Stages, sequencing and selection

The risk of injury is what professional athletes need to face. A torn ligament or a broken bone can take months to heal. The rehabilitation process can be described in two stages. The first stage is to repair the injured body part and allow the athlete to regain some basic body functions, such as being able to walk again. This could happen in a matter of a few weeks, even days. Then the long road of rehabilitation begins for the athlete to get back to full fitness and peak condition. This could take months, and the athlete may not even return to his or her peak after the recovery. 

The global economy is in a similar two-stage recovery process. We are probably at the start of the first stage of recovery from COVID-19’s debilitating injury and getting back to some form of normality. Yet, the second stage of returning to full fitness is likely to be a long process and requires sustainable medical solutions, such as a widely distributed vaccine, or at least an efficient and accurate testing process. 

Getting back on its feet

The April Purchasing Managers’ Index (PMI) for both manufacturing and services probably marks the lows in economic activities in this pandemic-induced recession due to full lockdown in Europe and severe social distancing measures in other parts of the world. The flash PMI data for May in the U.S. and Europe are already reflecting the bottoming out of economic activities. After contracting by 6.8% in the first quarter of the year, China’s economic activities are also picking up according to April’s economic data. 

In the U.S. and Europe, their economies were already in contraction in the first quarter, compared with the previous quarter. The second quarter is expected to be worse, reflecting the full impact from the lockdown. COVID-19 was powerful in shutting down the services sector, like food and beverages, entertainment, travel and leisure, and brick and mortar retail. These industries make up a sizable share of the developed world’s economy. Coming to a standstill means the U.S. economy could see activity drop by 20%-30% in the second quarter, compared with the previous quarter. The U.S. unemployment rate hit 14.7% in April, with 20.5 million jobs lost. 

With new infection cases coming down in Asia, Europe and the U.S., governments are allowing businesses to re-open gradually. Most governments are approaching this with great care since everyone wants to avoid a second wave of infections. There are some lessons learnt from China’s recovery process in recent months. 

The sequencing of recovery is noteworthy, since other economies may face a similar development. Factories and workplaces can open first because it is relatively easier to screen staff for a fever or potential symptoms. Some consumer services are also returning. However, consumers are less comfortable with crowded spaces, such as air travel, cinemas or concert halls. 

A similar pattern is emerging in other economies, and businesses are trying to find ways to cope with the new conventions. Social distancing rules and preferences mean restaurants may need to space their tables further apart. Sports events, such as in Germany and South Korea, are held in empty stadiums. Governments are discussing ‘travel bubbles’, where locations with low infection rates can allow their people to travel without stringent quarantine requirements. 

Now comes the hard part

The first stage of recovery is bringing some normality back to our lives, and this would be reflected in growth data in the months ahead. Once these low hanging fruits are picked, achieving the second stage of returning to full health will be more challenging. To get back to where we were in December 2019, a widely distributed vaccine, accurate and efficient testing or contact tracing will be needed. The potential return of another round of infections in the northern hemisphere in autumn could also be a challenge. 

This second stage of recovery also needs to take into account two things. First, some of the economic damages may be permanent. If firms are forced to close, their employees will not have a job to return to when things start to improve. Also, fresh economic risks could rise. The return of U.S.-China trade tensions is an old foe that investors need to pay more attention to again. 

For policymakers, they can breathe a sigh of relief that the economy has bottomed. They have stopped the bleeding, but it could be another several quarters before we get to this second stage of recovery. This means developed market central banks are likely to keep their policy rates close to zero for an extended period of time. They may ease back on asset purchases but unwinding their balance sheets is going to be difficult, especially when governments may need to provide more rounds of stimulus to support households and businesses before we get back on a stronger growth track. 

Select by focusing on the recovery sequence

Despite the worst recession since the Second World War, the equity market has been in a cheery mood. The S&P 500 is up 35% from its low in March. One key difference with this recession is that we know precisely when it started. Moreover, the global economy has very likely seen the worst of this downturn. However, getting back on its feet is the easier part. Returning to full fitness is going to be more challenging. 

Markets are celebrating this first stage. Aggressive medicines from governments and central banks to support the economy also help to numb the pain. Both the equity and corporate credit markets have quite accurately reflected the varying degree of recovery by sector. For example, technology, health care and consumer staples have outperformed, while energy, airlines and travel are still in a tough spot. Investors will need to monitor the next stage of recovery, as well as take into account new threats to global growth, such as geopolitical uncertainties.

We think fixed income should continue to be the core of portfolio allocation at this point. Having passed the worst, investors could look for more risks in high yield corporate credits. Default rates are still likely to rise but historically, high yield corporate credit spreads typically peak before the peak is in default. That said, depressed energy prices and a gloomy outlook in discretionary consumption mean investors will still need to choose carefully in this space. Emerging market fixed income, despite the strong U.S. dollar, has also performed well. We think investors can pay more attention to Chinese fixed income. International participation in the Chinese fixed income market is still low. It can also be a rich source of yields in an income-seeking world. 

This hunt for income and yield would also benefit high dividend equities. The weaker earnings outlook is clearly a challenge, but investors can still find sectors with stable dividend payouts and less government interference. Following the outperformance of the technology and health care sectors, industrial and consumer discretionary sectors could attract attention given they could benefit from this stage of the recovery. For sectors with very cheap value, such as energy and financials, we may need to wait for signs of the second stage of recovery to act as a catalyst. 

Global economy:

• The May flash PMIs for G4 economies show a bounce in economic activities, even though the level is still significantly below 50, indicating that manufacturing and services are still in contraction. With a decline in new infections, most European countries are looking to reopen their economies in May and June, even though significant social distancing policies are still in place. The U.S. is also expected to gradually reopen its economy, which hopefully would help the labor market. 
  (GTMA P. 15, 30)
• Developed market central banks have taken a pause in monetary easing, following aggressive actions in March and April. In contrast, emerging market central banks, such as Brazil, India and Turkey, cut their policy rates to support growth. Many of these emerging market countries are still facing a high number of infections, but their economies cannot afford a prolonged shutdown.
  (GTMA P. 21)

Equities:

• After the strong rebound in April, global equities maintained momentum in May. The S&P 500 was up 7.5% and the NASDAQ up 10.3%. The Stoxx50 was up 4%. The ongoing corporate earnings downgrade is starting to stabilize for 2021, but the general consensus is that we will not return to 2019 earnings level in most developed markets by 2021.
  (GTMA P. 34, 37)
• May was more challenging for Asian markets. Singapore and India are impacted by the ongoing COVID-19 pandemic. Hong Kong equities underperformed the region (down 6.8% in May) due to the rise in political tensions between the U.S. and China and also uncertainties from domestic politics. Domestic developers, tourism-related services and financials were particularly hard hit in Hong Kong.
  (GTMA P. 34, 42)

Fixed income:

• U.S. Treasury (UST) yields were broadly stable during May as the Federal Reserve (Fed) kept its policy largely unchanged. The 10-year yield was only up 7bps in the month and the slope of 2-year to 10-year yield steeped by 10bps. With the Fed unlikely to adopt negative policy rates, but maintain asset purchases to keep the long end steady until the economy recovers, we could see UST yields trapped in a range in the months ahead, especially in the short to mid section of the yield curve.
  (GTMA P. 47, 50)
• U.S. investment grade and high yield corporate credit spreads narrowed by 19bps and 120bps, respectively, in May. Investors are starting to feel more optimistic about the prospects of the economy reopening. However, the energy and leisure sectors continue to be challenging. Despite the strength in the U.S. dollar (USD) and the high number of new infections in markets such as Brazil, India and Russia, emerging markets debt also generated strong returns, especially in USD-denominated debt in May on the back of spread compression.
  (GTMA P. 47, 49, 56, 57, 59)

Other assets:

• Oil has rebounded back to USD 35pb (for West Texas Intermediate) with some early signs of the global economy bottoming out with lockdown being eased around the world. Saudi Arabia is also offering to cut supply by another one million barrels per day. That said, the prospects of oil prices returning to a more sustainable range of USD 50-60pb is still not optimistic since the market still needs to digest all the crude oil in storage, and the long road for oil consumption to return to pre-pandemic level. Gold remained range bound along with bond yields with the price of gold stuck between USD 1700 and USD 1750 per ounce.
  (GTMA P. 67, 68)