Covid-19 has pressured the global economy in an unprecedented way

Arnab Das discusses seven major themes likely to come into sharper focus, and the longer-term outlook.

Implications of the pandemic on specific marketsThe coming quarters may well see continued market volatility amid fundamental macro and firm-level pressures. Corporate credit (high grade, high yield and emerging markets) faces significant challenges. We would expect downgrades to continue, with the risk that “fallen angels” that drop below investment grade could cause some capacity and digestion problems in the smaller high-yield market over time. And defaults are likely to continue in many challenged sectors — including EM corporate credit, where refinancing pressures may also become an issue.

Pressure on earnings and dividends is likely to be a challenge in many equity markets — particularly in the EU and UK. Corporate consolidation is likely to be a theme, and both dividends and buybacks are likely to become much less of a support for US equities. 

At the time of writing, we believe that oil as a commodity and oil companies have been exceptionally undervalued owing to the joint negative demand shock of the pandemic and the negative supply shock of the oil price war. While we do not expect a rapid resolution of either issue, we do see a precedent in the 2014 Saudi-Russia oil price war, which also took place at a time of weak demand (albeit not as weak as now). The global supply glut was eventually and gradually fixed as OPEC+ coordination with Russia was established. 

Looking further ahead, as the world economy normalises post-pandemic into 2021, bond yields are likely to rise further, the US dollar to weaken further, and risk-asset risk premia and volatility to moderate. This process is already under way in much of DM, especially in US equities, but it probably will go further as the public health and the private economy eventually recover from the pandemic. This time around, though, we would expect EM to continue to lag across the board, given the significantly greater public health policy challenges, fiscal and external financing pressures, and general growth pressures many of the major EMs are likely to face.

Assessing the major themes and longer-term outlookOver the coming years, we would expect the landscape of the global economy to change significantly because major structural changes that were already under way before the coronavirus crisis will very likely continue and in some cases be accentuated by the confirmation that extreme events are possible and that therefore greater public, private, and portfolio “insurance” are useful.

We would expect the following seven major themes to come into sharper focus, which might well change the balance between the shares of labour income and capital returns in GDP.

We expect each of these themes to be addressed in different ways in different countries and sectors, pointing to a somewhat more bottom-up and less top-down investment environment — which would therefore be more alpha-rich and less beta-dominated over the long run.

All this points to a more joined-up role between asset allocation and selection, complete with a rising role for country- and stock-picking in the long run.

Public health and insuranceThe pandemic has fuelled an appetite for a kinder, gentler form of capitalism that includes better, more efficient, more inclusive, and more substantial public health resources and policies in many Western and EM countries. Past crises, particularly financial crises, have precipitated increases in “self-insurance” through, for example, higher household savings rates, higher levels of official foreign exchange reserves, and more restrictive regulatory policies. We may well see public and private behavioural change owing to the extreme social, economic, and political impact of the pandemic.

Climate changeThe abrupt slowdown and shift in activity from discretionary spending, including on air travel, domestic transport, and commuting, has sharply cut carbon emissions. But the issue of climate change is very likely to return to the fore as the world economy recovers. The pandemic crystallises the very real possibility of extreme events and Covid-19 is the first major pandemic in a century and, arguably, the first major shock to hit almost all countries at once. It is conceivable that some countries begin, and others redouble, their efforts to insure against and prevent the extreme downside risks and uncertainties of climate change.

Inequality and demographicsImproving income, regional, and age-based inequality is likely to continue to be a major issue in the West and in many emerging markets. Evidence of the need already abounds. We see it in the UK’s Brexit vote and the goal of “levelling up” disadvantaged, “left-behind” areas and sectors.

Another example is the US political focus on “red states versus blue states”, which may be crystallised by Covid-19’s hit to wealthy, well-heeled and -travelled, ageing, and urban elites, and exacerbated by the economic impact on gig-economy workers without much of a social safety net. We also see this need illustrated by China’s efforts to shift manufacturing and industry from the coast to inland.

The Fourth Industrial RevolutionThis revolution will probably continue unabated because of the importance of the digital economy in managing extreme events and crises. It is conceivable that customers, policymakers, and corporate management make a concerted effort to harness technology proactively to help manage or prevent crises, as has occurred reactively in this coronavirus crisis. Many ideas are within reach, such as refining 3D printing for specialised or mass-produced equipment, as well as mobilising big data, models, and AI for safeguards and social services instead of mainly for monetising personal data and for surveillance capitalism.

The future of the euroThe architecture of the eurozone remains incomplete. We hope Ursula von der Leyen, who has promoted the idea that her presidency would see a “geopolitical” EU Commission, takes the lead in making the most of this crisis — the third in a decade that threatens the euro — and fixes the house rather than adding more members, rooms, or roles (such as further internationalising the euro to challenge the dollar).

We doubt that the eurozone will offer the euro to the world as a dollar alternative, even though the world might like one because of unpredictable US policies and politics. If there are doubts about the cohesion of the eurozone every time there is a major crisis and there are constraints in providing internal financing within the eurozone, graver doubts might surround the region’s willingness to provide financing to the rest of the world in a crisis.

The future of emerging marketsChallenges to rapid and sustained emerging market growth have been magnified by the pandemic. According to the International Institute of Finance, the Covid-19 crisis has precipitated the largest, fastest single episode of capital outflows from EM equities, sovereign debt, and corporate debt with significant pressure on EM currencies and official FX reserves.

Private and official-sector estimates for the financing gap — the excess of external financing needs for debt rollovers and net external and budgetary financing over available committed resources (including domestic EM sources) run as high as $2.7 trillion, compared to some $1 trillion of usable IMF lending capacity. Indeed, some 80 countries have reportedly already approached the IMF with funding feelers. 

The pandemic is already thought to be running rampant in some major EM economies including Turkey. India may have a far higher numbers of cases than reported and is thought to have experienced as many as half the global fatalities in the 1918-21 Spanish Flu pandemic — a national trauma that intensified the struggle for independence because of the lack of a concerted public health response.

These Covid-19 challenges come on top of slowing trend growth for the globe and for EM countries, the Fourth Industrial Revolution, and partial reversals in globalisation. All these issues threaten the EM growth and catch-up model, which has worked in all the EM countries that have closed the income, wealth, and capital asset risk-premium gap with DM countries — namely shifting workers from agriculture to manufacturing and services.

Trade barriers and technology might limit export prospects. Supply chain concentration risks may induce both DM governments and multinational corporates to diversify away from concentrated sources of supply in the major EMs such as India, Turkey, Mexico, and others.

Globalisation, geo-economics, and geopoliticsTrade and investment barriers have risen because of US-China, US-EU, and US-EM geo-economic tensions as well as outright geopolitics — rivalry with China, the cost of defending Europe and parts of Asia.

Some of these shifts and tensions are structural and may well be intensified by Covid-19, which has exposed the weakness of US public health policies. Indeed, it is conceivable that the US may move towards a higher tax burden both to finance the cost of economic rescue programmes, and to improve and extend healthcare benefits.

Beyond navel-gazing, it is conceivable that the US may focus more financial and institutional resources on nation-building at home, perhaps at the expense of a more narrowly defined set of national interests, relying more on allies for “burden sharing” when it comes to geopolitics and greater symmetry in market access.

The lack of diversification and margin for error in just-in-time, concentrated supply chains and the concentration of specific technologies such as generic pharmaceuticals, 5G, robotics, and AI, point to greater political demands for re-shoring and diversification of sources of supply.

Import substitution policies, as the jargon has it, may boost growth in the short term but seem only to work in the longer term if at least competitive domestic markets are maintained in each industry that benefits from the protection of tariffs and the shelter of public policies for encouraging targeted industries.

Picking winners is hard to do, and protecting losers is too often the result. The key for investors may be to pick industries and firms whose cashflow and earnings are cushioned by competitive advantages rather than specific political motivations or support — even as the politics of many sectors changes in response to the Covid shock or geopolitical shocks.

The solution and the issue across all these themes is the policy choices made by individual countries, both to manage the Covid crisis and to bolster investment and growth prospects in the long run.

We expect very different choices based on the political, social, and economic structure and constraints in each country, which we expect will contribute to further shifting the market focus from buying or selling the market across EM to picking and choosing structural and tactical over- and underweights.

Arnab Das is a global macro strategist, EMEA at Invesco.