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Market updates | Macro outlook

Investment outlooks / Q3 2020
  • Output lost in this recession will leave a growth “pothole” greater than any prior downturn since the Great Depression
  • In the short term, fiscal and monetary is filling in that gap
  • In the long term, this is leading to imbalances and even bubbles

The second quarter of 2020 was at least as extraordinary as the first quarter. The Covid-19 pandemic and resulting global lockdown prompted an abrupt collapse in risk assets in late February and early March, leading to a wave of fiscal and monetary stimulus actions the likes of which have not been seen at least since World War Two. The speed with which financial stresses have eased, risk assets have rallied, and economic activity has recovered in the second quarter has been just as surprising.

Better isn’t the same as good…

The whipsaw rebound in economic activity is a clear sign that things are getting better, but it would be a mistake to conclude that things are good. Global real GDP growth is likely to rise by nearly 30 per cent in the third quarter over the second quarter at an annualised rate, easily the fastest ever seen in modern economic history (Figure 1). However, it could hardly be otherwise, coming on the heels of two double digit quarterly declines, themselves the two largest quarterly falls in history. Visually, this looks like the much-discussed V shaped recovery, but this is misleading. In 2008-09, the non-communist global economy shrank for the first time in the post-war period (Figure 2). It took five quarters to recover the level of GDP prior to recession, and if we sum the lost output (the small red triangle) over that period it works out to about 1.3 per cent of global output permanently lost. In the current recession, we estimate it will take about six quarters (i.e., mid-2021) to recover the 2019 peak in global output, with about 4.8 per cent of global GDP permanently lost (the larger red triangle). Thus, getting better is not the same as saying that things are good. Far from it.

Click chart to expand. Source: Dolfin, Bloomberg, Goldman Sachs, July 2020

Click chart to expand. Source: Dolfin, Bloomberg, Goldman Sachs, July 2020

…but it could have been worse

And yet, it could have been much worse. The single most important event of the second quarter was something that didn’t happen  – there was no systemic financial crisis. For this, the lion’s share of the credit belongs to the US Federal Reserve. The US is about a quarter of the global economy, the US dollar is the world’s reserve currency, and the US is the financial centre for global markets, so any response to the global economic crisis would necessarily depend upon strong and swift action by the US, and the Federal Reserve did not disappoint. They quickly comprehended the magnitude of the economic shock that would result from the lockdown, and immediately provided liquidity backstops through a variety of channels. These included interest rate cuts, expansion of quantitative easing, and targeted programmes to support credit markets. While many of these facilities remain mostly unused, the commitment by the Fed was enough to keep liquidity flowing. As a result, indicators of systemic financial stress mostly retraced the March panic.

The central bank response by the Fed and others enabled a similarly robust fiscal stimulus. Governments around the world sharply increased expenditure to support demand during lockdown, which has been critical to limiting the shock of bankruptcies and thus permanent unemployment. Were interest rates not held near zero by central banks, governments would find it extremely difficult to increase spending and thus borrowing without causing immediate stress on the markets.

Less pain now, but more pain later

As a result of the correlated (if not coordinated) global response, the combined cyclically adjusted fiscal stimulus in 2020 will likely be about 4 percentage points of global GDP (Figure 3). This is significantly larger than the total fiscal thrust in 2008 and 2009. The IMF estimates that global real GDP will shrink by about 4.9 per cent in 2020, and (all else held equal) that would have been closer to 9 per cent absent the fiscal response.

Of course, there is no such thing as a free lunch. Somebody always pays, eventually, and the next few years will inevitably see a fiscal drag on growth. These are rates of change, so in order to keep the stimulus flat, governments would have to continue to add support at the same pace. We expect governments to continue to spend in 2021, but at a more modest pace – and that will likely translate into at 2.5 percentage point drag. This drag will continue in years to come, first as governments reduce the stimulus and then as governments try to reduce their debts.

There will also be a payback for monetary policy – the other component that requires support. With interest rates having been near zero for nearly all major economies except for the US, central banks all swiftly turned to quantitative easing, which can be proxied by growth in central bank balance sheets (Figure 4). Prior to 2008, the Japanese were the only ones who had been implementing quantitative easing, and the G4 central banks’ balance sheets totalled around 7 per cent of global GDP. That surged during the global financial crisis, was never unwound, and has since surged again and now stands at around a quarter of global GDP.

It is important to note that liquidity is not a panacea – as Japan well knows. Liquidity cannot create demand, as fiscal stimulus does. The first objective for the Fed and other central banks, as noted above, was to ensure sufficient liquidity to avoid a systemic financial crisis. The second objective is to provide liquidity to enable governments and eventually consumers and corporates to borrow and thus spend. The danger, of course, is that eventually excess liquidity can result in inflation. Right now, that is a good problem to have, but eventually this liquidity will need to be drained – and that is going to hurt.

Click chart to expand. Source: Dolfin, Bloomberg, UBS, July 2020                                                          
Click chart to expand. Source: Dolfin, Bloomberg, UBS, July 2020

Consumption has been propped up by benefits

The eye of the economic storm is employment, and thus consumption. The unprecedented fiscal support, enabled by unprecedented monetary support, has done much to fill the hole from lost wages, at least for now. In the US, for example, employee income (the sum of private compensation and public benefits) was actually higher in May than prior to the start of the recession (Figure 5). This is entirely thanks to unemployment benefits, which would normally peak at around 2 per cent of total employment income in a recession but are now at 11 per cent (Figure 6).

This is an impressive result, but begs the question:what happens once governments roll back support for the unemployed? If the private sector hasn’t fully recovered, then those still unemployed will find themselves with less to spend, and thus demand will struggle.

Click chart to expand. Source: Dolfin, Bloomberg, US Department of Commerce, July 2020

Click chart to expand. Source: Dolfin, Bloomberg, US Department of Commerce, July 2020

Earnings and output are still travelling the same path, but at different speeds

While fiscal stimulus and its monetary enabler appears to have successfully averted (or delayed) much economic pain in the near term, one immediate impact will be the further divergence of financial and economic fundamental trends. Equity earnings track the business cycle. Ultimately, corporate earnings reflect economy-wide output and follow the ups and downs of industrial production (a good proxy for overall activity) closely. If anything, the two have become more synchronized in recent decades (Figure 7). However, since 2009 there has emerged a wedge between the price of earnings (e.g. the S&P 500 cyclically adjust price earnings ratio) and the price of output (e.g. the ratio of the real S&P 500 to industrial production) (Figure 8). This is likely because the infusion in liquidity prompted by the global financial crisis mean that real earnings per share didn’t fall proportionately less in 2009, and rose proportionately more in 2010, relative to economic activity. From 2011 the two again moved in sync, but this earnings-to-output expansion in 2009/10 put the price/earnings multiple on a different (higher) trend then the price/output multiple. In essence, more liquidity has meant more nominal earnings for the same output – which is one definition of a bubble.

The liquidity being added now looks like it will further inflate that bubble. This is the crux of the dilemma facing markets today – upside is constrained by the drag from economic and earnings growth, but the downside is limited by central bank liquidity. At some point the bubble will likely deflate, but that may not happen until central banks start to curtail their largesse. Thus, we expect markets to trade sideways in a wide range for the coming quarters if not years.

Click chart to expand. Source: Dolfin,  Bloomberg, July 2020


Weaker dollar may provide tactical allocation opportunities

With sideways markets, tactical allocation decisions become even more crucial to generating returns – particularly in the absence of meaningful yields on fixed income investments. We expect the dollar to weaken over the medium term, in part because the US has converged with the rest of the world in slashing rates to zero (and perhaps less) and in restarting quantitative easing. Without the support from interest rate differentials, the US dollar will likely depreciate.

This is a key component of our expectation for US risk assets to reverse their trend outperformance over the past decade. A strong dollar is associated with relative outperformance in both equities and high yield fixed income (Figures 9 and 10). Europe, in particular, looks better (in relative terms) than it has for some time. The coronavirus appears to have been brought under control more effectively than in the US, and the crisis appears to have resulted in stronger support for European integration (perhaps aided by the absence of post-Brexit Britain from the debate in Brussels). With European assets generally having more attractive valuations than US assets, we expect Europe to outperform in a weak-dollar world.

Click chart to expand. Source: Dolfin,  Bloomberg, July 2020

Click chart to expand. Source: Dolfin, Bloomberg, July 2020

Fortune may favour the bold, but not the foolhardy

It is important to bear in mind that investors are currently facing an extremely uncertain environment. Policy interventions have impacted the relationship between markets and fundamentals, in many cases suggesting bubbles. Much depends on bringing the coronavirus under control, on the post-pandemic consumer and producer behaviour, and most crucially on the actions of politicians and central bankers. For these reasons, we remain cautious.


Past performance is not a reliable indicator of future returns. Forecasts are not a reliable indicator of future returns. If the information is not listed in your base currency, then the result may increase or decrease due to currency fluctuations.

If not otherwise indicated, all graphs are sourced from Dolfin research, July 2020.

For more information please read our disclaimer.

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