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Market updates | Macro outlook

Investment outlooks / Q4 2020

The new normal is now

Notwithstanding some stumbles along the way, global economic activity rose sharply in the third quarter. The lockdowns in the first half of the year prompted the sharpest collapse in modern economic history as well as the most robust policy response ever seen, so a vigorous rebound was a near-certainty. However, we are now transitioning into the hard slog of the “New Normal”. Looking forward, we expect a slower pace of trend global growth for the coming years as tailwinds are replaced by headwinds. Risk markets have more than priced in the recovery, and from here on we expect several years of broadly sideways markets within a wide range and with substantial differentiation between regions, sectors, styles and factors – and with occasional bubbles (see Figures 1.1 and 1.2). The decades long run of the passive buy-and-hold approach to investing probably won’t work very well in the New Normal as investors are forced to take more risk in exchange for less return. Instead, the macro environment will likely push investors into more active management.

Figure 1.1. Click chart to expand.
Figure 1.2. Click chart to expand.

Worry about a double-dip recession, but don’t worry too much

Sequential economic growth in the coming quarters is likely to be lacklustre at best. The third quarter rebound was flattered in quarter-on-quarter terms in part because the second quarter collapse was so stunning. The next few quarters simply won’t benefit from the same comparison. Moreover, high-frequency indicators of growth since August have visibly levelled off. Pre-recession levels of economic activity have been only partially recovered, and the pace of economic activity appears to be settling at a lower speed than prior to the lockdown recession.

Policy, both fiscal and monetary, is increasingly going to be a drag on activity. The torrent of public support seen the second quarter is simply unsustainable; in the US, for example, personal incomes actually rose during the lockdown because government transfer payments exceeded lost wages. Schemes to support vulnerable firms and workers are being ratcheted down around the world, and merely reducing this stimulus will show up as a negative in economic activity and data.

The private sector is unlikely to be able to offset that negative, at least in the near term. As support schemes taper off, permanent layoffs are accelerating, and in the US are running at a faster pace then during the Global Financial Crisis. Bankruptcies and delinquencies are also increasing, and banks are tightening credit conditions. The Federal Reserve’s backstop credit facilities have been largely untouched, and while they have succeeded in preventing a liquidity crunch from forcing firms into bankruptcy they are unable to guarantee solvency.

The recovery has been clearest in the goods sector, where consumption can continue apace via online distribution channels. Indeed, government transfers in the US briefly took disposable income above pre-recession levels, more than offsetting lost wages, and this has shown up in expenditure on goods (Figure 1.3). By contrast, spending on services, which more often require face-to-face interaction, is still far below pre-recession levels (Figure 1.4). Even more disturbing is that while goods expenditure appears to be rolling over, the recovery in services consumption is also losing momentum. As services constitutes two-thirds of the US private sector, the economy will not be on a sustainable recovery path until the service sector is on a sustainable recovery path.

Figure 1.3. Click chart to expand.
Figure 1.4. Click chart to expand.

Thus, the next couple quarters may well show a slip back into economic contraction. For investors, however, that probably won’t spark a collapse in financial markets – a selloff, maybe, or perhaps just stagnation, but not a collapse. To begin with, equity markets have long since written off 2020 and 2021, and have been focused on earnings for 2022 and beyond to justify valuations. In addition, another round of policy support is likely, although on a smaller scale then was provided in March and with less effect. Not enough to prop up growth, but perhaps enough to sooth animal spirits for a time.

Copper is a winner, crude is a loser

The economic recovery has been uneven and disjointed, creating clear winners and losers. A perfect example is in the commodity space, with crude suffering from overcapacity and a collapse in demand, while copper benefits from tight capacity and firm demand.

Over the past several years, oil production in the US has surged thanks to fracking. The US became a net-petroleum exporter for the first time in decades, while OPEC+ struggled to reduce its own production to accommodate the US output. The market was oversupplied before the pandemic, and when lockdowns caused transport demand to collapse the crude oil market imploded. Prices and timespreads were even briefly negative, as paper longs discovered that they might have to take delivery with no place left to store it. While transportation demand has recovered somewhat, it remains well below pre-pandemic levels and is unlikely to swiftly recover. Even worse (for oil producers) is that the adoption of electric vehicles is accelerating and BP has even declared that peak oil demand is basically now. On the supply side, US shale oil frackers were slow to shutter capacity as the Fed’s free money bought them a bit of time. As a result, the oil market remains oversupplied, though consolidation amongst the producers is gathering pace.

Big oil isn’t dead, but it is getting smaller. The current consolidation phase will likely help tighten the markets in the coming quarters, helping prices to recover by mid-year to around $65 per barrel for Brent. However, we think it extremely unlikely that prices will spike for the foreseeable future (barring a war or natural disaster), and that oil prices will remain in contango more often than not.

The contrast with copper is stark. The mining industry has spent most of the past decade sweating off excess capacity and inventory built during the last boom, and entered the Lockdown Recession in a modest deficit. The lockdown caused some mining activities to pause, tightening supply marginally, but more importantly did not have a meaningful or sustained impact on copper demand. Global consumption of goods – particularly copper-intensive electronics – has weathered the storm better then services or travel, and a significant portion of government stimulus efforts (particularly in China) are pointed at copper-intensive infrastructure projects.

Over the past fifteen years, a copper long has outperformed Brent crude oil by four-fold (Figure 1.5), only partially because of an relative increase in long dated flat price (Figure 1.6). The bulk of the crude oil underperformance has been due to the occasional bouts of super contango that have sunk the oil market with increasing frequency in the past few years (Figure 1.7). While crude is likely to firm up in the first half of 2021 as supply cuts start to impact, we continue to see a healthier medium term outlook for base metals. Copper in particular is likely to be in backwardation more often than not in the next year or two, and we see potential for copper to retest the 2011 highs around $10,000 per tonne over the medium term.

Figure 1.5. Click chart to expand.
Figure 1.6. Click chart to expand.
Figure 1.7. Click chart to expand.

Dollar weakness will take over as a support for gold

One of the consensus trades this year has been shorting the US dollar, and we think that is probably a trend that will continue. Yield differentials have underpinned the strong dollar over the past five years, but with developed market rates converging to zero this support has vanished (Figure 1.8 and 1.9). The dollar will instead be driven more by growth differentials and by the US current account deficit, which will provide for oscillations around the weakening trend we expect.

Figure 1.8. Click chart to expand.
Figure 1.9. Click chart to expand.

The weaker dollar will add to the bullish case for base metals (and help dampen the bearish case for crude oil), but will be particularly significant for gold prices. Gold is not really a commodity, even though it is dug out of the ground and has a cost of production, because it has no meaningful consumption value and thus isn’t prone to scarcity. However, gold does serve as a store of value, particularly when money supply is swollen. Declining interest rates have been the primary driver for gold over the past several years, as cheaper borrowing costs make it easier for investors to hold an asset which generates no returns. With interest rates pinned to zero and thus fading to the background, the weaker dollar is likely to step forward to give fresh impetus to gold. Thus, we remain favorable to gold.

Surfing waves, not riding the tide

For the past several years there were powerful economic forces that created a rising tide that lifted (nearly) all economic and financial boats. Two of the most important have been globalisation and the growth of China, and the structural decline in interest rates. Trade flows have stopped expanding over the past several years, though they haven’t declined. At a minimum, this implies that efficiency gains from trade will be less supportive for growth. Meanwhile,  China is moving beyond the “catch up” phase of rapid growth, though China’s growth prospects still look good – just not as good. Even more important has been the decline in interest rates since the early 1980s. This has both increased access to capital for firms and consumers for investing and spending, and has supported market valuations by increasing the discounted value of future earnings and dividends. The rush to zero rates earlier this year, and subsequent pledge by the Fed to effectively keep them at zero for several years (or until inflation averages above 2 per cent, which is several years away at best), greatly contributed to the equity market rally this summer. The BIS estimates that roughly half of the equity rebound in the US – and a fifth of the rebound in Europe – was directly due to the repricing effect of lower interest rates. From here, however, nominal rates cannot really decline, and thus cannot inflate asset prices further.

Riding the rising tide made it relatively simple for passive investors. All they had to do was ignore fluctuations and hold the market. Without a rising tide, however, investors will need to take more risk in order to realise the same return. So far this year, this has meant increasing duration and reducing credit quality in fixed, and accepting higher valuations in equities. Moving forward, an increased tactical allocation risk will be necessary. In essence, surfing the market waves to pick winners and drop losers.

Rotating to value and cyclicals and Europe to catch the next wave

This year has seen some extreme divergences in relative sector performance. Global consumer discretionary, for example, has performed well, while energy has plummeted, bringing the year to date relative performance to a staggering 66 per cent.

Our macro outlook points to some specific sectoral opportunities. The weaker dollar, for example, is associated with non-US equities performing relatively better – US investments are less attractive to the rest of the world, and the rest of the world is more attractive to the US; thus, Europe should do (relatively) well. The better outlook for goods consumption versus pandemic constrained services should be supportive for cyclicals. Value, which has underperformed growth for years, is likely to catch a wind with an end to the rate cutting trend, as ever-lower rates have meant ever-higher discounted value of future earnings, which favoured growth (Figure 2.0). Cyclicals are also likely to do well relative to defensives as rates run out of room to fall (Figure 2.1).

Figure 2.0. Click chart to expand.
Figure 2.1. Click chart to expand.

It may also be time to look beyond those equities which were well positioned for the pandemic. In some cases – digital subscription services or e-commerce, for example – the mega cap giants like Netflix or Amazon have taken so much market share that there isn’t as much scope for them to grow faster than the economy as a whole. The space remains attractive, but it makes sense to start thinking about challengers rather than incumbents in the New Normal. In a similar vein, while the first wave of lockdowns spurred a surge in specific purchases like home office computing and communication equipment, demand for such durables is likely somewhat saturated at this point.

Don’t pack away your umbrella, there is still a storm over the horizon

Someday, rates are going to rise. When that happens, markets generally are going to be in trouble. The bond market will be an obvious casualty, and so will equities as future earnings are worth less as the discount rate rises. There will be an economic hit as well, when debt-heavy corporations and governments suddenly find themselves forced to either roll over debt at an ever higher cost or pay down debt out of retained earnings or higher taxes. Either way, it will be a downpour for the markets.

That day isn’t today, and it isn’t around the corner, but it will come. Rates are likely to be suppressed for several years at least, but investors should be prepared for periodic sharp sell offs whenever a whiff of rate hikes is in the air.


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, October 2020.

For more information please read our disclaimer.

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