Section 1: Q1 2021 Outlook

 

We Expect an Uneven Recovery and a Prolonged Global Recession

While the world was hoping to see the conclusion of the global pandemic as we entered 2021, instead, we find ourselves more in the middle of the cycle. The pandemic has plunged the global economy into its deepest recession since the Second World War, killing millions and freezing economies across multiple continents. As we enter 2021, there have been over 94 million documented cases of COVID 19 and over 2 million deaths reported globally.ⁱ

The impact of weakened fundamental drivers of growth, will steepen the slowdown in labor productivity over the next decade. The pandemic is likely to steepen the long-expected slowdown in potential growth, undermining prospects for labor productivity and poverty reduction. Limiting the spread of the virus, providing relief for vulnerable populations, and overcoming vaccine-related challenges are key immediate priorities.

International bodies, such as the World Health Organization and the Group of Seven, that had been relied upon for a game plan to coordinate a global attack on a global pandemic, proved to be incapable of delivering. Adding to the disaster has been the propensity for the gaps in scientists’ understanding of COVID-19 that have been filled by opportunists.

 

2020: Teetering Between Recovery and Chaos

From the early months of the pandemic in the spring of 2020, the nature of exponential growth of infections led to a doubling every five or six days. A majority of countries failed to anticipate how they would deal with the spread. Italy’s advanced health-care system collapsed under the burden of cases in March as other countries delayed. Britain went into lockdown two weeks after Italy. During that time infections multiplied between four and eight times. In contrast, Asian countries, such as Taiwan, Singapore, and Vietnam drew on their experience of earlier coronaviruses and acted early and effectively.

Entering April, in response to the global spread, the world underwent a de-globalization as borders closed and travel virtually ceased. And as anticipated, a second wave that was more rampant than the first wave of the virus occurred in the fall. Despite having had months to prepare, governments failed to see the crisis coming for a second time.

Moving forward, the vaccine is a game-changer, allowing restrictions to begin to be lifted. The news of a rollout in record time has brought hope to the situation. The most immediate risk is that the rollout of vaccines is slower than the spread of the virus, held back by bottlenecks in production, or more likely, distribution and administration. As of December 30th, 2.8 million doses of vaccine had been administered in the U.S., a rate at which it will take four full years to vaccinate the entire population. Hopefully this will change as supply chain issues are ironed out and the incoming Biden Administration takes a much more proactive stance. Assuming that there is no virus mutation, by the end of 2021 it is hoped that much of the Western population will have been vaccinated. Western economies can only then begin to return to their long-term trend growth.

 

Underlying Geopolitical Challenges

2020 saw the deepest global economic setback of the post-war era. Political dysfunction became a way of life in the U.S. and elsewhere. Record joblessness in North America, second and third virus waves, U.S. civil unrest, a near-war with Iran, simmering trade and tech tensions with China, a Russian hack, Brexit uncertainty (again), and an endless U.S. election cycle that then required four days to declare a winner are notable events that followed a profoundly traumatic decade. Underlying challenges were made worse by the economic stress caused by the virus.

• Democracy receded from the heights of the post-Cold War era, retreating in more places than it advanced,
• Brexit and surging populism threatened European integration, one of the defining endeavors of the post-World War II era,
• Globalization encountered fierce political and geopolitical headwinds, as the World Trade Organization become gridlocked,
• China’s economic rise grew more ominous, and
• America became an uncertain advocate of free trade.

COVID-19 is expected to increase global inequality, both within and between countries.

Within countries, the pandemic has hit lower-paid workers particularly hard – the informally employed, women, immigrants, and the low-skilled. Lower-income workers tend to be less able to work from home than higher-income workers and are more likely to be exposed to the pandemic at work and are more vulnerable to job or income losses due to lockdowns.ⁱⁱ The share of lower-paid workers is higher in essential services where workers are more exposed to the pandemic. Social benefits may fail to reach middle income households that have suffered income losses but are outside existing poverty alleviation programs.ⁱⁱⁱ

With regard to inequality between countries, lower-income countries tend to have large informal sectors that concentrate in activities, and operate in facilities, that require close interactions and are particularly vulnerable to pandemic-related disruptions. In addition to causing losses in output levels, the pandemic has set back fundamental drivers of long-term output growth – investment, improvements in education and health, and increases in female labor force participation. Weakening fundamental drivers of growth will be reflected in lower potential growth prospects over the 2020s.

 

Government Debt and Fiscal Policy Risks

A number of risks related to the pandemic will add to the collateral damage and make the recovery more uneven. These include the rising debt levels in global economies as well as the debt resulting at the corporate level as pandemic related weakness impacts many sectors.

When COVID-19 first began to spread around the world in the spring of 2020, this health emergency risked triggering an economic and financial crisis. America’s financial mechanisms froze as companies scrambled for cash, dumping even their holdings of usually safe Treasuries. Companies and investors the world over rushed into dollars. The bottom fell out of the oil market as demand collapsed. In April the futures price for West Texas Intermediate crude went negative, declining to -$37 per barrel.

As countries locked down, they experienced their deepest downturns in recent memory. But financial panic was averted. The banks stayed resilient. Part of that is a consequence of regulation after the global financial crisis. Fiscal stimulus, government credit guarantees, and central bank action have prevented many losses from occurring. The Federal Reserve stepped into Treasury and corporate-bond markets, a sign of the growing importance of capital markets as a source of credit. The stimulus helped Wall Street, even as Main Street suffered. By August, and again towards the end of the year, the S&P 500 stock market index was hitting record highs. The exuberance was at first concentrated around the sorts of companies, such as those in tech and health care, that did well out of the pandemic. But as news of an effective vaccine broke in early November, it rippled out to emerging markets.

The pandemic has exacerbated the risks to Main Street associated with a decade-long wave of global debt accumulation. Debt levels have reached historic highs, making the global economy particularly vulnerable to financial market stress. There is now almost universal agreement among governments and central banks over the need to maintain fiscal and monetary support until recoveries are entrenched. As a result of sharp output collapses, unprecedented policy stimulus across global economies has led to debt-to-GDP ratios that are set to reach new highs. Global government debt is expected to have reached 99 percent of GDP for the first time on record in 2020.^iv

The COVID-19 pandemic is likely to deepen and prolong a slowdown in output, productivity, and investment growth that has been underway for a decade. Weak growth will further increase debt burdens and erode borrowers’ ability to service debt. For some countries in debt distress, the economic outlook may only improve once debt relief via debt write-offs occurs, rather than rescheduling. Pre-emptive debt restructurings have generally been associated with better macroeconomic outcomes rather than restructurings that occur after a default has occurred.^v

2020 fiscal easing outstrips 2009 although the amount varies across regions, resulting in divergent growth. Among Emerging Market and Developing Economies (EMDEs), total debt had risen by about 7 percentage points of GDP each year since 2009. In 2020, government debt alone is expected to rise by 9 percentage points of GDP, the most since a series of late 1980s debt crises while corporate indebtedness is also likely to sharply increase.^vi

The pandemic has made this wave of debt more dangerous by increasing its risky features. The sheer magnitude and speed of the debt buildup heightens the risk that not all of it will be used for productive purposes. Previous waves of debt have ended with widespread financial crises. When debt resolution was protracted, growth was often slow to recover or even resulted in a lost decade of growth. There is a risk that this fourth wave of debt since 1970, like its predecessors, also ends with a major financial crisis, with some countries already experiencing debt distress.

Since 1970, about half of all countries that experienced a rapid buildup of debt also experienced a financial crisis. Where debt accumulation episodes were accompanied by crises, output and investment were significantly lower even several years after the end of the episode than in countries without crises.^vii

A different but related risk is that ultra-loose monetary policies have led to a misallocation of capital that ultimately threatens the stability of the financial system in one or several major economies. This is possible – history shows how a combination of easy money and liberalized capital markets can cause asset price bubbles to inflate, which can then cause economic and financial market dislocation when they burst. This process typically plays out over years. While it is worth keeping at least one eye on China’s property market, we think that the valuation of major asset classes (including equities) can for now be justified in the context of lower interest rates.

 

Uneven Economic Recovery in 2021

Although the global economy is emerging from the collapse triggered by COVID-19, the recovery is expected to be slow and global GDP is expected to remain below pre-pandemic levels for all of 2021 and 2022. Recessions that feature financial crises are significantly deeper and longer than recessions that do not.^viii Against this backdrop, widespread financial crises, combined with a prolonged pandemic and delayed vaccination, could result in a double-dip global recession, with a further contraction in activity this year.

Throughout the second half of 2020, world trade rebounded strongly. The recovery to date has largely played out in the goods economy much more than in services, as consumers can carry on with purchases from home while other activities requiring face-to-face interactions, such as leisure and travel, are more challenging to resume.

According to the World Bank Global Economic Prospects, published in January 2021, the World Bank projects global economic output to expand 4% in 2021 but remain more than 5% below its pre-pandemic trend. They also project global trade volume growth at 5% in 2021 following a 9.5% contraction in 2020.

Global growth is projected to moderate to 3.8% in 2022, weighed down by the pandemic’s lasting damage to potential growth. In particular, the impact of the pandemic on investment and human capital is expected to erode growth prospects in emerging market and developing economies (EMDEs) and set back key development goals.

In the baseline scenario, global output in 2025 would be about 5% below the pre-pandemic trend and there would be a cumulative output loss during 2020-25 equivalent to 36% of 2019 global GDP.

In addition to causing losses in output levels, the pandemic has set back fundamental drivers of long-term output growth – investment, improvements in education and health, and increases in female labor force participation. Weakening fundamental drivers of growth will be reflected in lower potential growth prospects over the 2020s. The World Bank projects global potential growth would slow by another 0.3 percentage points a year compared with pre pandemic trends, to 1.9% a year over 2020- 29, below the 2.1% a year expected before the pandemic.

 

Global Prospects

SOURCES: COVID-19 COMMUNITY MOBILITY REPORTS (DATABASE); HAVER ANALYTICS; OUR WORLD IN
DATA (DATABASE); WORLD BANK.

 

Like human capital accumulation, infrastructure investment raises growth directly by increasing the capital stock and indirectly through its collateral benefits for productivity. Good infrastructure investment can raise productivity by improving competitiveness, lowering production costs, facilitating trade, strengthening human capital, and encouraging innovation and knowledge diffusion. For example, better transportation networks can reduce the cost and time of new construction and installation of new equipment, and improved access to electricity and better sanitation can raise educational attainment and public health standards.

The World Bank Global Economic Prospects Report includes two adverse scenarios; one where new infections remain elevated in much of the world, and a second where vaccination delays re-ignite financial stress that spurs widespread corporate and sovereign defaults. Such outcomes could mean just 1.6% growth this year or even another global contraction.

A more prolific pandemic could lead to even larger income losses. In a downside scenario of persistently higher caseloads and delayed vaccination, global output in 2025 would be about 8% below earlier expectations, and there would be a cumulative loss equivalent to 54% of 2019 global output. Delays in vaccine deployment could disappoint financial markets and trigger a repricing of risks. Amid record-high debt, higher borrowing costs could tip many firms into bankruptcy, weakening bank balance sheets, possibly to an extent that could trigger a financial crisis. In such a severe downside scenario, the report projects that global output could contract by another 0.7% in 2021. Cumulative output losses over 2020-25 could amount to 68% of 2019 output globally.

The International Monetary Fund in October slightly lowered its 2021 growth forecast to 5.2%, warning that despite massive stimulus from central banks and governments the world still faces an uneven recovery until the virus is tamed.

 

Country Level Outlook

The U.S. economy remains stronger than most other global economies. The fall in U.S. activity in the first half of 2020 was nearly three times as large as the peak decline during the global financial crisis, underscoring the depth of the recession. For 2020, U.S. output is estimated to have fallen by 3.6%. Although the pandemic’s economic impact was not as severe as envisioned in previous projections, last year’s contraction was more than one percentage point larger than that of 2009.

Substantial fiscal support to household incomes – far exceeding similar measures delivered during the global financial crisis – contributed to a robust initial rebound in the third quarter of 2020, which was subsequently cut short by a broad resurgence of the pandemic. The 2021 U.S. growth forecast was cut to 3.5% from 4% in June on subdued demand seen in the early part of the year amid new restrictions and a broad virus resurgence.^ix

The near-term outlook for other countries including Canada remains clouded by the resurgence in infections and lockdown measures which are weighing heavily on economic activity. While Canada and the U.S. are expected to cross the finish line of 2020 with gains, the Euro area and U.K. economies are projected to contract given more expansive lockdown measures. Substantial monetary and fiscal policy support will underpin modest growth in all four economies in early 2021 with the momentum building as more people are vaccinated, restrictions ease, and confidence improves.

Other highlights from the World Bank report include:

• Euro area projection reduced to 3.6% from 4.5% following stringent lockdowns, with sectors like tourism likely to remain depressed.
• Latin America estimate raised to 3.7% from 2.8% on prospects for restrictions easing, faster vaccinations in the second half, and rising oil and metal prices.
• Many emerging countries had less fiscal room to offer big handouts and as a consequence may suffer greater economic damage.
• Subdued demand and heightened economic uncertainty, combined with disruptions to schooling and employment, are weighing heavily on labor productivity.

 

Conclusion

The history of the pandemic has been one of hope over experience, with governments anticipating that lockdowns will be short-lived but then retreating as the virus spreads in ways that we failed to envisage.

Policy support from both central banks and governments will eventually lead to the transition to a sustainable recovery. With weak fiscal positions severely constraining government support measures in many countries, it will be a challenge to recover with sustainable and equitable growth.

The COVID-19 pandemic is a global crisis that necessitates a coordinated global response. Only when the pandemic is effectively managed in all countries will individual countries be safe from resurgence, allowing global growth outcomes to improve materially. We expect emerging markets will continue to outpace advanced economies.

Global cooperation is critical in addressing many of these challenges. The global community needs to make sure the ongoing debt wave does not end with a string of debt crises in EMDEs, as was the case with earlier waves of debt accumulation.

 

 

Section 2: Four Themes

 

Theme 1: China

China is on track for its slowest growth since the Mao era, although set against the gloomy global backdrop, economic performance has been exceptional. Structural weaknesses in China’s economy – demographics, rising debt burdens and diminishing returns on investment – are currently being papered over with stimulus.

Growth in China decelerated to an estimated 2% in 2020 – the slowest pace since 1976. It could have been worse but has been helped by effective control of the pandemic and public investment-led stimulus. Accommodative fiscal and monetary policies led to a sharp increase in the government deficit and total debt. Fiscal policy support, which initially focused on providing relief and boosting public investment, is starting to moderate. The recovery has been uneven as import growth lagged a rebound in exports, contributing to a widening current account surplus.

According to the World Bank Report, growth is forecast to pick up to 7.9% in 2021, above previous projections due to the release of pent-up demand, and to 5.2% in 2022 as deleveraging efforts resume. Even as GDP returns to its pre-pandemic level in 2021, it is still expected to be about 2% below its pre-pandemic projections by 2022.

We remain concerned about China’s rising debt and uneven recovery.

 

Theme 2: Interest Rates

The pandemic led to a global recession as governments shut down large segments of their economies in an effort to slow the spread of the virus. Unprecedented monetary policy accommodation has calmed financial markets, reduced borrowing costs, and supported credit extension. However, historically low global interest rates may conceal solvency problems that will surface in the next episode of financial stress or capital outflows.

At the onset of the pandemic, short-term interest rates fell as central banks reduced short-term policy rates. The Federal Reserve, for example, reduced the federal funds rate (that is, the interest rate that financial institutions charge each other for overnight loans of their monetary reserves) from 1.6% to near zero over a two-week span in early to mid-March.

Long-term interest rates fell as well, as central banks, including the Federal Reserve, made direct purchases of long-term securities and instituted a number of lending programs aimed at maintaining the functioning of financial markets. Additional downward pressure on long-term interest rates came from investors shifting out of risky assets, such as equities, and into safe assets, such as U.S. Treasury securities. Rates were also held down by the fall in demand for investment as firms postponed and cancelled capital expenditure projects.

The 10-year Treasury yield bottomed in August and is above 1% in the first week of January 2021, for the first time since March last year. This follows the Georgia Senate run-off election and an ensuing rise in the chance that the Biden administration passes further fiscal stimulus. The recent rise in rates has effectively been a tightening but the Fed is unlikely to let monetary conditions continue to tighten, as the economy continues to recover. Yields have edged up in the U.K., but not to the same extent as in the U.S. The recovery in risky assets has continued to push down corporate bond spreads, below their pre-virus levels. The next round of fiscal stimulus is expected to assist the state and local government sector. Munis are attractive as a result and have rallied as Treasuries sold off.

The rise in market rates and steepening yield curve is a big plus for financials, especially for the regional banks which will not face any regulatory risk. There is concern over commercial real estate exposure, but that is really a problem that commercial mortgage-backed securities and structured finance players will confront.

We continue to have concerns that asset prices have been driven up by exceptionally loose monetary policy and that they will reverse once central banks start to raise real interest rates back towards their historical levels. At the same time, the equilibrium level of real interest rates is lower than in the past and this is expected to cushion and correction.

 

Theme 3: Inflation

In general, the global inflation story has continued to be one of disinflation due to subdued demand outweighing boosts to price pressures from coronavirus-related supply constraints. Deflationary pressures from technology are likely to remain muted. Inflation rates are subdued, as they have been for the past decade, but stimulus and demographic trends could prompt a comeback. Higher public debt burden, slower global labor force growth, and the possibility that globalization will be partly reversed, will lead to a gradual rise in inflation over the longer-term. In the near term, with oil prices around $55 per barrel, base effects will ensure a jump in energy price inflation on the anniversary of last April’s collapse in oil prices.

In the U.S., the pandemic has increased the odds of future inflation, as the Fed is expected to be less committed to ensuring price stability in the future. There is no other central bank as openly committed to policy easing as much as the Fed, and no other central bank boosting the monetary aggregates at the same pace. The Fed has stated that it will not touch rates for three more years even if inflation crosses above 2% and the jobless rate drops below 4%. 3% inflation is something the central bank would be fine with. That would imply a prolonged period of negative real rates, which should be bullish for long-duration assets, bullish for hard assets, and bearish for the dollar.

 

Theme 4: Commodities

Energy and Gold Prices in 2021

Oil prices partially recovered over the second half of 2020 as production fell sharply. This rebound was more modest than the broader recovery in commodity prices as oil demand disappointed while the rise in other commodity prices was mainly driven by strong demand from China. We expect the demand for oil in 2021 to remain subdued and prices to stay within the current range.

Gold was one of the best performing major assets of 2020 driven by a combination of high risk and low interest rates. Given our more cautious outlook for the speed of the recovery, compared to a crypto currency like bitcoin, the risk that gold could go to zero does not exist as there is a floor in its price, because it has physical properties that make it useful even outside of its primary function as a safe-haven asset. Bitcoin, which has marginal intrinsic value, relies on the faith of its holders that it is worth more than nothing and that the technology is sound. We note that the volatility of bitcoin is five times that of gold.

We do not expect to see a strong rebound in energy prices from here but the environment that we have described may result in strong gold investment demand, which could offset low consumption as it did during 2020. We believe there are strong arguments for holding a portfolio that includes hard assets such as gold, things that will keep their value in the face of the ongoing risks that we have discussed in this Outlook.

 

 

Section 3. Investment Outlook

 

Global Pandemic Leads Us to a Recession Forecast for the Next Twelve Months

 

SOURCE: FRAME GLOBAL ASSET MANAGEMENT

 

Frame Global Asset Management considers these trends and factors them into our outlook for the economy in our twelve-month forward period. We look back to periods of similar economic behavior and use this information to predict the future behavior of the asset classes that we consider. Our investment process allows us to adapt for non-traditional monetary policy and other exogenous variables.

 

 

Section 4. December 2020 Portfolio Models

COVID-19 has wreaked havoc on the world economy, which is set to contract the most since WWII this year as governments shut down large segments of their economies to slow the spread of the virus. There are some signs of recovery as the latest data from the CPB Netherlands Bureau for September showed that real world trade in goods was just 1.5% below its December 2019 level. We have maintained our Recession outlook over our forecast horizon of the next 12 months.

In December, we maintained the asset allocation that was established in November for all models. We continue to favor shorter duration fixed income. With interest rates low or negative, we have maintained exposure to gold. Equity exposure across all models reflects our view that markets are looking through the uncertainty of the pandemic and towards the resumption of more normal life once the population is vaccinated.

We are closing in on the end of a year that introduced the current global pandemic, triggering the deepest global economic setback of the post-war era, record joblessness in North America, second and third virus waves, U.S. civil unrest, a near-war with Iran, trade and tech tensions with China, a Russian hack, Brexit uncertainty (again), and an endless U.S. election cycle that then required four days to declare a winner. The pandemic is unfortunately not over as we enter 2021.

 

Deborah Frame, CFA, MBA

President and Chief Investment Officer

January 14, 2021

 

ⁱJohns Hopkins University. National Public Health Agencies. January 18, 2021.
ⁱⁱWorld Bank. 2021. Global Economic Prospects, January 2021. Washington, DC: World Bank. doi: 10.1596/978-1-4648-1612-3. License: Creative Commons Attribution CC BY 3.0 IGO.
ⁱⁱⁱWorld Bank. 2021. Global Economic Prospects, January 2021.
^ivWorld Bank. 2021. Global Economic Prospects, January 2021.
^vWorld Bank. 2021. Global Economic Prospects, January 2021.
^viWorld Bank. 2021. Global Economic Prospects, January 2021.
^viiWorld Bank. 2021. Global Economic Prospects, January 2021.
^viiiWorld Bank. 2021. Global Economic Prospects, January 2021.
^ixWorld Bank. 2021. Global Economic Prospects, January 2021.

Section 1: Q4 2020 Outlook

 

Teetering Between Recovery and Chaos

COVID-19 has depressed economic activity around the world. Monetary and fiscal responses from governments and central banks in both developed and emerging economies since March are without precedent, far surpassing actions taken during the global financial crisis.

We are currently living in a world that is teetering between recovery and chaos. As a Portfolio Manager, our job is to offer you solutions that provide your investments with the best protection through our portfolio models, addressing the current uncertainty and acknowledging the new economic regime that is the outcome of this global event.

Containing the virus’ spread is the best way to save the economy and investment markets. Policies that allow economic activity to proceed safely, without placing people at undue health risk are needed. The global economy cannot recover until the epidemic is under control. This will happen when efforts to provide relief to individuals and businesses complement efforts to control the spread of the virus.

These are unprecedented times. Investors want to minimize volatility and losses. Traditional investment management that focus on broad diversification among asset classes and relative over and under weights to a broad array of asset classes have experienced losses. The Frame Global Asset Management investment process addresses the global movement of capital into and out of the U.S. and incorporates a forward-looking view of where capital is heading in this changing world.

We know that there is a direct link between macroeconomic and geopolitical uncertainty and volatility and correlations within markets and asset classes. We also know that capital around the world moves to markets where it sees the greatest opportunity. This is largely driven by relative interest rates, currency differentials, and perceived safety/risk. Common sources of macro risk – including the Fed, energy prices, geopolitics, inflation shocks, regulatory change, sovereign risk, elections, and fiscal-policy dysfunction – can affect both single stock volatility within an asset class and the correlation among stocks and bonds.

The chaos of the economic collapse during this pandemic has obscured the initial impact of global central bank actions. Emergency programs have come while nominal interest rates are low by historical standards. As a result, monetary policy will be constrained in its ability to provide further support to a recovery. Aside from rate cuts, central banks have also begun to increase the money supply via a sweeping Quantitative Easing program. But the conditions for QE to stimulate demand are less favorable now than they were in 2008–2014. This is because the current recession combines a shock to demand with a shock to supply. As supply chains are broken and workers cannot report to their jobs, many firms are not be able to increase output and would not be able to even if the demand returned.

 

The State of the Global Economy

In the face of large budget deficits, a stock market bubble, and the impact of plummeting oil prices from last year, the state of the global economy was less than ideal heading into 2020.

One of the rare benefits of crises and recessions is that they remove both unproductive firms and financial excess, creating space for more productive firms and fresh financial investment. This did not happen after the Recession of 2008, resulting in a weak economic recovery from the crisis that varied in economies around the world. In dealing with the Great Financial Crisis (GFC) of 2008, the U.S. recapitalized, merged, and permitted the failure of some banks, but Europe chose the opposite approach resulting in undercapitalized and ailing banks surviving.

However, the most impactful mistakes were made after the GFC on both sides of the Atlantic. For the past decade, central banks have enacted zero or negative interest rate policies and sought to manage economic downturns through policies of quantitative easing (QE). Such programs were adopted in Japan, the European Union, and United States, each with varying degrees of success. Intermediary banks paid the sellers of bonds (households, funds, banks, etc.) and the Fed compensated the banks with reserves. In practice, the Fed forced excess reserves onto the balance sheets of banks far beyond levels they would have acquired independently. Because of the higher supply of reserves system-wide, their marginal benefit decreased, bidding up the prices of various securities. This led the banks to issue additional and often riskier loans until the balance of the marginal benefits was restored. Also, because Quantitative Easing and low policy rates depressed long-term rates, many of the securities that the commercial banks held had no yield advantage over reserves, making the banks more likely to substitute less-liquid securities with more credit risk.

More than ten years later, through FX reserves and through QE programs, central banks globally hold government bonds issued by a relatively small number of advanced economies. Meanwhile, growth in the wake of the 2008 financial crisis slowed and the U.S. economy began to show signs of recession heading into 2020.

 

The Monetary Policy Challenge and the Unintended Consequences of Quantitative Easing

From its initial detection in Wuhan, China to the outbreak’s late-February global explosion, the early 2020 onset of the novel coronavirus (COVID-19) pandemic brought chaos to financial markets worldwide.

During the immediate aftermath of COVID-19 reaching pandemic proportions, led by the U.S Federal Reserve (FED), central banks around the globe fought massive uncertainty and took action to restore pricing stability. In an attempt to mitigate the negative economic implications of the coronavirus, a new policy of unlimited quantitative easing was implemented.

The experience of using QE through the past decade has made us aware of a number of unintended consequences. As quantitative easing lowers long-term interest rates, a low-cost financing environment can lead to excessive speculative behavior, which will lead to rapid expansion of debt and add to the market risks. In addition, quantitative easing can lead to excessive issue of cash and push up asset prices, creating bubbles. Globally, quantitative easing is likely to generate more debt and market risks in other countries, especially for emerging economies. If the United States attempts to withdraw easing policies in the future, emerging markets might experience currency devaluation and a fall in the stock market, given the current influx of large amounts of capital to emerging market countries. And although unlimited quantitative easing may lead to a quick economic recovery in the short term, it ignores the urgency of long-term and deep-seated structural problems in the U.S. and other economies.

 

A New Wave of Disinflation

One of the concerns raised about QE that has not proven to be threatening in this pandemic is inflation. To glean insights into the possible economic consequences of Covid-19, a Federal Reserve Bank of San Francisco working paper examined the medium- and long-term effects of 15 pandemics, ranging from the Black Death in the 14th century to the 2009 H1N1 outbreak.ⁱ

 

Response of the European Real Natural Rate of Interest Following Pandemics and Wars

SOURCE: ÒSCAR JORDÀ, SANJAY R. SINGH, ALAN M. TAYLOR. 2020. “LONGER-RUN ECONOMIC CONSEQUENCES OF PANDEMICS,” FEDERAL RESERVE BANK OF SAN FRANCISCO, WORKING PAPER 2020-09. VIA MARK YAMADA ON ADVISOR’S EDGE.

 

The figure above shows how the natural rate of interest responded after the pandemics ended (defined as a smoothed risk-free rate plus a high-quality bond return premium). The figure shows pandemics have been deflationary for decades following the event, while wars have been inflationary. Recessions are usually deflationary because low output and low demand temper prices.

 

Risk Appetite

The distinction between Pandemics and wars comes down to risk appetite. The reality is that we are in uncharted territory and the future is very much dependent upon how the public health crisis evolves. Until risk appetite recovers, disinflationary pressures will prevail. Inflation may come back into focus to the extent that supply is constrained, because of layoffs and the lag time required to re-hire and re-train. Demand could return because of income replacement from unemployment insurance and other government relief measures. These could be exacerbated by the type and timing of additional relief measures.

Fiscal policy has a necessary role in this recovery. In the U.S. it is the responsibility of Congress and the White House, not the Fed. At this point Congress needs to start deploying all its fiscal tools. The proposed $2 trillion package of loans to businesses and cash for households is not guaranteed to bring a swift, V-shaped recovery. The CARES Act is not stimulus, it is relief. Essentially, it is income and cash flow replacement. It is bridge financing, not outright stimulus. The federal government is attempting to create a bridge over a crisis that has caused incomes for individuals and businesses to disappear because of behavioral changes and rolling lockdowns to flatten the infection curve. Stimulus depends on how funds are administered. Businesses are unlikely to invest in capital spending without greater certainty and/or tax incentives. Consumers will be cautious until personal safety and employment certainty are evident, so stimulus may be muted. As a result, post-pandemic deflation is likely.

At the end of the day, this all comes down to risk appetite. Capital reserves are endogenous – a closed system. They cannot be and are not lent out. They always stay within the fed funds system. Secondly, banks create credit – not the Fed. Lastly, credit is a function of risk appetite. What does this all mean for inflation? QE and increasing excess reserves are not inflationary unless there is demand for credit, which is driven by risk appetite. Unless there is risk appetite to borrow and banks have risk appetite to lend, then reserves just sit there as excess reserves.

Until risk appetite recovers, disinflationary pressures likely prevail. With that said, we are in uncharted territory and the future is very much path dependent upon how the public health crisis evolves. As we have come to learn through this crisis, almost anything is possible, but inflation fears should be of little worry at the moment.

 

The Price of Saving the Economy

The federal budget deficit has soared to a record $3.1 trillion in the 2020 fiscal year, as the coronavirus pandemic fueled enormous government spending while tax receipts plunged as households and businesses struggled with economic shutdowns.ⁱⁱ

The Fed has increased the size of its footprint in the economy by more than two-thirds and proved to investors that it would step in to buy entirely new kinds of assets.

The gap between what the U.S. spends and what it earns through tax receipts and other revenue is now $2 trillion more than what the White House budget forecast in February. It is also three times as large as the $984 billion deficit in the 2019 fiscal year.ⁱⁱⁱ

The shortfall underscores the long-term economic challenge facing the United States as it tries to emerge from the sharpest downturn since the Great Depression. Interest rates are low, meaning it costs less for the government to borrow money, although the ballooning deficit is complicating policy choices as Republicans resist another large stimulus package, citing concerns about the U.S. debt burden.

This massive deficit is the result of two Fed policies. First, when panic struck financial markets in March, Fed officials lowered the target for their benchmark rate to a range of zero to 0.25%, where they say it will likely remain for years. They have consistently ruled out pushing rates into negative territory. Second, large-scale bond repurchases, interbank loans, corporate loans and currency swaps were executed. In late 2019, nominal interest rates from the overnight to a 10-year maturity averaged between 1.5 and 2 percent. On March 3, 2020, the Federal Open Market Committee reduced the Federal Funds Target Rate by ½ point to 1.00%-1.25% in an emergency policy move. Two weeks later, on March 15th, the FED elected to drop the Federal Funds Target Rate to 0.0%-0.25% to calm the markets. The Fed currently purchases about $120 billion a month combined in Treasuries and mortgage-backed bonds. The damage of the COVID-19 recession will be magnified by the Federal Reserve’s inability to cut interest rates further, leading it to undertake massive additional asset purchases. As the Fed continues to push further into different corners of the economy, it is making it more difficult to get out at some point.^iv

History shows that the Fed’s interventions in the name of crisis management are very difficult to withdraw from once a crisis is over. The actions it took from 2008 to 2010, presented as temporary, remain largely in place.

Michael Kiley, a senior Fed economist and deputy director of the bank’s financial stability division, has forecast that bond purchases equal to 30% of U.S. economic output (about $6.5 trillion) will be required to offset the impact of the Fed’s benchmark rate already being nearly zero. The Fed has so far purchased bonds through so-called open-market operations and emergency lending facilities equal to about $3 trillion since March, implying that another $3.5 trillion is needed, to make up for the monetary policy handicap of zero rates.

Globally, QE by central banks in 2021 is expected to more than double the previous peak in 2010 after the financial crisis. Quantitative easing in Central and Eastern Europe has aided coronavirus crisis responses but risks would be more pronounced if QE undermined perceptions of central bank independence and economic policy framework credibility according to Fitch Ratings.^v

 

Since the Onset of this Stress Event, We Have Demonstrated that Our Investment Approach is Successful

Traditional investment managers are handicapped when their portfolios are “macroeconomic regime” agnostic. The Frame Global Asset Management investment process monitors the global movement of capital into and out of the United States. Markets are forward looking, and when we look at the behavior of markets, we see that they eventually reflect the reality of the current and anticipated future macroenvironment. We make extensive use of our internal expertise in interpreting economic data. We exploit these inefficiencies and provide our clients with superior outcomes. We focus on minimizing capital losses by recognizing macro and geopolitical risks that are present and expected over our forecast time horizon

In July, we maintained the asset allocation that was established in June for all models. We continued to be positioned in shorter duration fixed income. We expected interest rates to remain low or negative across the globe and as a result, we continued to have exposure to gold which is a store of value in this environment and a preferred asset for central banks for the foreseeable future. Equity exposure to large cap across all models reflects our view that shifting business models during this pandemic have had a negative impact on bottom lines but that select businesses are benefiting from the shift. We are continuing to monitor the recovery in Europe following the Eurozone’s agreement on a stimulus package. Within FX, we are monitoring the US dollar, which tends to perform inversely with global growth. Independent shocks to risk including politics and the outcome of the U.S. election in November could affect dollar performance over the back half of 2020.

In August, we maintained the asset allocation that was established in July for all models. We continued to be positioned in shorter duration fixed income. We expected interest rates to remain low or negative across the globe and as a result, we maintained exposure to gold while monitoring four variables: the US dollar, stock market volatility, real interest rates, and inflation. We continued monitoring the recovery in Europe following the Eurozone’s agreement on a stimulus package.

In September, we maintained the asset allocation that was established in August for all models. We continued to be positioned in shorter duration fixed income due to larger-than-average duration supply from the Fed. Lower rates mean lower income as inflation is positively correlated to yields. With interest rates low or negative, we have maintained exposure to gold. The U.S., as the largest democracy in the world, is still seen as the safest place to invest. The Bank’s monetary policy objective is to deliver price stability and, subject to that, to support the Government’s economic objectives including those for growth and employment. Monetary stability means stable prices and confidence in the currency. A reflection of this stability has been evidenced through most of history as capital flows to the U.S. from abroad for opportunity and to escape other relatively riskier international environments.

 

Economic Regime Based Investing

Unfortunately, a multitude of variables persist regarding the containment and eradication of the COVID-19 contagion. Until the U.S. addresses the long-term structural problems of its economy, ranging from an aging population, to inadequate welfare policies, worsening income inequality, low productivity, insufficient investment in the real economy, and long-term fiscal and foreign trade deficits, it is entirely plausible that the Fed will be struggling a decade from now to undo the emergency actions of today. It is very likely that a new economic regime is underway. Our investment approach allows us to anticipate and adapt to a change like this.

 

 

Section 2. Four Themes

 

Theme 1: The November U.S. Election

While the course of the pandemic is by far the biggest risk to our forecasts over the next year or two, the November 3rd elections have the potential to leave a wide-ranging and long-lasting impact on the economic outlook. The chaotic handling of the pandemic together with Trump’s response to widespread protests in American cities have helped Biden open a wide early lead in the national polls. A Joe Biden victory in November together with Democrats winning back control of the Senate could see a big increase in taxation and federal spending, together with a shakeup of healthcare, regulatory, and trade policy. Uncertainty is exacerbated by the impact of voting during a global pandemic on turnout models and potential operational issues including an increase in voting by mail.

Of more importance is the makeup of Congress, with a clean sweep of the House, Senate, and the Presidency enabling either party to loosen fiscal policy more markedly.

 

Trump & Biden’s Positions on the Key Issues

SOURCE: CAPITAL ECONOMICS

 

Theme 2: Secular Stagnation

The Pandemic is exacerbating secular stagnation that was already present before 2020. This refers to a rise in the amount of desired saving relative to desired investment, which has prompted interest rates to fall to balance the two. This in turn reflects various factors such as the impact on saving of ageing populations, shareholders’ desire for short-term returns, and a dearth of investment opportunities.

We anticipate rest-of-world GDP will finish this year nearly 5% below pre crisis levels as virus containment and macroeconomic policy are not being managed effectively. Recent policy developments have reinforced concerns on this front. Although treatment has improved and mortality rates have decreased, COVID-19 has not been contained and new cases globally have moved back to their mid-year high. At the same time, there is no evidence that fiscal policy is moving to offset the run-off in emergency stimulus.

 

Theme 3: A Flare-Up in Trade Tensions with China

The results of the phase one trade deal between China and the United States and the trade war that preceded it have significantly hurt the American economy without solving the underlying economic concerns that the trade war was meant to resolve. Six months after the deal was inked, the costs and benefits of this agreement are coming into clearer focus. The effects of the trade war go beyond economics. President Trump’s prioritization on the trade deal and de-prioritization of all other dimensions of the relationship produced a more permissive environment for China to advance its interests abroad and oppress its own people at home, secure in the knowledge that American responses would be muted by a president who was reluctant to risk losing the deal.

 

Theme 4: Forecast Uncertainty

The International Monetary Fund has noted several risks around their 2020 forecast.

The forecast sights the depth of the contraction in the second quarter of 2020 as well as the magnitude and persistence of the adverse shock. These elements, in turn, depend on several uncertain factors including:

• The length of the pandemic and required lockdowns
• Voluntary social distancing, which will affect spending
• Displaced workers’ ability to secure employment, possibly in different sectors
• Scarring from firm closures and unemployed workers exiting the workforce, which may make it more difficult for activity to bounce back once the pandemic fades
• The impact of changes to strengthen workplace safety—such as staggered work shifts, enhanced hygiene and cleaning between shifts, new workplace practices relating to proximity of personnel on production lines—which incur business costs
• Global supply chain reconfigurations that affect productivity as companies try to enhance their resilience to supply disruptions
•The extent of cross-border spillovers from weaker external demand as well as funding shortfalls
• Eventual resolution of the current disconnects between asset valuations and prospects for economic activity

 

 

Section 3. Investment Outlook

 

Global Pandemic Leads Us to a Recession Forecast for the Next Twelve Months

 

SOURCE: FRAME GLOBAL ASSET MANAGEMENT

 

Frame Global Asset Management considers these trends and factors them into our outlook for the economy in our twelve-month forward period. We look back to periods of similar economic behavior and use this information to predict the future behavior of the asset classes that we consider. Our investment process allows us to adapt for non-traditional monetary policy and other exogenous variables.

 

 

Section 4. September 2020 Portfolio Models

The global pandemic-induced GDP collapse has led to higher debt service burdens and lower ability to repay, resulting in an increase in non-performing loans and credit risk. We are now in a twilight zone of partial lockdowns. Fearful of rebellion, and of snuffing out signs of economic recovery, governments are opting for a hodge-podge of curbs. Financial intermediaries have become more risk averse, slowing the flow of much-needed new credit and debt. These signs of cooling are consistent with our view to maintaining our Recession Outlook for our forecast horizon of the next twelve months. Our outlook depends on what happens with fiscal policy and the spread of COVID-19, and we will continue to closely monitor these.

In September, we maintained the asset allocation that was established in August for all models. We continue to be positioned in shorter duration fixed income due to larger-than-average duration supply from the Fed. Lower rates mean lower income as inflation is positively correlated to yields. With interest rates low or negative, we have maintained exposure to gold. Equity exposure to large cap across all models reflects our view that shifting business models during this pandemic have had a negative impact on bottom lines but that select businesses are benefiting from the shift. We are continuing to monitor the recovery in Europe following the Eurozone’s agreement on a stimulus package.

 

Deborah Frame, CFA, MBA

President and Chief Investment Officer

October 14, 2020

 

ⁱFederal Reserve Bank of San Francisco. Longer-Run Economic Consequences of Pandemics. June 2020.
ⁱⁱTrading Economics. U.S. Government Budget. October 16, 2020.
ⁱⁱⁱTrading Economics. U.S. Government Budget. October 16, 2020.
^ivFederal Reserve. FOMC Statement. September 16, 2020.
^vFitch Ratings London. June 3, 2020.