Will the economic and market recovery continue?

Many are predicting that markets will retest their March lows or have another collapse.

Concerns include a possible second wave of infections, an apparent disconnect between recovering equities and contracting economic activity, tensions between the US and China, and the November US election. The economic gloom has not been helped by the latest IMF outlook lowering its forecast for global growth to -4.9% and projecting that the recovery will be gradual.

I remain optimistic that economic activity and financial assets can continue to make progress over the next few months, but I expect volatility to stay elevated and market leadership to change.

The decisive shift in monetary and fiscal policy is a massive support for both the economy and markets.

Historically, equities and other risk assets usually benefit when a surge of liquidity is pushed into a weak but recovering economy, coupled with falling inflation, extremely low interest rates and high unemployment.

Even if consumption and investment recover faster than expected as lockdown eases, the anecdotal evidence from China is that the supply side will recover at a much faster rate than demand. This will keep inflation low and so price deflation in the US and Europe is a possibility before this cycle ends.

This ‘sweet spot’ for risk assets could last for some time. Jerome Powell, the Fed chair, has recently said the Fed would keep interest rates at zero until 2022 at least.

The Fed made the mistake of tightening prematurely after the GFC in 2008 and is unlikely to make the same mistake. Other global central banks will do the same.

There are genuine concerns that a second wave of infections will occur as economies reopen, border controls are relaxed and as people become less concerned about physical distancing.

Certainly this is a real risk and the renewed spike in infections across America’s south-western states has spooked investors.

Moving forward, policymakers will try to strike a balance between public health needs and economic interests, even if a serious second wave does emerge. Although it is difficult to make sense of all of the information, especially given that top scientists have different and competing views, countries are now in a much better position to manage the virus.

Another risk is that the China-US strife is intensifying once again.

At present, Trump seems to have backed off from upping the ante but this could change as we approach the US election and he feels that he needs a political lift or a scapegoat to blame for the economic demise. Increased tensions between the world’s two biggest economies and super powers are here to stay and likely to intensify. It’s also unclear whether China can fulfil its part of the trade deal, meaning that a Sino-US trade war could easily be rekindled.

The November US election is also an increasing risk.

Although Trump has alienated a large part of the US and global population, a win for Joe Biden and a Democrat-controlled House could set off alarm bells for the stock market. Investors would likely fear higher taxes, more regulation and an avalanche of social programmes. Having said that, this would be a bit of a two-edged sword since a Biden administration would be less confrontational on the global stage, which could help rebuild trust and cooperation between the US and its allies.

Europe also remains a threat as the crisis has once again highlighted the yawning divide between the Eurozone’s northern and southern members at a time of severe economic pain and tragic human suffering.

However, very importantly, senior policy makers, led by Angela Merkel and Germany, seem to have recognised this threat and have acted quickly and aggressively in an effort to lessen the risk. The region has shown strong political support for the ECB’s extremely accommodative monetary policy, injected huge fiscal stimulus into the economy and are seeking to establish a potentially game-changing approach to common debt through the medium of the European Commission.

Markets have recovered surprisingly well over the past few months and this does look strange when compared to the economic gloom and continuing threat from Covid-19.

However, assuming that the lockdown exits proceed as expected, we are through the trough of the economic collapse and the most recent data emerging from Asia, Europe and the US would seem to suggest that activity is picking up quicker than expected.

Markets are also a discounting mechanism and are looking forward to the anticipated powerful recovery in the global economy which will be fuelled by unprecedented liquidity in the system, near zero financing costs and pent-up demand. As we have seen so many times in the past, it always feels uncomfortable for the majority of investors when markets ‘climb a wall of worry’ and this time is unlikely to be any different.

There are plenty of reasons to be cautious, and we will almost certainly see bouts of volatility and market weakness along the way. For longer-term investors, it makes sense to focus on the opportunities available across a range of equity themes including technology, health care, emerging markets and undervalued UK assets. For most investors, it also makes sense to retain sufficient hedges in place against some of the perceived risks including a weaker-than-expected growth environment or the emergence of rising inflation sooner than anticipated.

These hedges would include higher cash balances than usual, long-term government bonds and gold.

As always, the path ahead is full of uncertainty but a focus on the longer term and some of the irrefutable trends and themes that will drive markets forward should continue to result in a reasonable return.