for a stronger 2021. In the meantime, there are some parts of the US economy that are thriving — including housing and construction. It makes sense that after months confined mostly to home, those still earning pre-Covid incomes but with fewer opportunities to spend are looking to improve where they live. The Fed’s low interest rate posture is another incentive. Both home improvements and new builds are responding. Existing home sales hit $6.54 million in September, its highest level since June 2006. Housing permits also hit a similar multi-year high in September as well.

2. Investing in skills, care — and in a good workplace for women — will pay off

We know that Covid-19 is shaking up work patterns. The increased ability to work from home may bring welcome flexibility over the longer term. But for many women, school closures have been the final straw that makes it too difficult to combine a career and raising children. For those with no choice but to continue to work to survive, there is increased stress from the conflicts and worries of who will take good care of their children while they are out of the house. In both the US and the UK, the important nutritional role of school-provided meals has been demonstrated by growing food insecurity when schools are closed.

A new study from Chatham House — where RockCreek Advisory Board member Dame DeAnne Julius is now a distinguished Fellow and past Chair — argues for doubling investments in the “care economy” to build the social infrastructure — health care, childcare and education — needed to support jobs and workforce participation. The Covid-19 recovery action plan from the Chatham House Gender and Inclusive Growth Initiative argues that if governments and corporations invest in social infrastructure and family-friendly policies, support women-owned businesses, and provide women with skills training, vocational and professional education, they could create 475 million jobs by 2030, of which 117 million would be additional.

3. Investor Takeaway

Big Tech. Investor enthusiasm for tech companies has powered equities to record levels in the US and China, the two homes for big tech companies. As described below, cyclicals have rebounded sharply this month. But many still want to put their money on tech. And in today’s Covid-19 world, we are all depending even more on the devices and online platforms of big tech — and small. Maybe it is a love-hate relationship. As last week’s major antitrust case against Google was unveiled by the US Justice Department, many politicians and advocates cheered. Google executives argue that their search engine has most of the market because it is just better than others; analysts are less sure. Unlike Microsoft in the 1990s, Google is faced with competition from other tech behemoths, including Amazon on paid search. But any case will take a long time to grind through the courts, just as Google’s appeal against the European decision — and $9 billion fine — that focused on its Android operating system. In the meantime, it is important for regulators and politicians on both sides of the Atlantic to think through what public good is at stake that requires regulation of tech — whether privacy, misinformation, a lid on innovation or concerns about cybersecurity — and how best to fashion rules to protect those interests. To some, the extraordinary wealth that these companies have created for their founders and early employees is a signal that something is wrong. Some say taxation on this wealth is the way to go.

Cyclicals & Value. Rising nominal rates and inflation expectations may also affect the performance of cyclical sectors. Investors had a taste of such a rotation as the market has mainly been led this month by financials, materials and industrials. Weaker technology returns are highly unusual in the age of Covid-19 and even long before that. Driving forces of these unremarkable returns may be due to the increasing prospects for a major round of post-election fiscal stimulus combined with possible approval of a Covid-19 vaccine on the horizon. While we are not necessarily calling a lasting rotation out of secular growth winners, interim periods such as the last few weeks may be more prevalent in the future. However, given the magnitude of how much cyclical stocks have cumulatively underperformed defensive stocks, investors may need to be prepared for some possible pain in the long defensive vs. cyclical trade that has been so profitable until recently. According to recent analysis, there have been 15 style rotations out of defensive and into cyclical stocks since the GFC. On average they have lasted for four months while delivering 15 percent outperformance for cyclicals.

Emerging Markets. Emerging markets assets continue their positive run with every major market except Russia showing strong gains. This marks four weeks straight of positive gains, a trend not seen since July. Despite the broad-based gains, there remains a large valuation gap between North Asian markets and the rest of EM. This is particularly true when comparing emerging Asia to Latin America. Chinese, Korean and Taiwanese markets have vastly outperformed LatAm this year, and as a result, the valuation premium Asia enjoys over LatAm is now at historical highs. Asia’s premium to LatAm has increased from around 25 percent to 75 percent. This type of dispersion generally presages some measure of mean reversion. Over the past 20 years, every historical period of two or more quarters in which Asia has enjoyed such a large valuation premium to LatAm has preceded a period of strong LatAm outperformance. In addition to lower equity valuations, Latin American economies are now also characterized by very cheap currencies. Brazil’s real effective exchange rate has not been this cheap since the early 2000s, Mexico’s not since the tequila crisis in the mid-1990s (in each case, the bottom preceded a period of high dollar returns from domestic stocks).
While country and regional differences across emerging markets have been stark, a similar trend is evident at the sector level. Emerging market healthcare stocks are up around 33 percent year to date, while financials are down by over 21 percent. Perhaps not surprising given the magnitude of global economic shock and the respective cyclicality and a-cyclicality of those sectors, the valuation differential between the two sectors has reached historical highs, as the chart below illustrates. When valuation dispersions reach this sort of extreme, a reversal becomes increasingly likely. We must however consider that this valuation differential is here to stay if not widen further. North Asia’s exceptionally effective response to the pandemic and the region’s dominance in technology-related industries could very well augur a regime change in emerging markets asset values for time to come.
Higher Yields. Fixed income markets continued to be a place to watch this week as we saw the back-end of the US Treasury curve steepen despite Congress’ inability to deliver near-term fiscal stimulus. The spread between 30yr and 5yr treasuries closed at its widest point since 2016, and the spread between the 10yr and the 2yr is the steepest it has been since 2017. Steepening of the yield curve in the absence of additional fiscal stimulus may signify that investors believe either that post-election it is likely we see a fiscal package or that the recovery can proceed in the absence of any fiscal stimulus. Both nominal and real yields ended the week higher, with nominal yields outpacing real by enough to drive breakeven inflation higher. While it is too early to call a regime shift, if inflation expectations begin to be reflected by nominal rates rising as opposed to real yields falling there could be a meaningful rotation in asset class performance. A significant improvement in real rates could also spell trouble for higher-yielding asset classes, such as emerging markets debt. In this rates scenario, the dollar could reverse course, spelling trouble for gold and other assets. A significant reversal in the dollar fortunes would require a substantial move higher in nominal rates coupled with improvements in the current and fiscal account balances.
RockCreek Update
The RockCreek team remains hard at work from home and has been able to maintain a strong culture and sense of community with morning coffees, virtual town halls, bicycle rides and competitions. Like other firms, RockCreek is giving the team time to vote on November 3.

RockCreek was included in a case study by the World Economic Forum on the importance of resilience in light of the Covid-19 pandemic. The report, entitled Investor Leadership: Retooling for a Resilient Future, is available here.

RockCreek Senior Advisor Caroline Atkinson participated in a panel at the 2020 Institute of International Finance (IIF) Annual Membership Meeting to discuss the most critical issues facing the financial industry due to the pandemic. Watch here.

This past week, Afsaneh Beschloss joined a panel moderated by Michael Milken to discuss the effect of Covid-19 on global markets at the Milken Institute Global Conference. Watch here. She also co-chaired the final day of the World Economic Forum Jobs Reset Summit, which focused on job creation, diversity, equity and inclusion. Watch here.

Team RockCreek

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