The initial pick-up in economic activity that we saw in June began to fade in July as households and firms remained in cautious mode, particularly with new virus cases rising in some countries. Monetary policy is less effective as global interest rates are at their lowest levels, leaving central banks with little ammunition.  Central banks are conducting quantitative easing on a much larger scale than during the global financial crisis, buy­ing a wider variety of assets. In August, we maintained the Recession Outlook for our twelve- month forward time horizon.

The global pandemic has exacerbated long standing tensions between the U.S. and China, as trade, technology, and investment act as accelerators towards increased protectionism and re-onshoring. The CPB World Trade Monitor recorded a contraction of -1.1% in May and -17% for the first five months of 2020. Labor market disruptions would also keep growth potential slow as even countries that have provided ample labor market support continue to see reduced immigration, high unemployment levels, and permanent job losses.

China, Vietnam, Taiwan, and Korea are furthest along the road to recovery while economies in southern Europe, Latin America, and Africa lag behind. China has returned to growth, reporting GDP growth of 11.5% YOY for Q2 of 2020, after a contraction of -10% in Q1.1

 Eurozone GDP results showed that their economy shrank 12.1% during Q2, the worst result on record, highlighting the economic challenges that Europe faced during lockdown.2 During Q2, Spain’s GDP contracted sharply by 18.5% while Germany saw a lower infection rate and was able to relax restrictions sooner, resulting in a relatively moderate 10% decline.3,4 On July 21, the leaders of the European Union agreed on a COVID-19 rescue package, providing €750 billion in additional aid, consisting of €390 billion in grants to replenish member-country coffers and €360 billion in loans.5 This is a significant step forward for the EU, as it marks the first time the bloc has raised debt in common. In the U.K., recovery has been slow and the unwinding of the furlough scheme from August is likely to prompt a second wave of unemployment. Additional uncertainty around Brexit is expected to dampen business investment further.

The economic recovery in the United States was strong in May and June, with several indicators beating expectations. It stalled in July, with a report from the Department of Labor showing initial jobless claims rising for the first time since March. Despite ongoing government support, 42% of job losses in the U.S. may be permanent, which means out of the 41 million Americans that have filed for jobless claims, at least 17 million will have no job to return to.6 According to the CBO, the federal budget deficit reached $2.8 trillion for the first 10 months of fiscal year 2020, $1.9 trillion more than recorded during the same period last year. In Canada, greater reliance on commodities and higher private sector debt will likely impede GDP recovery to its pre-virus level.

U.S. equities continued their rally in July. The gap between what is happening in the real world and financial markets is wide. Risks associated with weak macroeconomic data and fears of a resurgence of COVID-19 have been diminished by Fed stimulus and strong earnings results. For July, the S&P 500 gained by 5.6%, while S&P MidCap 400 and S&P SmallCap 600 gained 4.6% and 4.1%, respectively. The S&P 500 gained 2.4% for the year ending July. In Canada, the S&P/TSX Composite was up 4.5% in July. International markets also gained, with the S&P China 500 up 9.8% and the S&P Hong Kong BMI up 0.7%. European equities ended July negative as the S&P Europe 350 declined 1.5% and S&P United Kingdom declined 4.6%.

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

While deflation caused by current weak demand is a near-term risk, current fiscal and monetary stimulus measures will likely result in inflation in the future. We continue to monitor developments regarding deficits, government intervention and regulation, reduced globalization, and greater taxation. Our approach to portfolio management is nimble, opportunistic, and deliberate in identifying asset classes that are best placed to generate returns in a new world order. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, President and CIO

 

1 Trading Economics. China GDP. July 16, 2020.

2 Trading Economics. Eurozone GDP. August 14, 2020.

3 Trading Economics. Spain GDP. July 31, 2020.

4 Trading Economics. Germany GDP. July 30, 2020.

5 Special European Council. EU Budget. July 17-21, 2020.

6 TD Economics. The Post-Pandemic Global Economy. June 4, 2020.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. July 31, 2020. Index performance is based on total returns and expressed in the local currency of the index.

 

 

The “golden era” of globalization is behind us. A drive towards de-globalization, that began for many nations following the Global Financial Crisis, has intensified as the current pandemic has exposed some of the vulnerabilities from global supply chains. The risk is that the current recession becomes a global depression. Depressions entail a prolonged period of weak economic growth, widespread excess capacity, deflationary pressure, and a wave of bankruptcies. Accompanying this is a hiring cycle that is incapable of reducing the unemployment rate in the absence of demand. Central banks have removed price discovery, the ability to appropriately price risk in fixed income markets by bailing out managers of risk. In July, we maintained our current Recession outlook and continue to monitor developments regarding future large public deficits, debts, government intervention and regulation, reduced globalization and more localized supply chains, an end to just-in-time inventories, and greater taxation.

Fiscal packages have been implemented around the world to support companies and individuals during the lockdown periods. The scale of this fiscal effort is resulting in soaring budget deficits that are not about traditional shovels in the ground and the future multiplier effects on the economy. Rather, they are a transfer from future taxpayers to today’s household and business. The impact is a higher corporate cost structure per unit of output leading to lower margins and higher prices. There are concerns about possible inflationary consequences and disruptions to global supply chains compounding supply-demand imbalances.

China’s 10% quarterly contraction in Q1 was reversed in Q2, but the weakness in the rest of the world and continuing problems with full reopening would slow GDP in Q3.1 The ECB has recently increased the firepower of the Pandemic Emergency Purchase Program to €1,350 billion and extended the program’s horizon.2 The U.K. faces additional uncertainty related to the year-end Brexit transition deadline which could add another unwelcome shock.

The U.S. has long prided itself as the wealthiest, strongest, and most scientifically advanced nation in the world, and the it entered the COVID crisis in solid shape. In June, it led the world in both confirmed virus cases and related deaths, creating a different geopolitical backdrop. Fiscal and monetary policy responses intended to help households and businesses are set to expire, adding increased uncertainty around the recovery. In Canada, the recently extended government support package has lessened the shock to household incomes and laid the foundations for recovery. Business investment has been challenged due to the structural weakening of the Canadian energy patch and depressed oil prices.

U.S. equities staged a recovery in Q2 following Q1’s decline. The S&P 500 gained 20.5% while the S&P MidCap 400 gained 24.1% and S&P SmallCap 600 gained 21.9%. For June, the same indices returned 2.0%, 1.3% and 3.7%, respectively. U.S. fixed income performance was broadly positive. Canadian equities recovered strongly with the S&P/TSX Composite up 17.0% in Q2 and 2.5% in June. The S&P Europe 350 added 3.4% in June and 12.9% for the quarter, while it remains down 12.4% YTD. The S&P United Kingdom continued to lag broader European benchmarks, gaining 8.2% in Q2. U.K. stocks have disappointed for the year ending June, down 17.6%. Asian equities recovered strongly in Q2, with the S&P China 500 up 15.4% and the S&P Hong Kong BMI up 10.6%.

In July, we maintained the asset allocation that was established in June for all models. We continue to be positioned in shorter duration fixed income. We expect interest rates to remain low or negative across the globe and as a result, we continue 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.

The scale of the economic damage caused by the pandemic led to an extended period of weak economic growth, excess capacity, deflationary pressure, and a wave of bankruptcies. Financial repression is likely to remain through our outlook time horizon (the next 12 months) as central banks continue to demonstrate their willingness to keep widening their safety net. Several geopolitical factors could upend the initial rebound, including global tensions regarding the future treatment of China technology firms (Huawei perhaps most important), China’s relations and influence in Taiwan and Hong Kong, and initiatives aimed at addressing China’s human rights violations. Another key dimension will be the future trade relationship between China and the U.S. and China’s relations with the rest of the world as the rising tide of nationalism, populism, isolationism, and socialism gain more momentum globally. Brexit-related risks, threats to European Union solidarity, and November’s U.S. presidential election continue to be monitored. Our approach to portfolio management is nimble, opportunistic, and deliberate in identifying asset classes that are best placed to generate returns in a new world order. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, President and CIO

 

1Trading Economics, China GDP. July 16, 2020.

2Trading Economics, Euro Area Interest Rates. July 16, 2020.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. June 30, 2020. Index performance is based on total returns and expressed in the local currency of the index.

 

 

Section 1: Q3 2020 Outlook

 

A Crisis Like No Other: Recovery in A Changed World

The global economy is in its worst downturn since the 1930s. For the first time, all regions are projected to experience negative growth in 2020. There are, however, substantial differences across individual economies, reflecting the evolution of the pandemic and the effectiveness of containment strategies: variations in economic structure (dependence on severely affected sectors, such as tourism and oil), reliance on external financial flows, and pre-crisis growth trends. As we review and look forward in this Third Quarter 2020 Outlook, we are forecasting a recession in the U.S. and most of the globe that will extend beyond our twelve-month time horizon. Our approach to portfolio management is nimble, opportunistic, and deliberate in identifying asset classes that are best placed to generate returns in a new world order. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

The impact of COVID-19 on the global economy is deeper and longer than initially expected. Economic data available at the time of the April 2020 International Monetary Fund World Economic Outlook forecasted an unprecedented decline in global activity due to the COVID-19 pandemic. Data releases since then suggest even deeper downturns than previously projected for several economies. Economic activity remains suppressed due to concerns of multiple waves and global economic output is not forecasted to return to pre-pandemic levels until 2023, led by emerging markets. The IMF projects recovery to be much slower for advanced economies, which are not expected to exceed 2019 real GDP levels until 2026.

The World Trade Organization 2020 forecast estimates that the volume of global merchandise trade will decline by between 13 and 32 per cent compared to the previous year. They expect central banks to keep interest rates low, and in many countries negative, while credit spreads will remain elevated through to 2024. Global growth is projected at negative 4.9 percent in 2020. The COVID-19 pandemic has had a more negative impact on activity in the first half of 2020 than anticipated, and the recovery is projected to be more gradual than previously forecast. In 2021, the WTO projected global growth at 5.4 percent, leaving 2021 GDP 6.5 percentage points lower than in the pre-COVID-19 projections of January 2020.

We expect monetary and fiscal policy to remain strongly supportive with most governments able to sustain higher debt loads without the need for severe austerity. The adverse impact on low-income households is particularly acute, undoing the progress made in reducing extreme poverty in the world since the 1990s. Synchronized deep downturns are foreseen in the United States (–8.0 percent), Japan (–5.8 percent), the United Kingdom (–10.2 percent), Germany (–7.8 percent), France (–12.5 percent), and Italy and Spain (–12.8 percent). In 2021, the IMF projected the advanced economy growth rate to strengthen to 4.8 percent, leaving 2021 GDP for the group about 4 percent below its 2019 level.

The downward revision to growth prospects for emerging market and developing economies over 2020–21 (2.8 percentage points) exceeds the revision for advanced economies (1.8 percentage points). Excluding China, the downward revision for emerging market and developing economies over 2020–21 is 3.6 percentage points.i

The steep decline in activity comes with a catastrophic hit to the global labor market. Some countries (notably Europe) have contained the fallout with effective short-term work schemes. According to the International Labor Organization, the global decline in work hours in 2020 Q1 compared to 2019 Q4 was equivalent to the loss of 130 million full-time jobs. The decline in 2020 Q2 is likely to be equivalent to more than 300 million full-time jobs.ii Where economies have been reopening, activity may have troughed in April, as suggested by the May employment report for the United States, where furloughed workers are returning to work in some of the sectors most affected by the lockdown.

The synchronized nature of the downturn has amplified disruptions around the globe. The WTO reported that global trade contracted by close to –3.5 percent (year over year) in the first quarter, reflecting weak demand, the collapse in cross-border tourism, and supply dislocations related to shutdowns (exacerbated by trade restrictions). This underscores why international cooperation to keep global markets open for goods and services is more important than ever.

The pandemic is creating a sharp rise in corporate, government, and individual debt. We see four options to deal with this debt: Default, Austerity, Inflation, and Living with the Extra Debt.

Here we review Austerity, Inflation and Living with the Extra Debt. We will defer a review of the Default option until a point in time when we believe it is viable.

 

1. Austerity and The Paradox of Thrift

The term austerity is taken to mean any measure (i.e. tax rises as well as spending cuts) taken to reduce the structural budget deficit. The prospect of tax increases and government spending cuts to pay for the big fiscal packages that governments have launched to see their countries through the coronavirus crisis will result in austerity that will burden the recovery when lockdowns are eased. The coronavirus will result in a sharp rise in government debt as larger deficits and a deterioration in the trajectory of the debt ratio occur. Some governments are running significant primary budget deficits as the coronavirus results in a rise in health spending and an expanded role for the state more generally. This comes as many countries already face rising spending related to the ageing population.

The impact of austerity depends on the types of tax rises/spending cuts that are introduced and the circumstances at the time. Cuts in day-to-day spending would be less damaging to the economy’s supply potential than the cuts in public sector investment or incentive-blunting tax rises that formed part of the post-financial crisis austerity drive. In addition, there needs to be scope for monetary policy to loosen to compensate. Unfortunately, central banks have depleted their toolboxes. It is most effective when a country is undertaking austerity in isolation, as strong net exports can potentially help to offset the impact on demand.

The Paradox of Thrift was popularized by the renowned economist John Maynard Keynes. It states that individuals try to save more during an economic recession, which essentially leads to a fall in aggregate demand and hence in economic growth. Such a situation is harmful for everybody as investments give lower returns than normal. Scars from the crisis will alter spending behavior for years. Bloomberg Economics has forecast that personal savings rates will settle in around 3 to 4 percentage points above the pre-crisis level of around 8%, a drain of 1% annually in GDP growth. That is $200 billion of forgone spending per year. The paradox of thrift is causing chaos for the traditional retail sector as Brooks Brothers (founded in 1818) files for bankruptcy (following Neiman Marcus, J.C. Penney and J. Crew Group). Other retailers are closing outlets as well (Bed Bath & Beyond is saying it will permanently shutter 200 of its 1,500 stores).

With elections pending around the globe, there will be voter resistance to more spending cuts. The coronavirus crisis will lead to pressure for governments to spend more, not less, with demands for increases in funding for health services and greater welfare spending. Most countries are unlikely to contemplate government austerity before their economies are fully recovered but recovery will be impeded due to austerity among their citizens.

 

2. Deflation in the Short-Term: Inflation in the Long-Term

The unprecedented monetary and fiscal measures implemented around the world are expected lead to weaker long-term growth and currency debasement. The risk of a surge in inflation is nil in 2020 and 2021 as the disinflationary effects of weaker demand outweigh any supply shortages over our twelve-month forecast time horizon. Average inflation in advanced economies has dropped about 1.3 percentage points since the end of 2019, to 0.4 percent (year over year) as of April 2020, while in emerging market economies it has fallen 1.2 percentage points, to 4.2 percent.iii

 

Inflation Is the Price to Be Paid

The 25% year-over-year surge in M2 growth has not resulted in inflation. This is explained by the Quantity Theory of Money: MV = PY, where “M” is the money stock, “V” is money velocity (the turnover rate), “P” is the price level and “Y” is the real level of output. Both sides must equal each other. The problem is that money velocity is contracting to a record low, and at a record rate, with a decline of 27% on a year-over-year basis, overtaking the run-up in the money supply.iv

 

Massive policy stimulus has raised inflation risks for the future when demand does recover.

Policymakers will need to deal with any rise in inflation resulting from the permanent rise in the money supply by imposing controls on lending or raising interest rates. Such measures will impose costs on the economy and the financial system. A rise in inflation would push up borrowing costs, making it more expensive to finance deficits and refinance maturing debt. There would be an initial drop in the debt ratio, given that most government debt does not mature in the short-term, but the average maturity of government debt is not exclusively long.
To avoid this, governments will need to use the bond market, either by monetizing the debt and/or by financial repression (i.e. forcing the private sector to buy debt at below market prices).

 

Debt Monetization

Major economies have not yet reached the stage of debt monetization. There is no formal, universally agreed upon definition of debt monetization but there are two defining characteristics that make it distinct from central banks’ purchases of government bonds through asset purchase programs like quantitative easing (QE). The first is that it involves the central bank funding the government directly, rather than just buying its debt in the secondary market. The second is that it is permanent rather than temporary.

So far in this crisis, many central banks have bought government debt in the secondary market via their asset purchase programs. When the central bank buys bonds in the secondary market, it generally does so to meet its own objectives such as maintaining the functioning of financial markets or meeting its inflation target.

Only a few central banks have funded their government directly. This occurs when the central bank buys new bonds straight from the government either directly or in auctions (the primary market), or by doing away with government bonds altogether and the central bank simply handing money to the government. The Indonesian central bank (which is buying government debt at auction) and the Philippines central bank (which has bought debt directly from the government under a three-month repo agreement) have done this. Although the Bank of England extended a direct loan to the UK Treasury under the Ways and Means facility, this was essentially just a bridging loan.v

 

Financial Repression

More recently, financial repression has tended to take the form of quantitative easing (QE) or more stringent requirements for banks to hold low-risk assets including government bonds. QE has brought the added benefit that the government is just paying the interest to itself on a portion of its debt. Financial repression also describes measures by which governments channel funds from the private sector to themselves as a form of debt reduction. The overall policy actions result in the government being able to borrow at extremely low interest rates, obtaining low-cost funding for government expenditures.

Raising inflation through large amounts of QE would risk inflating another asset price bubble which, when it burst, could prompt another financial and economic crisis. High inflation could also hurt real economic growth. This would also lessen the drop in the debt to GDP ratio. Bringing inflation back down again would require a sharp slowdown in the real economy. Governments could choose to live with high inflation once the debt burden had been reduced, but this would also inflict significant long-term damage on the economy, by reducing investment and distorting price signals, distorting asset prices. When inflation has been used to reduce debt in the past, it has usually happened because a government has resorted to this out of desperation and weakness, rather than because it has judged that it is in the best interests of the economy in the long term. This is negative for the dollar and positive for precious metals.

The current situation in which asset purchase programs are facilitating fiscal expansions are having the same macro-economic effects as debt monetization. While direct financing is likely to be done with the sole intent of funding government spending, under recent asset purchase programs there is a blurring of the line between central banks and governments. Some central banks (including the U.S. Fed) have abandoned quantitative constraints on the amount of their asset purchases. When the debt held by the central bank is not sold back to the market, the government never has to repay the money given to it by the central bank. This equates to a form of so-called “helicopter drop”, meaning that government debt never rises. The permanent rise in the money supply might be reversed in the future as central banks sought to reverse the resulting inflation pressures while the current temporary asset purchase programs might never be reversed and become debt monetization after all.

 

3. Living With Debt

In China, where the recovery from the sharp contraction in the first quarter is underway, growth is projected at 1.0 percent in 2020, supported in part by policy stimulus. Much of the economy already appears to be growing again in year-on-year terms. Significant infrastructure-focused stimulus is now being rolled out.

In countries where the dynamics are less favorable, they will have to reduce debt in one of the other potentially more painful ways. Before the coronavirus struck with interest rates so low, government debt in many countries was expected to rise further while still being sustainable in the long run. When interest rates are lower than GDP growth, debt will rise at a slower rate than GDP and, over time, the debt to GDP ratio will shrink. This is sustainable. In most developed economies and many emerging markets, nominal interest rates have been lower than nominal GDP growth. Countries where interest rates are lower than GDP growth will be able to run a primary deficit, while ensuring that debt as a share of GDP is falling. This hinges on governments keeping their primary budget deficits low. This ensures that the overall deficit (rather than just debt servicing costs) increase at a slower rate than GDP.

When we look at a comparison of total debt to GDP, Canada’s 350% ratio compares to 330% in the U.S. Fitch cut Canada’s AAA rating down to AA+ in June, citing a “deterioration in Canada’s public finances.” Italy’s debt ratio is 360% and its credit rating is BBB. Greece is 340% and it is rated BB-. Spain’s debt ratio is 360% and it has a BBB- ranking. China is at 290% and has an A+ rating by S&P.vi

In the past half-decade, the growth in corporate debt has outstripped the profits to service the debt by a factor of nearly five. Debt-to-equity ratios of 40%, as they stand, were at eight-year highs going into this recession, the same level as in the first quarter of the credit crisis in 2008.

Corporations across the globe tapped bond markets for $384 billion from January to May, resulting for the entire year in an extra $1 trillion of liabilities that are now added to already strained balance sheets. The Fed-led bailouts of impaired companies is, for the third cycle in a row, happening in a recession that is made worse by too much debt being fought with even more debt. Firms with below investment grade or junk credit ratings have been able to float a record $48 billion in new bonds in June, because of the Fed’s program support. For investment grade companies, from March to May, they issued more than $230 billion of new debt.vii Both the federal government and the corporate sector come out of this pandemic with crippled balance sheets. Unfortunately, the corporate sector is in much worse shape as the federal government has taxing authority while companies do not.

When the pandemic struck, governments around the world opened up the fiscal taps in an attempt to limit the human suffering from the necessary lockdowns. Before the coronavirus, support was growing for the idea that many governments could cope with higher levels of debt. This reflected the fact that in most developed markets, as well as many emerging markets, nominal interest rates are below the rate of nominal GDP growth. This implies that, as long as a government is not running big primary budget deficits, the debt to GDP ratio can erode over time. However, the current recession has been made worse by overextended private and public sector balance sheets that were run up during the expansion that was underway prior to the pandemic. That overhang constrained economic growth to the point that the last expansion was the weakest on record and cleaning up the pile of debt will impede future growth, even once we are past this health crisis.

The Bruegel think tank has compiled the cumulative fiscal responses by major European economies and the United States. Their summary breaks the efforts down into three categories: (1) direct fiscal response, (2) tax deferrals, and (3) other liquidity provisions and guarantees. Given the uncertainty about the 2020 GDP forecast, the sizes of the stimulus are scaled relative to 2019 GDP. From this perspective, the U.S. has committed roughly 9.1% of 2019 GDP to fiscal measures, while Germany’s measures are equivalent to roughly 13.3%. The German government had left themselves the fiscal room to respond aggressively to a crisis. The implied debt ratios would grow to 96.8% for the U.S. and 82.1% from the Germans, leaving German authorities in a superior position relative to where the U.S. was before the crisis.viii

In the U.S., federal spending rose to more than US$1.1 trillion in June, more than twice what the government spends in a typical month.ix The amount of tax revenue collected by the federal government remained largely flat, at about US$240 billion, in part because the Treasury Department delayed the tax filing deadline until July.x The huge surge in June pushed the budget deficit for the first nine months of the fiscal year to US$2.7 trillion. For the twelve months to June, the deficit has hit $3 trillion or 14% of GDP. The U.S. budget deficit widened to US$864 billion (about $1.1 trillion) in June, a stark jump from $8 billion in June 2019, almost matching the entire gap for the prior fiscal year ($984 billion).xi

U.S. GDP recovered some lost ground in May and June but renewed outbreaks over recent weeks make apparent that the recovery will not be a perfect V-shape. Without additional government stimulus, the recovery could be in jeopardy. Six U.S. banks have announced $35 billion in cuts to their profits. Government programs are temporarily propping up consumers and businesses. The biggest banks are planning on bad loans. JPMorgan, Citigroup and Wells Fargo set aside almost $28 billion in the second quarter; a mark only surpassed by the last three months of 2008. All three lenders said their economic outlook had deteriorated as the coronavirus rages unchecked across America. Congressional bailout money has only delayed the debt tsunami Wall Street sees coming.

Germany is responsible for 29% of the euro area GDP and is the economic engine of the block. Fiscal authorities avoided crowding out investment to the private sector during the expansion and are now stepping in to provide needed capital to fuel the recovery. German consumers showed up in May as the economy re-opened, pushing nominal retail sales up 8.2% year-over-year, reflecting some pent-up demand.xii Surveys of economic activity in Germany suggest that it held up better between March and May than France, Italy or Spain. That may be because of its heavy reliance on manufacturing, where maintaining both output and a social distance is easier than, say, in retail or hospitality services. Capital Economics argues that Poland will experience Europe’s smallest contraction in GDP this year in part because it relies little on foreign tourists.

The Office for Budget Responsibility (OBR) has warned that the government’s UK debt/GDP ratio could balloon to more than 500% during the next fifty years in a “downside” scenario has barely caused a ripple in the Gilt market. In Britain, the OBR believes, borrowing, which was forecast to be 55 billion pounds (about $95 billion), could now hit 322 billion pounds (about $550 billion). That is the equivalent of over 16 per cent of GDP, the highest for any year since the Second World War, and the deficit and debt could be higher if the economy performs worse than expected.

 

Country Fiscal Measures in Response to the COVID-19 Pandemic (Percent of GDP)

SOURCE: IMF JUNE 2020 WORLD ECONOMIC OUTLOOK UPDATE
NOTE: (DATA SOURCE: NATIONAL AUTHORITIES; AND IMF STAFF ESTIMATES.) DATA ARE AS OF JUNE 12, 2020. COUNTRY GROUPS ARE WEIGHTED BY GDP IN PURCHASING POWER PARITY-ADJUSTED CURRENT US DOLLARS. REVENUE AND SPENDING MEASURES EXCLUDE DEFERRED TAXES AND ADVANCE PAYMENTS. AES = ADVANCED ECONOMIES; EMS = EMERGING MARKETS; G20 = GROUP OF TWENTY ECONOMIES; LIDCS = LOW-INCOME DEVELOPING COUNTRIES.

 

Change in Global Government Debt and Overall Fiscal Balance (Percent of GDP)

SOURCE: IMF JUNE 2020 WORLD ECONOMIC OUTLOOK UPDATE (IMF STAFF ESTIMATES.)

 

Frame Global Asset Management uses macro-economic analysis in order to develop a twelve-month forward view of where the global economy is heading. We factor this outlook into our Portfolio Model creation, combined with a view to minimize losses. As we advance through the current Covid-19 pandemic, we focus on the facts that we can rely on and adjust our forward views accordingly.

In addition to the unknowns at this time with regard to the COVID-19 pandemic, we understand that maintaining open supply lines globally will allow for access to medical products and food. Restricting trade and disrupting established supply chains will hinder the ramp up of the manufacture of much-needed protective equipment, testing kits, ventilators, and other essentials. In the longer run, a turn towards protectionism will slow down the global economic recovery, to the detriment of all countries, most damagingly for the poorest.

We are living a recession that was made worse by overextended private and public sector balance sheets hanging over from the last expansion. Current debt will hang over future growth, even once we are past this health crisis. The depth will depend on two main factors: how long it takes to bring the pandemic under control, and the policies governments implement, domestically and at the international level in order to mitigate the pandemic’s economic consequences.

The economic, social, and financial fallout from the Covid-19 pandemic will almost certainly continue for a prolonged period. It is impossible to predict the exact course that financial markets will take as the pandemic continues.

Governments, rather than having to resort to austerity, default, or inflating debt away, will need to demonstrate to financial markets that they will return debt to a sustainable path.

 

As we enter the back half of 2020, we identify the following risks:

• Secular stagnation – 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.
• A flare-up in trade tensions with China
• More delays on the re-openings
• The second-quarter earnings season – Key will be guidance, especially since the market is expecting the numbers to turn positive by Q4
• The November U.S. election
• A U.S. fiscal cliff

 

International Monetary Fund Risks Noted

As is the case everywhere, there is uncertainty around the IMF 2020 forecast. Their 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 2. Four Themes

 

Theme 1: The Global Economy is in Recession

According to Yelp, nearly 66,000 businesses have shut their doors since March 1st and the rate of closures is on an upswing into mid-July. Researchers at Harvard estimate the number of business closures is closer to 110,000 nationwide, which makes sense since we already know that the run-up in permanent job losses since the crisis began has totaled an epic 1.6 million.xiii Erratic economic data has driven volatility. Italian industrial production, which just came out for May, soared 42.1% month-over-month, while the year-over-year pace was -20.3%. France saw a 19.6% industrial production pop in May and a year-over-year trend hitting -23.4%. Taiwan’s exports fell last month for a fourth straight month and officials there warned that global demand is going to struggle to recover with the latest outbreak of the coronavirus (adding the heightened tensions between the U.S. and China as another roadblock).xiv

We expect import declines as a GDP offset when inventories go down as this was the case in the U.S. as inbound goods shipments from abroad fell back 1.2% in May. What was most concerning from a capital spending intention standpoint was the 1.9% pullback in capital goods imports, which compounded the 10.7% plunge in April that left the three-month number with a decline of -31.9% at an annual pace.xv

The even bigger problem was the export figure — sliding 5.8% after big declines in April (-25.1%) and March (-7.4%). The numbers are so staggering that the three-month trend has collapsed to an -81.7% annual rate. The entire foreign sector has been hit. And the pullback in business investment plans in the context of eroding profit growth, a complete lack of visibility, and preservation of cash on the balance sheet, has gone global because U.S. exports of capital goods sunk 2.5% in May after a 23.8% decline in April, taking the three-month trend to a -75.3% annual rate.xvi The implications of this for future productivity at a time when labor force participation rates enter a period of secular decline is a severe challenge to the world potential GDP growth rate. This is one reason why deflation today will point morph into stagflation once demand stabilizes. This environment of nil or negative growth accompanied by inflation is a very difficult one to emerge from.

 

Theme 2: Gold is a Safe Haven: Central Banks Agree

Gold performed strongly in the first half of 2020, increasing by 16.8% in US dollar terms and outperforming all other major asset classes. Gold breached the $1800-mark for the first time since 2011. The World Gold Council reports a record of nearly $40 billion flooded into gold-backed ETFs in the first half of the year. Though equity markets around the world rebounded sharply from their Q1 lows, the high level of uncertainty surrounding the COVID-19 pandemic, the massive wave of central bank stimulus, and the ultra-low interest rate environment prompted a flight into the safe haven.

Fundamental drivers of the gold price are the low yield environment, substantial fiscal and monetary stimulus, and the inflationary impact on asset prices.

In the current global economic environment, three drivers are supportive of investment demand for gold:

• high risk and uncertainty
• low opportunity cost
• positive price momentum.

Traditionally, assets such as U.S. Treasuries and G-10 sovereign bonds comprise the bulk of central bank reserve portfolios. Gold is also held as it tends to outperform other assets during periods of market stress.

The case for central banks holding gold remains strong, especially considering the economic uncertainty caused by the COVID-19 pandemic. This was supported by the findings in the recently published 2020 Central Bank Survey, Gold Trends Report, World Gold Council. Factors related to the economic environment, such as negative interest rates, were overwhelming drivers of these planned purchases. This is supported by gold’s role as a safe haven in times of crisis, as well as its lack of default risk. Our view remains that central banks will remain net purchasers in 2020.

 

Theme 3: Oil Prices: Geopolitics Meets the Pandemic

The oil market experienced sharp decreases in the first quarter of 2020 as it was inundated with low-cost oil after Saudi Arabia launched a price war with Russia. The two countries put an end to the dispute in April by agreeing to reduce production by nearly 10 million barrels per day to stimulate markets. But prices continued to plummet when it became clear that the promised reductions would not be enough to offset the collapse in demand that has been exacerbated by the pandemic. The coronavirus pandemic caused oil demand to drop so rapidly that on April 20th, U.S. oil to be delivered in May settled at -$37.60 per barrel, the first negative close in history. Producers, who were running out of storage space as demand for energy collapsed, were willing to pay buyers to take crude off their hands. The effects of cheap crude infiltrated the global economy.

The double black swan has caused oil prices to collapse to levels that make it impossible for U.S. shale oil companies to make money. In a $20 oil environment, 533 U.S. oil exploration and production companies would be expected to file for bankruptcy by the end of 2021, according to Rystad Energy. At $10, there would be more than 1,100 bankruptcies, Rystad estimates. Rystad’s $20 scenario predicts more than $70 billion of oil company debt will get reorganized in bankruptcy, followed by $177 billion in 2021. That accounts for exploration and production companies but not the servicing industry that provides the tools and manpower to drillers.xvii

In a June Oil Market Report, the International Energy Association predicted that for the year 2020, demand for oil will drop by 8.1 million barrels per day, the biggest-ever decline. Changes in lifestyle and reduced commuting in developed economies are expected to result in a permanent reduction in oil demand.

 

Theme 4: Global Currency Revaluation

The reductions in interest rates across Group-of-10 countries in response to the pandemic-induced halt to their economies has left most currencies yielding close to zero on a nominal basis.

The dollar, an important symbol of America’s global standing, remains the primary currency of choice for investors who use it to trade a wide array of assets around the globe. It is also the world’s top reserve currency, held in large quantities by governments, central banks, and other major financial institutions. The dollar benefits from being the currency of choice for many global transactions, including the trading of commodities like oil. It accounts for 62% of the world’s currency reserves and is involved in 88% of all global currency trades.xviii When the coronavirus became a global pandemic in March, there was a move to snap up US dollars, the world’s ultimate safe haven asset. After an extended stretch of gains, the US dollar lost ground in June as safe-haven demand for US dollars declined.

Investors are becoming less positive about the dollar’s outlook. Growing debt loads and commitment to “America First” policies have added to risks. A worsening economic outlook in the United States and a diminished role on the world stage could encourage allies to look to other top currencies. Research now supports the idea that an “America First” philosophy could hurt the dollar in the long run. A working paper published by the National Bureau of Economic Research in 2017 found that foreign demand for dollars could decline if the country was no longer seen as guaranteeing the security of its allies, leading them to hold more of their reserves in euros, yen and renminbi.xix Russia and China are increasingly avoiding the dollar when settling crude oil deals. After the United States pulled out of the Iran nuclear agreement, top EU officials began lobbying for greater use of the euro. According to a JP Morgan report by John Normand and Federico Manicardi, the risk of currency debasement may heighten next year and will show in the value of Japanese yen or gold rather than the dollar.

 

 

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: June 2020 Portfolio Models

The role of the financial industry as an allocator and distributor of capital to the economy will be paramount to the evolution of the current pandemic. The current health crisis has morphed into an economic crisis, which has morphed into a financial crisis. While advances in testing and contact tracing will help, risk of a second wave of infections and the re-imposition of strict containment measures is likely to remain until a vaccine is developed. Simultaneously, geopolitical risks are heating up amid escalating tensions over Hong Kong, civil unrest in the U.S., and the return of Brexit uncertainty. We are monitoring these developments and have maintained our previous Recession Outlook for the U.S. economy to reflect a Recession that began in March and extends through the end of the year.

In June, we maintained the asset allocation that was established in May for all portfolio models. We continue to be positioned in shorter duration fixed income. We expect interest rates to remain low or negative across the globe and as a result, we continue 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.

 

Deborah Frame, CFA, MBA

President and Chief Investment Officer

July 14, 2020

 

iIMF. World Economic Forum. June 2020.
iiIMF. World Economic Forum. June 2020.
iiiIMF. World Economic Forum. June 2020.
ivTrading Economics. Country Interest Rates. June 2020.
vU.K. Government. Treasury Loans. July 16, 2020.
viTrading Economics. Country Lists, Credit Ratings. June 2020.
viiOECD. Corporate Debt to Equity Ratios. June 2020.
viiiChristie, Rebecca. EU Opportunity. The Bruegel Think Tank. July 16, 2020.
ixTrading Economics. U.S. Government Spending. June 2020.
xWorld Bank. U.S. Federal Tax Revenue. July 2020.
xiTrading Economics. U.S. Federal Government Budget. June 2020.
xiiTrading Economics. Germany Retail Sales. July 1, 2020.
xiiiNational Bureau of Economic Research. How Are Small Businesses Adjusting to COVID-19? NBER Working Paper 26989. April 2020.
xivTrading Economics. Country Economic Data. June 2020.
xvTrading Economics. U.S. Imports of Capital Goods. May 2020.
xviTrading Economics. U.S. Exports of Capital Goods. May 2020.
xviiRystad Energy. COVID-19 Report. 14th Edition. July 3, 2020.
xviiiWorld Gold Council. July 2020.
xixNational Bureau of Economic Research. Foreign Safe Asset Demand and the Dollar Exchange Rate. NBER Working Paper 24439. Issued March 2018. Revised March 2019.

The role of the financial industry as an allocator and distributor of capital to the economy is critical to the evolution of the current pandemic. The current health crisis has morphed into an economic crisis, which has morphed into a financial crisis. While advances in testing and contact tracing will help, risk of a second wave of infections and the re-imposition of strict containment measures is likely to remain until a vaccine is developed. Simultaneously, geopolitical risks are heating up amid escalating tensions over Hong Kong, civil unrest in the U.S. and the return of Brexit uncertainty. We are monitoring these developments and have maintained our previous Recession outlook for the U.S. economy to reflect a Recession that began in March and extends through the end of the year.

Central banks globally have taken action. The China National People’s Congress (NPC) has laid out plans for fiscal stimulus. Japan’s fiscal support measures turned out to be larger than initially planned, at 22% of GDP.1 The European Central Bank announced €750B in stimulus grants and loans to be funded by the currency area’s first joint debt.2 The 17.1% month over month collapse in eurozone industrial output in April was partly reversed in May and June, but the recovery will be much more gradual than the slump.3 In the U.K., GDP figures for April showed that output fell by a cumulative 25% since its pre-crisis peak in February.4

The FOMC minutes reinforced the Fed’s commitment, putting floors on risk markets. The Fed has moved to the outer limits of monetary intervention to backstop CMBS, investment grade bonds, the muni market, and high yield debt. The Fed’s balance sheet has expanded more in three months than it did cumulatively in the six-year period from December 2007 to November 2013.5 The U.S. international trade deficit widened to $49.4 billion in April as exports slumped.6 The closure of motor vehicle production plants throughout North America had the greatest impact on the slump. Retail sales plummeted in April, down 16.4%, a 21.6% year-over-year decline but began to recover in May (up 17.7%) as thousands of stores and restaurants reopened after lockdowns and federal stimulus checks and tax refunds fueled a burst of spending.7 The permanent devastating impact on the economy can be seen in retail bankruptcy filings, as retailers J.C. Penney, J. Crew, and Neiman Marcus declared bankruptcy, and Lord & Taylor plans to liquidate.8 Unemployment was 14.7% in April, followed by an improvement in May to 13.3% as 2.5 million jobs were added back to the nonfarm employment.9

Statistics Canada announced that the services trade balance jumped from a deficit of $1.1 billion in March to a surplus of $0.3bn in April, reflecting that more Canadians travel abroad than foreigners travel to Canada.10

Markets during May were driven by some positive data and reopening plans. The S&P 500 closed up 4.8% for the month. The S&P MidCap 400 gained 7.3% and S&P SmallCap 600 gained 4.3%. Canadian equities had a positive month, with the S&P/TSX Composite up 3.0%. S&P Europe 350 gained 2.9% as contributing nations unlocked at differing speeds with German equities providing the greatest positive contribution. Asian equities continued their recovery, with the S&P Pan Asia BMI up 3.0%. S&P China 500 gained 1.0%, S&P Korea BMI was up 4.8%, while S&P Hong Kong BMI dropped 7.8% in May.

In June, we maintained the asset allocation that was established in May for all portfolio models. We continue to be positioned in shorter duration fixed income. We expect interest rates to remain low or negative across the globe and as a result, we continue 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.

The scale of the economic damage caused by the coronavirus outbreak will lead to an extended period of weak economic growth, excess capacity, deflationary pressure, and a wave of bankruptcies. Financial repression is likely to remain through our outlook time horizon (the next twelve months) as central banks continue to demonstrate their willingness to keep widening their safety net. We will continue to monitor the data for growth, inflation, and recession signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our approach to portfolio management is nimble, opportunistic, and deliberate in identifying asset classes that are best placed to generate returns in a new world order. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame , President and CIO

 

1KPMG Insights, Japan. April 7th, 2020.

2European Central Bank. March 18th, 2020.

3Trading Economics, Eurozone Industrial Production. April 2020.

4Trading Economics, United Kingdom GDP Growth. May 13th, 2020.

5Trading Economics, U.S. Central Bank Balance Sheet. June 10th, 2020.

6Trading Economics, U.S. Balance of Trade. June 4th, 2020.

7Trading Economics, U.S. Retail Sales. June 16th, 2020.

8S&P Global Market Intelligence. May 15th, 2020.

9Trading Economics, U.S. Unemployment Rate. June 5th, 2020.

10Trading Economics, Canada Balance of Trade. June 4th, 2020.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. May 29, 2020. Index performance is based on total returns and expressed in the local currency of the index.

 

 

The economic impact of the extraordinary measures taken by governments all around the world to flatten the COVID-19 pandemic curve is highly uncertain. The outcome will depend on the evolution of the virus and the intensity and efficacy of containment efforts. Economic data continue to show severe economic disruptions associated with COVID-19 and only limited signs of a recovery so far. The dichotomy between the supply and demand side is concerning as evidenced by the re-opening of some economies where consumers remain on the sidelines. Central banks are now operating at the limits of what they can do to support aggregate demand. Consequently, we are entering an era of more active fiscal policy. We are monitoring these developments and have maintained our previous Recession Outlook for the U.S. economy to reflect a Recession that began in March and extends through to the end of the year.

Emerging Market central banks are cutting rates aggressively, allowing their currencies to depreciate while supporting domestic demand. This is bearish for EM currencies and sovereign spreads in the near-term but will lead to stronger economic recovery down the road. In China, industrial production rebounded to a 3.9% annual growth rate in April while retail sales remained weak as they contracted at an annual 7.5%1.

In this crisis, the U.S. government is ramping up its deficit much faster and much more aggressively than it did in 2008. A corporate bond-buying program was announced by the Fed in March, as part of a package of pandemic rescue measures. The program, which is managed by BlackRock, will take $75 billion in equity from the Treasury and leverage it 10-to-1, giving it up to $750 billion to buy corporate bonds for the first time in its history, starting with bond ETFs2. On April 8, the Federal Reserve widened the credit ratings of corporate bonds it will buy to include recently downgraded corporate bonds that have a rating no lower than BB-, as well as ETFs that have exposure to eligible non-investment grade corporate bonds3.

The U.S. trade deficit widened in March as a decline in exports outweighed that in imports. The service sector declined, driven by the collapse in international tourism. The April ISM non-manufactur­ing index declined 10.7 points to 41.84. The jobs report showed that U.S. payrolls plunged by 20.5 million in April as the unemployment rate skyrocketed to 14.7%5. The consumption basket of U.S. households has shifted in a way not reflected in the CPI’s basket. People are buying more food from the grocery store, more gym equipment, etc. while not spending money in restaurants and hotels, suggesting that the basket faced by the consumer is experiencing greater inflation than what the BLS measures. In Canada, real manufacturing sales fell 8.3% in March, and Automotive News reported total auto production of zero units in the month of April6. Existing home sales fell by 57% in April7.

After March’s carnage, April offered a welcome rally. The S&P 500 gained 12.8%, the best monthly performance since January 1987. The S&P MidCap 400 was up 14.2% while the S&P SmallCap 600 gained 12.7%. In Canada, the S&P/TSX Composite gained 10.8%. The pandemic is only one of two shocks, the other being global energy prices. This weakness has also been apparent in the Canadian dollar. Northern European equities outperformed, while Southern Europe lagged as politicians squabbled over the form and magnitude of potential relief for the nations hit hardest by COVID-19. The S&P Europe 350 gained 6.1% on the month while the S&P United Kingdom gained 3.5%.  Asian equities began to recover in April, with the S&P Pan Asia BMI up 8.5% while the S&P China 500 gained 6.1%.

In May, we maintained the asset allocation between Equities and Fixed Income but adjusted our exposure within Fixed Income. We added Mortgage Backed Securities while removing Municipal Bonds, the 3-7 year Treasury was added to replace the 7-10 year Treasury, and the 20+ year Treasury was removed with the allocation going to Mortgage Backed Securities and Gold for the Growth and Aggressive Growth Models. Gold continues to be present in all models as it performs well in high risk, low yield environments as a risk-free asset class.

The market is reconciling a deep global recession of uncertain length, with a V-shaped recovery in financial markets supported by an extraordinary central bank back-stop. We will continue to monitor the data for growth, inflation, and recession signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our approach to portfolio management is nimble, opportunistic, and deliberate in identifying asset classes that are best placed to generate returns in a new world order. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame , President and CIO

 

Trading Economics, China Industrial Production and Retail Sales. April 2020.

The Federal Reserve. March 23rd, 2020.

The Federal Reserve. April 8th, 2020.

Trading Economics, U.S. ISM. May 5th, 2020.

Trading Economics, U.S. Unemployment Rate. April 2020.

Trading Economics, Canada Manufacturing Production. April 2020.

CREA Monthly Housing Statistics. May 2020.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. April 30, 2020. Index performance is based on total returns and expressed in the local currency of the index.

 

 

The economic cost of the COVID-19 crisis may pale in comparison to the human cost. Many people fear for their own health and that of their loved ones. As such, there is a “real” element to the fear factor. Measures to contain the virus have upended supply chains and financial markets and have weighed on commodity prices. Consumer and business confidence are expected to remain subdued for some time, not least if fears of a second wave of the virus linger. We are monitoring these developments and have maintained our previous Recession outlook for the U.S. economy to reflect a Recession beginning in March and extending through the end of the year, as the situation will deteriorate further before beginning to recover.

With lockdowns in place across much of the world, the IMF has downgraded their forecasts further in recent days, now forecasting global real GDP to fall by over 3% this year. That compares with a pre-virus forecast assuming growth of about 3%. This means that 2020 is set to be the worst year for the global economy since the end of the Second World War, when world GDP in 1945 plunged by 5.5%.1

The Fed has launched many new programs. The U.S. was on track for an outright fiscal drag in 2020 due to expiring stimulus, living with the largest fiscal deficit and thus is the least capable of delivering more fiscal stimulus. The Federal Reserve has now expanded its balance sheet beyond $6 trillion, an increase of almost $2 trillion in less than a month.2 It has taken extraordinary steps to lift regulations to help banks play their part in the relief effort. One consequence may be that central bank support could help most risky assets to outperform safe ones by a wide margin as these measures go far beyond conventional monetary easing in their efforts to backstop the financial system. With a policy interest rate that has been cut to a range of 0% to 0.25% and commitment that rates would stay low indefinitely, the supply of funds outside of the Feds own money creation may become scarce. By virtue of a system that promotes superior productivity growth, the country’s knack for nurturing world-beating companies, and less challenging demographics than the developed world, there is some hope that the U.S. can outpace most of the developed world in economic recovery.

Canada will rack up debt faster in this crisis than any other developed country, relative to its economy, according to data from the IMF. It is fortunate that Canada’s governments went into this economic crisis in a much better financial position than most other developed countries. Net government debt (total government debt minus its cash holdings) was at 40% of economic output before the crisis. The average for developed countries was 107%. This may be why Canada’s governments have proven more willing to spend their way out of the crisis than some others.3

Global markets in Q1 were devastated by the coronavirus pandemic. U.S. equities posted their worst quarter since 2008, with the S&P 500 down 19.6%. The S&P MidCap 400 and the S&P SmallCap 600 were down 29.7% and 32.6%, respectively. Canadian equities were likewise battered, with the S&P/TSX Composite down 20.9% for the quarter. The Canadian Energy sector was down by 30.8% in March and 37.2% in the first quarter. The global pandemic fears also spread rapidly across Europe. Italy, and then Spain. The S&P Europe 350 fell 14.0% in March to complete a 22.4% drop this quarter, the worst monthly and quarterly performance since September 2002. International markets were not spared, and the S&P Pan Asia BMI was down by 20% for the quarter. U.S. Treasuries benefited from a flight to safety. Corporate bonds fared less well, as spreads widened across sectors and grades of the credit market.

In April, we maintained the asset allocation positioning that we established on February 19th. This reflects our view on deflationary and recessionary influences that dominate the global economy.  Allocation to equities was reduced in February to 12% in Tactical Conservative, 17% in Tactical Moderate Growth, 26% in Tactical Growth, and 34% in Tactical Aggressive Growth. In February, within the Fixed Income allocation, we added the 20+ year Treasury Bond. Gold continues to be present in all models as it performs well in high risk, low yield environments as a risk-free asset class. Gold has played an important role in portfolios as a source of liquidity and collateral. As has been the case in previous market selloffs, we have seen that the stronger the pullback in the stock market, the more negatively correlated gold becomes.

This shutdown will cause the greatest short-term drop in output that the global economy has ever experienced, and the pace of the subsequent recovery is hard to determine at this time. No one knows how long the supply and demand disruptions will constrain growth. We will continue to monitor the data for growth, inflation, and recession signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, President and CIO

 

1 Capital Economics. Global Economics Update. March 31, 2020.

2 Capital Economics. U.S. Economic Update. April 16, 2020.

3 National Bank of Canada. Public Sector Debt. April 15, 2020.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. March 31, 2020. Index performance is based on total returns and expressed in the local currency of the index.

 

 

 

Section 1: Q2 2020 Outlook

 

Global Risk: The World Is Heading for the Sharpest and Deepest Global Slowdown Since WW2

The economic cost of the COVID-19 crisis may pale in comparison to the human cost. Many people fear for their own health and that of their loved ones. As such, there is a “real” element to the fear factor. Measures to contain the virus have upended supply chains and financial markets and weighed on commodity prices. Consumer and business confidence is expected to remain subdued for some time, not least if fears of a second wave of the virus linger. Given the hit to both the services and goods-producing sectors, the International Monetary Fund (IMF) expects real GDP to contract at a greater than 30% annualized pace in the current quarter.i

This shutdown will cause the greatest short-term drop in output that the global economy has ever experienced, and the pace of the subsequent recovery is hard to determine at this time. No one knows how long the supply and demand disruptions will constrain growth.

Markets are looking for confidence in the policy response. Policy must ensure that households, businesses, and the financial system remain liquid. Policy should also aim to minimize damage to the solvency of all stakeholders, preventing sharp drops in business and household cash-flow positions from triggering a wave of bankruptcies in the real economy and of margin calls in the financial system.

 

Containment and Stabilization Followed by Recovery

With lockdowns in place across much of the world, the IMF has downgraded their forecasts further in recent days, now forecasting global real GDP to fall by over 3% this year.ii That compares with a pre-virus forecast assuming growth of about 3%. This means that 2020 is set to be the worst year for the global economy since the end of the Second World War, when world GDP in 1945 plunged by 5.5%. Most of the output lost in the first half of this year will probably be lost forever and it could take years for demand to recover completely. Demand for travel abroad may stay weak for months and possibly years. Secular stagnation forces, political uncertainty, and empty monetary toolkits indicate that rapid recovery is not possible even after the virus-related supply and demand disruptions have faded. Firms will be considering how to repay their emergency loans, while in some countries there might be the prospect of a new wave of austerity to repay the rise in public debt. Early signs from China are that demand has been slow to return despite firms being told to resume normal operations in February.

This crisis will need to be dealt with in two phases: a phase of containment and stabilization followed by the recovery phase. In both phases public health and economic policies have crucial roles to play. Quarantines, lockdowns, and social distancing are all critical for slowing transmission, giving the health care system time to handle the surge in demand for its services and buying time for researchers to try to develop therapies and a vaccine. These measures can help avoid an even more severe and protracted slump in activity and set the stage for economic recovery.

The new policy mix will require that fiscal policy be used to attain full employment and price stability, while monetary policy will be used to ensure debt sustainability by keeping sovereign yields low. As well as going all-out in its role as lender of last resort, central banks will be required to do the same for the financial system.

So far, the fiscal response in affected countries has been swift and sizable in many advanced economies including Australia, France, Germany, Italy, Japan, Spain, the United Kingdom, and the United States. Many emerging market and developing economies, such as China, Indonesia, and South Africa have also begun providing or announc¬ing significant fiscal support to heavily impacted sectors and workers. Fiscal measures will need to be scaled up if the stoppages to economic activity are persistent, or the pickup in activity as restrictions are lifted is too weak.iii

Globally, central banks’ response to the coronavirus crisis has been unprecedented and is likely to change the way that financial markets function for years to come. Countries are starting out with very different fiscal positions. Central banks’ balance sheets will be far larger and contain a much wider variety of assets than before as a result. Germany currently enjoys a budget surplus and has plenty of fiscal capacity, and China is now pumping in substantial support.

The Fed has launched many new programs. The U.S. was on track for an outright fiscal drag in 2020 due to expiring stimulus, living with the largest fiscal deficit and thus is the least capable of delivering more fiscal stimulus. Now the Fed is giving the Treasury access to its printing press. This means that, in the extreme, the administration is free to use its control, to instruct the Fed to print more money so it can buy securities and hand out loans in an effort to ramp financial markets higher. The case for central-bank independence has gone largely unquestioned for years. Logic assumed that politicians think short-term and make decisions for political reasons. At full or close-to-full employment, expansionary monetary policy might briefly juice the economy but, after a delay, create inflation. When monetary policy is kept at arm’s length from politics by making it the responsibility of an independent central bank, you avoid the problem. This logic is now being put to the test.

The Fed’s actions can be split into three main categories. First, it has acted as a “buyer of last resort” in many markets. This covers its open-ended purchases of Treasuries and mortgage-backed securities (MBS), including agency commercial MBS. It also covers its purchases of commercial paper, corporate bonds, and municipal bonds. Though the aim is different, the Fed will also purchase so-called “Main Street” loans. Second, it has lent against all kinds of collateral, either to support key parts of the financial system, or to encourage more lending by other institutions. The Money Market Mutual Fund Liquidity Facility and Primary Dealer Credit Facility are examples of the former. The Term Asset-Backed Securities Loan Facility is an example of the latter. That facility lends against asset-backed securities (whose underlying exposure is to a wide variety of loans including auto loans and leveraged loans), aiming to boost issuance. Third, it has acted to limit financial distress outside the U.S., and the associated upward pressure on its currency, by making cheap dollar funding readily available. This covers the Fed’s revived and expanded swap lines, plus its new Foreign and International Monetary Authority (FIMA) repo facility.iv

The Federal Reserve has now expanded its balance sheet beyond $6 trillion, an increase of almost $2 trillion in less than a month. It has taken extraordinary steps to lift regulations to help banks play their part in the relief effort. One consequence may be that central bank support could help most risky assets to outperform safe ones by a wide margin as these measures go far beyond conventional monetary easing in their efforts to backstop the financial system.v With a policy interest rate that has been cut to a range of 0% to 0.25% and commitment that rates would stay low indefinitely, the supply of funds outside of the Feds own money creation may become scarce. By virtue of a system that promotes superior productivity growth, the country’s knack for nurturing world-beating companies, and less challenging demographics than the developed world, there is some hope that the U.S. can outpace most of the developed world in economic recovery.

 

Controlling Our Own Behavior it the Middle of a Pandemic

In the middle of this global pandemic, we consider what we can and cannot control. This applies not only to our individual behavior, but also when it comes to our investment positioning.

In theory, being prepared for a low-probability, high-consequence event such as a pandemic is possible. Identify threats. Consider how to mitigate. Weigh costs of mitigation against probability and consequence, factoring in available resources and competing demands. Prepare.

An economist describes loss aversion as when an individual’s utility is concave over gains and convex over losses. This means that a gain contributes less to utility/happiness than an equal dollar loss subtracts from utility/happiness. The current economic meltdown presents us with the reality that when a capital loss is suffered, ability to recover the same amount that was lost must be done from a lower base, requiring a larger percent recovery just to break even. This pain is not imagined, it is very real (see our White Paper at www.frameglobal.com/education). Avoiding losses in the first place is much preferred to recovering from losses.

 

We Put Economic Theory into Practice and Have Been Rewarded

Frame Global Asset Management considers the outlook for the global economy relative to a view of expected U.S. GDP growth in the twelve months ahead. We track asset class behavior over time, both in terms of returns – gains and losses – and correlations to other asset classes. When historic data for asset classes is partitioned under broad macro-economic environments, patterns of behavior become obvious. The outlook falls into one of the following five broad descriptions: GROWTH, STAGNATION, RECESSION, INFLATION, or CHAOS, allowing for a transitioning in the period from one environment to another. Macro-economic environments contribute to asset class return distributions. As an economic cycle progresses through different economic environments, including Chaos and Recession, we know that asset classes experience a large distribution of returns, calculated over the measurement period.

Along with consideration of greater downside risk to asset classes from periodic extreme unexpected negative events, we incorporate this information to create tactical asset allocation portfolio models, delivered with an optimal combination of broad asset class exposure.

 

Expected Asset Class Behavior in Recession

Using a statistical sampling technique called bootstrapping, we can see that in a Recession Environment, U.S. Treasuries are expected to experience losses only 7.8% of the time and earn an average return of 11.62%.

 

Gold is expected to experience losses 37% of the time and earn an average return of 8.31%.

 

The S&P 500 is expected to experience losses 76% of the time and earn an average return of negative 9.2%.

 

SOURCE: FRAME GLOBAL ASSET MANAGEMENT

 

We Positioned for Recession in February and Avoided Losses in the First Quarter in our Conservative and Moderate Growth Portfolio Models

We define the economic environment “Chaos” as a high impact, low probability event. In a Chaos environment, all asset classes become highly correlated and suffer simultaneous losses. In this environment, we look for asset classes that will be expected to experience low correlations as we move out of Chaos and typically into Recession. There is no question that the current pandemic event has had high impact. The low probability was considered low in the broader markets and economies up until February 19th, 2020, the peak of the S&P Dow Jones. But there were indications coming from China about the virility of the virus and the high mortality rate beginning in January. Without complete cessation of all movement of people across boarders at that time, we determined that it was inevitable that the virus would spread globally.

 

In our Portfolio Updates we highlighted the following:

January 20th, 2020:
“The trend towards populism and protectionist policy remains a risk to the stability of global financial markets while heightened geopolitical strains also have the potential to create volatility.”

“We are monitoring these developments and have concluded that our Stagnation outlook for the U.S. economy over our forecast time horizon of twelve months still stands, with a recession likely in 2021.”

February 19th, 2020:
“The coronavirus outbreak in China has generated economic waves that are disrupting global supply networks that act as the backbone of the global economy and comes as the global economy was already cooling off.”

“In February, we reduced exposure to U.S. equities across all models and reintroduced the U.S. long-term Treasury Bond. This reflects our view on deflationary influences that dominate the global economy.”

“The trend towards populism and protectionist policy remains a risk to the stability of global financial markets and the COVID-19 outbreak is likely to delay recovery and intensify disinflation.”

March 17th, 2020:
“A global recession in 2020 is all but confirmed as nations shut down economic activity to limit the spread of COVID-19. The virus is unique in that it is a demand shock and supply shock, and also a negative wealth, oil price, and credit shock. There will be a wide range of subsequent effects. We are monitoring these developments and have updated our previous Stagnation followed by Recession outlook for the U.S. economy to reflect a Recession in March, extending through to the end of the year, as the situation will deteriorate further before beginning to recover.”

 

Because the market is forward looking, a Chaos environment is typically short lived and followed by a Recession. We are now positioned for Recession for the twelve- month period ahead.

 

 

Section 2. Four Themes

 

Theme 1: The Entire Global Economy is in Recession

The Great Lockdown is projected to shrink global growth dramatically. A partial recovery is projected for 2021, with above trend growth rates, but GDP will remain below the pre-virus trend, with considerable uncertainty about the strength of the rebound.

Global growth is projected at -3.0% in 2020, an outcome far worse than during the 2009 global financial crisis. The growth forecast is marked down by more than 6 percentage points relative to the October 2019 IMF and January 2020 IMF Update projections – an extraordinary revision over such a short period of time.vi

Recent economic reports helped fill in the picture of what happened to the economy in March and early April, and it is clear that the spread of COVID-19 led to a sharp contraction across much of the U.S. and other major economies. With the shutdown in China occurring in January, imports into the U.S. plunged in February, while exports had yet to be affected. With large parts of the U.S. domestic economy now closed, import demand will contract sharply over the coming months. Export demand so far appears to have held up much better, but widespread factory shutdowns means export volumes are likely to contract too.

The U.S. trade deficit will narrow in the next few months but should reverse over the rest of the year, as the stronger dollar weighs more on exports. With oil production dropping sharply, the U.S. is likely to return to being a net oil importer once gasoline demand recovers.vii

Canada will rack up debt faster in this crisis than any other developed country, relative to its economy, according to data from the IMF. It is fortunate that Canada’s governments went into this economic crisis in a much better financial position than most other developed countries. Net government debt (total government debt minus its cash holdings) was at 40% of economic output before the crisis. The average for developed countries was 107%. This may be why Canada’s governments have proven more willing to spend their way out of the crisis than some others.viii

 

Big-time fiscal deterioration in Canada

SOURCE: NATIONAL BANK FINANCIAL, IMF

NOTE: EUR = EURO AREA. COUNTRY AGGREGATES SHADED BLUE, CANADA RED.

 

Theme 2: Gold is a Safe Haven

Gold has played an important role in portfolios as a source of liquidity and collateral. Like most asset classes, gold is being affected by the unprecedented economic and financial market conditions in play around the globe. Recent volatility in the gold price has been driven by massive liquidations across all assets, and likely magnified by leveraged positions and rule-based trading.

Gold has also likely been used to raise cash to cover losses in other asset classes because it remains one of the best performing asset classes year-to-date, despite recent fluctuations, and it is a high quality and highly liquid asset. But coming out of the market selloff we have seen that the stronger the pullback in the stock market, the more negatively correlated gold becomes with the market, highlighting its effectiveness in a sustained pullback (see graph below).

Gold prices denominated in many other currencies, however, continued to reach all-time highs. This highlights a continued trend of growth in gold ETFs outside of the U.S. over the past few years; a trend underscored by European funds seeing the largest absolute inflows and Asia and other regions registering the largest percentage growth during the month. It serves as a safe haven in the longer term.ix

 

Correlation increased across all major asset classes except three-month Treasuries during the COVID-19 selloff

SOURCE: WORLD GOLD COUNCIL, BLOOMBERG

 

Theme 3: Oil Prices and Geopolitical Risk

Demand for oil has been hit by the coronavirus pandemic while global storage facilities are overflowing. International and domestic travel restrictions throughout the world and a sharp reduction in road traffic are expected to lead to a further decline in oil demand in 2020 that could exceed 10 million barrels a day, about 10 percent of global daily oil production.x

Confronting a weak demand environment, the OPEC+ coalition broke down on March 6th, 2020, leading to the worst one-day price drop in the oil market since 1991. This was repeated on April 21st. Oil prices had already declined 7.3% between August 2019 and February 2020, falling from $57.60 to $53.40, before further declining by 39.6% in March to $32.30 as the COVID-19 outbreak abruptly reversed a positive trend as containment measures directly hit the transportation sector, which accounts for more than 60% of oil demand.

After trading close to $20 toward the end of March, oil prices recovered somewhat in early April as the OPEC+ coalition resumed talks, but by mid-April the price of American crude oil crashed by more than a fifth, falling below $15 a barrel to its lowest point in two decades. The slump came even as OPEC producers and their allies have promised to slash production.xi

The drop in oil prices has already had a marked impact on Canada’s dollar. Canada’s currency is likely to remain around 70 US cents in the near term as uncertainty about the depth and duration of the crisis sees investors gravitate to the safety of US dollars.

 

Theme 4: Global Currency Revaluation

Every recession, financial crisis or geopolitical shock has left a permanent imprint on at least one major asset class. COVID-19’s aftermath is expected to involve at least one regime change. (See Frame Global Asset Management White Paper 3).

The currencies of commodity exporters with flexible exchange rates among emerging market and advanced economies have depreciated sharply since the beginning of the year, while the US dollar has appreciated by some 8.5% in real effective terms as of April 3rd, the yen by about 5%, and the euro by some 3%.xii The broad dollar will continue to be supported by the ongoing deleveraging demand and will maintain a bid against Emerging Market currencies where there are balance sheet vulnerabilities, and Petro currencies which will continue to suffer from the oil supply glut.

While the COVID-19 shock is depressing both global demand and supply, a demand shock this large will probably produce the first negative year-on-year readings on global CPI inflation in several decades. This decline is not just an energy price effect: global core inflation could drop below 1% for the first time in at least 20 years, which will sustain central bank concerns of deflation even once the expansion materializes.

Longer term implications, given the scale of the Fed’s purchases of Treasury securities in the first few weeks of the pandemic and the size of the broader expansion in its balance sheet, suggest that the Fed is monetizing the deficit. The monetary base expansion will eventually trigger a corresponding rise in broad money and consequently, when the economy’s resources are fully utilized again, the prices of goods and services too.

The revenue loss around a recession results with the contraction in aggregate demand. Margin compression is by far the biggest contributor to profit losses in a recession. Margins are driven by many factors, but the three most important are: prices (a positive), wages (a negative), and productivity (a positive). Roughly two-thirds of the variation in global corporate profit growth can be explained by the difference between price inflation and growth in unit labor costs (that is, wages relative to productivity). During recessions, wage inflation is held back but this pales in comparison to the loss in pricing power. At the same time, some degree of labor hoarding creates pro-cyclicality in productivity growth.

Inflation and margin compression will factor into the revaluation of global currencies. We will continue to monitor these.

 

 

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. March 2020 Portfolio Models

A global recession in 2020 is all but confirmed as nations shut down economic activity to limit the spread of COVID-19. The virus is unique in that it is a demand shock and supply shock, and also a negative wealth, oil price, and credit shock. There will be a wide range of subsequent effects. We are monitoring these developments and have updated our previous Stagnation followed by Recession outlook for the U.S. economy to reflect a Recession in March, extending through to the end of the year, as the situation will deteriorate further before beginning to recover.

In March, we maintained the asset allocation positioning that we established on February 19th. This reflects our view on deflationary and recessionary influences that dominate the global economy.

 

Deborah Frame, CFA, MBA

President and Chief Investment Officer

April 14, 2020

 

iIMF. World Economic Outlook. April 14th, 2020.
iiIMF. World Economic Outlook. April 14th, 2020.
iiiIMF. World Economic Outlook. April 14th, 2020.
ivCapital Economics. U.S. Economic Update. April 16th, 2020.
vCapital Economics. U.S. Economic Update. April 16th, 2020.
viIMF. World Economic Outlook. April 14th, 2020.
viiCapital Economics. U.S. Economic Update. April 16th, 2020.
viiiNational Bank of Canada. Public Sector Debt. April 15th, 2020.
ixWorld Gold Council. April 8th, 2020.
xCapital Economics. U.S. Economic Update. April 16th, 2020.
xiCapital Economics. U.S. Economic Update. April 16th, 2020.
xiiTrading Economics. Currencies. April 20th, 2020.

 

A global recession in 2020 is all but confirmed as nations shut down economic activity to limit the spread of COVID-19. The virus is unique in that it is a demand shock and supply shock, and also a negative wealth, oil price, and credit shock. There will be a wide range of subsequent effects. We are monitoring these developments and have updated our previous Stagnation followed by Recession outlook for the U.S. economy to reflect a Recession in March, extending through to the end of the year, as the situation will deteriorate further before beginning to recover.

There is evidence that the disease has likely peaked in China. The Bloomberg China Economic Recovery Index shows that 70% of economic activity was restored by March 9th, up from just 27% at the beginning of February.1 A coordinated global response has started to emerge. Based on the experience in China, virus incidents are unlikely to peak in Europe and the U.S. until June.

The Russia-Saudi spat that has resulted in the current global oil glut and the expected decline in demand due to this pandemic will keep oil prices low with mixed effect across economies. It will have a negative impact on oil-exporting emerging markets outside Asia, while also affecting oil-and-gas related capital expenditure in the U.S. Net oil importers in Europe and Asia will be beneficiaries although the stronger US dollar will offset a portion of the benefit.

In January, a record 31.8 million Americans were employed in retail trade, hotels and motels, air transportation, restaurants and other eating places, arts, entertainment and recreation, and offices of real estate agents & brokers.2 Many of these establishments have seen their businesses collapse in recent weeks and have reduced their payrolls significantly. As we enter the third week in March, 158 million Americans have been told to stay home from work and other activities.3 This doesn’t include the multiplier effects on other industries. Initial unemployment claims and the unemployment rate are soaring and will remain high through the second quarter.

Market behavior in recent weeks has broken records for the speed of its decline. It took only 16 trading sessions for the S&P 500 to fall 20% from its highs, the quickest descent into bear market territory on record.4 U.S. equities were battered in February, down 13% from their peak on February 19th. The S&P 500 was down 8.2%, while smaller caps lagged, with the S&P Midcap 400 and the S&P SmallCap 600 down 9.5% and 9.6%, respectively. The S&P/TSX Composite was down 5.9%.

Asian equities took part in the sell-off, with the S&P Pan Asia BMI closing the month with a decline of 6.6%. European equities struggled in the face of a broader global sell-off. The S&P Europe 350 dropped 8.6% on the month. U.K. equities continued to lag their European counterparts; the S&P United Kingdom declined 9.0% on the month, returning all of its gains from the past 12 months.

In March, we maintained the asset allocation positioning that we established on February 19th. This reflects our view on deflationary and recessionary influences that dominate the global economy.  Allocation to equities was reduced in February to 12% in Tactical Conservative, 17% in Tactical Moderate Growth, 26% in Tactical Growth, and 34% in Tactical Aggressive Growth. In February, within the Fixed Income allocation, we added the 20+ year Treasury Bond. As of March 25th, the 10- year treasury yield has declined by 1.577% since the start of the year, rewarding this position. Gold continues to be present in all models as it performs well in high risk, low yield environments as a risk-free asset class.

Historically, central bank stimulus is bullish for bullion. In the early days of the selloff, safe haven assets such as gold and treasuries sold off when margin calls on equities and credit occurred as equity portfolio managers were sitting with record-low cash buffers. Gold provides diversification in a portfolio and is correlated with the stock market, becoming inversely correlated during periods of stress. In a world of historically low interest rates, gold is a safe-haven. Similar short-term movement was seen in the ten-year note and in State and Local government bonds and Mortgaged Back Securities guaranteed by the federal government in response to liquidity funding requirements.

The shape of the recovery from the pandemic and for the global economy are highly correlated.  The second-order effects of schools closing, businesses closing due to staff absence, and a paralysis in consumer and corporate confidence will create challenges for commerce and credit markets. Policymakers will need to protect both supply and demand by providing ample liquidity to banks and corporations, in order to minimize the risk of default and job losses. The trend towards global populism and protectionism remains a risk to the recovery. We expect to see prolonged disinflation. We will continue to monitor the data for growth, inflation, and recession signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame , President and CIO

 

1Bloomberg. China Economic Recovery Index. March 9, 2020.

2Trading Economics, United States Employed Persons. January 2020.

3New York Times, World Coronavirus Updates. March 23, 2020.

4Financial Times. “S&P 500 suffers its quickest fall into bear market on record”. March 13, 2020.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. February 28, 2020. Index performance is based on total returns and expressed in the local currency of the index.

 

 

The coronavirus outbreak in China has generated economic waves that are disrupting global supply networks that act as the backbone of the global economy and comes as the global economy was already cooling off. Profit warnings from companies with significant operations in China and abroad have begun. We are monitoring these developments and have concluded that our Stagnation outlook for the U.S. economy will shift to Recession beginning in the back half of the twelve-month time horizon.

China is likely heading into a consumer recession, as auto sales there plunged 18% year over year in January to their lowest level in eight years.1 China accounts for 16% of global GDP on a US dollar basis, compared to 4% in 2003.2 In 2019, China accounted for 75% of total world oil demand.3 Commodities markets have tumbled as factories are idled. Iron ore demand is down more than 10% this year. Copper and nickel are down about 8%, while zinc and aluminum are both down more than 5% in 2020.4

In Japan, the world’s third-largest economy declined 1.6% in the fourth quarter of 2019 as the country absorbed the effects of a sales tax hike and a powerful typhoon. It was Japan’s largest contraction compared to the previous quarter since 2014.5

The U.K. and Germany managed to escape a technical recession while France and Italy contracted. Switzerland’s core CPI declined 0.5% sequentially in January. Italy, Germany, and France experienced a 2.7% decline in December industrial production. EU auto sales also declined 7.4% YoY in January.6 The UK’s future trade relationship with the EU remains unanswered. Brexit has already cost the UK economy between 2.5-3.0% of lost output.7 The final economic bill will depend on the extent to which EU trade is disrupted as the UK pursues greater autonomy over regulation, migration, and state aid.

In the U.S. the budget deficit to GDP ratio stands at 4.9%, up from 4.3% a year ago. The last time we saw this level was in May 2013 when the unemployment rate was 400 basis points higher than it is today at 7.5%.8 January nonfarm employment growth was 225,000 jobs. While the unemployment rate ticked up to 3.6%, this increase was driven by a jump in labor force participation.9 The coronavirus impact will be felt in the U.S., resulting in weaker exports, imports, and inventories. Canada’s economy has stalled as transportation activity has been disrupted by blockades set up by anti-pipeline protestors. Real manufacturing shipments fell 0.4% in December and real retail sales were flat. A recent rise in insolvencies comes amid a relatively robust job market.10

U.S. equities started the year strongly, but gains were erased towards the end of the month as a result of coronavirus fears. The S&P 500 was flat in January while the S&P MidCap 400 and the S&P SmallCap 600 were down 2.6% and 4.0%, respectively. Canadian equities were positive, with the S&P/TSX Composite up 1.7%. The S&P Europe 350 finished January with a loss of 1.3%, ending a four-month streak of gains. The S&P United Kingdom lagged its European counterparts in January, with the index declining 3.3% in pound sterling terms. U.S. fixed income performance was positive across the board, with treasuries and corporates leading the way. The decline in the U.S. long bond’s yield reflects a confluence of factors including easy Federal Reserve monetary policy, concerns about the COVID-19 epidemic’s impact on economic growth, and an absence of inflationary pressures. Gold is continuing its advance, after breaking out from a six-year base formation, rising as the US dollar rises, not the usual correlation.

In February, we reduced exposure to U.S. equities across all models and reintroduced the U.S. long-term Treasury Bond. This reflects our view on deflationary influences that dominate the global economy. Allocation to equities was reduced to 12% in Tactical Conservative, 17% in Tactical Moderate Growth, 26% in Tactical Growth, and 34% in Tactical Aggressive Growth. Within the Fixed Income allocation, we added the 20+ year Treasury Bond as long rates are expected to decline further. Gold continues to be present in all models as it performs well in high risk, low yield environments as a risk-free asset class.

The trend towards populism and protectionist policy remains a risk to the stability of global financial markets and the COVID-19 outbreak is likely to delay recovery and intensify disinflation. We will continue to monitor the data for growth, inflation, and recession signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, President and CIO

 

Trading Economics, China Vehicle Sales. February 13, 2020.

Visual Capitalist. 70 Years of China Economic Growth. October 12, 2019.

Trading Economics, China Imports of Fuel Oil. February 2020.

Trading Economics, Commodity Prices. February 2020.

Trading Economics, Japan Q4 2019 GDP. February 2020.

Trading Economics, E.U. Economic Data. February 2020.

Oxford Economics. Brexit. February 2020.

Trading Economics, U.S. Debt to GDP. February 2020.

Trading Economics, U.S. Non-Farm Payrolls. February 2020.

10 Trading Economics, Canada Insolvencies. February 2020.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. January 31, 2020. Index performance is based on total returns and expressed in the local currency of the index.

Global growth is projected to reach 2.5% in 20201. Reduced trade uncertainty combined with last year’s easing in financial conditions helped business sentiment stabilize in many major economies. The U.S. dollar benefitted from safe-haven demand over the past year amid this trade uncertainty. Global manufacturing activity generally remains soft; the global manufacturing PMI fell to 50.1 in December, consistent with stagnation.2 Trade challenges between the world’s two largest economies are likely to continue, with no long-term deal to tackle structural issues and imbalances between the U.S. and China. Growth forecasts for advanced and developing economies have been revised down as a result of weaker than expected trade and manufacturing activity. We are monitoring these developments and have concluded that our Stagnation outlook for the U.S. economy over our forecast time horizon of twelve months still stands, with a recession likely in 2021.

GDP growth in China has slowed to 6% in the third quarter of 2019, its slowest pace in about 30 years.3 Policymakers are focused on measures to limit risks arising from excessive debt burdens, even if it means weaker rates of growth. An uptick in infrastructure projects towards the end of last year has been the main driver of growth. Eurozone growth continues to underperform, dampened by the gradual slowdown in China, the ongoing Brexit saga, White House protectionism, and the threat of more tariffs. The accommodative policy measures implemented by the ECB and fiscal policy should continue to prop up the economy. Concern grows about the corrosive side effects of negative interest rates as the ECB’s bond-buying program nears its self-imposed limits.

The U.S. leads the global charge as their economy is entering its eleventh year of expansion, the longest on record. The consumer remains the main source of strength due to strong job gains and low interest rates that have bolstered spending. While the U.S. has proven successful in securing a trade deal with Canada and Mexico and extracting a “phase one” trade agreement with China, vulnerabilities remain due to their sizeable trade deficit. As a share of GDP, the U.S.’s goods trade deficit over the last two years has narrowed only marginally below the last decade average, driven mainly by a slight reduction in U.S. import demand, where lower merchandise imports from China have been replaced by imports from Mexico, Europe, and developing countries in Asia.4 The PMI for the sector hit its lowest level in a decade in December.5 Conflicts in Iraq and Afghanistan have left the American public strongly opposed to further major conflicts in the Middle East and a direct conflict with Iran would raise downside risks to business activity. For Canada, healthy demand stateside and receding North American (USMCA) trade tensions helped facilitate the much-needed rotation towards exports and business investment from the consumer and housing sector in the fourth quarter.

One of the most notable effects of last year’s Fed rate cuts was support for asset prices. U.S. equities ended 2019 strongly with the S&P 500 up 31.5% for the year, despite lackluster profits, slowing global growth, and recession fears. It is worth noting that a late-2018 selloff provided a flattering comparison for 2019. Mega-caps dominated as gains for the S&P MidCap 400 and the S&P SmallCap 600 were 26.2% and 22.8% for the year, and 2.8% and 3.0% for December, respectively, while the S&P 500 was up 3.0% for the month. U.S. fixed income performance was positive across the board. The S&P/TSX Composite gained 22.9% during 2019 and was up 0.5% in December, closing out the decade with its best annual performance since 2009. European equities also experienced their best year since 2009 with S&P Europe 350 up 27.2% for the year and 2.1% for December. The S&P United Kingdom finished 2019 up 17.2% for the year. Commodities also rallied, with the DJCI up 10.1% and the S&P GSCI up 17.6% for the year, driven by gains in Energy and Precious Metals.

In January we maintained the December allocation between Equities and Fixed Income across all models. Allocation to equities remains at 17% in Tactical Conservative, 22% in Tactical Moderate Growth, 36% in Tactical Growth, and 44% in Tactical Aggressive Growth. Within the Fixed Income allocation, we maintained the weight of the 7-10-year maturity in order to protect the portfolio from a rebound in long rates. Gold continues to be present in all models as it performs well in high risk, low yield environments as a risk-free asset class.

The trend towards populism and protectionist policy remains a risk to the stability of global financial markets while heightened geopolitical strains also have the potential to create volatility. We will continue to monitor the data for growth, inflation, and recession signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame , President and CIO

 

The World Bank Group. Flagship Report. Global Economic Prospects. January 2020.

2 J.P. Morgan Global Manufacturing PMI. News Release. January 2, 2020

Trading Economics. China GDP. January 20, 2020.

Trading Economics. U.S. Goods Trade Deficit. November 26, 2019.

Trading Economics. U.S. PMI. January 2020.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. December 31, 2019. Index performance is based on total returns and expressed in the local currency of the index.