Wake me up when 2020 ends

While many have been on holiday, central bankers have been busy at work. The Fed has announced it will pursue an inflation "make‑up" strategy, which should see policy remain more accommodative than under its previous framework. This could serve as a blueprint for the ECB's policy review due in mid-2021. But also for BOE Governor Bailey, who has suggested a shift in policy approach (i.e. unwinding QE before raising interest rates). We have further pushed out our expectations for Fed tightening, to the extent we now believe it will be among the last to raise rates in mid-2025. Instead, the BOE and ECB are set to lead the charge in late-2023. We also now look for the Reserve Bank of Australia to cut the cash rate to 0.10% in the fourth quarter owing to recent hints. 

However, this continues to hinge on how the pandemic evolves. It has taken a turn for the worse this month, with daily cases exceeding 300,000 for the first time. This is being driven by India, which, despite a low testing per capita rate, is reporting nearly 100,000 new cases a day. Moreover, some developed countries are now seeing a resurgence; France, Spain and the Netherlands have all chalked up record case numbers in recent weeks. Governments are putting curbs in place to try and avoid Israel's fate, which has become the first major economy to re‑enter lockdown. Our assumption is still that this "nuclear option" will be avoided by most, but the tighter restrictions will nevertheless be another hindrance to the recovery.

As expected, this is now losing pace as the sweet spot of re‑opening and pent‑up demand begins to fade. Another issue is that activity is beginning to run up against social distancing limits, such as on factory production lines and construction sites. Overcoming these will require widespread inoculation, with experts estimating 60% of the 7.8 billion global population will need to be vaccinated. With seven of the nine vaccines in their final-stage trials requiring two doses, this means nearly 10 billion doses will need to be made. This is roughly equivalent to the combined manufacturing capacity of the frontrunner candidates. Among the most promising is one being developed by AstraZeneca.

But this had to be briefly halted after a trial participant became ill, serving as a reminder that the path to a vaccine is unlikely to be problem-free. However, it is widely expected that one or more will be available in the first half of 2021, which has led us to pencil in a firmer global recovery in the second half of 2021. However, we have had to make some adjustments to our 2020 forecasts. Chief amongst these is that we have cut our projections for Indian GDP owing to the severity of the second-quarter decline, which at 23.9% year-on-year (YoY) was among the worst in the world. We now look for a more marked global contraction of 4.0% in 2020 (previously ‑3.9%), followed by a firmer rebound of 5.7% (previously +5.6%) in 2021. But risks remain skewed towards a more protracted economic recovery.

The S&P 500 Index has fallen for three weeks in a row, driven by declines in technology stocks. It is now roughly 9% below its peak, putting it on the verge of "correction" territory. Also, the VIX has climbed above 30 as the US presidential election comes into view, with futures pointing to it remaining elevated until January. This is in mirror contrast to four years ago, when markets weren’t pricing in a rise in volatility until January 2017. In fact, contracts expiring at the end of October and November this year carry the biggest election premium on record. But, of course, this is partly due to other risks coming into relief around the turn of the year, including the possibility of a severe second wave and a breakdown in the UK‑EU trading relationship.

Another notable market mover has been the Turkish lira, which has fallen over 20% this year to a record low of 7.6 versus the US dollar. A key factor behind this has been the Turkish central bank, which pursued aggressive easing even in the face of persistent above‑target inflation. Attempts to defend the lira have depleted the country’s foreign-exchange reserves by over 40% this year. However, Moody’s estimates reserves are “close to zero” once banks' required reserves for domestic and foreign liabilities are netted out. These rising external vulnerabilities could lead to a balance of payments crisis, which could have wide‑reaching consequences for the global economy due to the high exposure of European banks to Turkey.

Before Trump's illness stole all the headlines, US coronavirus cases dropped to around 40,000 in mid-September from a high of more than 66,000 in late-July. However, daily infections remain elevated and the national picture continues to mask a divergent trend at the state level. Currently, the bulk of cases being added come from North Dakota, South Dakota, Missouri and Iowa. The rise in the latter is particularly significant so close to the election. The state's junior senator, Republican Joni Ernst has come under fire for downplaying the severity of the pandemic with the Democrats fighting hard to take the seat this November. As such the handling of Covid-19 in states such as these is not only critical in shaping the near term economic outlook, via the impact on local restrictions which follow but the policies we can expect from next year.

As the national daily case count rose sharply through the summer, restrictions were tightened in key states. Google trends data is useful in assessing how activity responded to such moves. Nevertheless, after the collapse in second-quarter GDP, third-quarter GDP looks on track for a chunky 25% rise on a seasonally adjusted annual rate (SAAR) basis, before slower growth in the fourth quarter. The extent of ongoing fiscal support remains an open question for our forecasts. One issue is that people claiming for loss of pay have received much less financial support since 31 July.

Without a fiscal deal soon, this could drag materially on fourth-quarter consumption. But for now, we envisage a 4.2% drop in GDP over 2020 and a 4.5% rise in 2021. The Fed has updated its Statement on Longer-Run Goals and Monetary Policy Strategy. It has followed this with new guidance which sets out three conditions for a move away from accommodative policy; firstly, for the labour market to be consistent with maximum employment; secondly, for inflation to reach 2%; and thirdly, for it to see that inflation is on track to "moderately exceed" 2% for "some time". The new guidance is set in the context of a strategy which requires the Fed to "make-up" for periods of inflation undershoots.

Looking at the Fed's latest median inflation projections and recent history of PCE inflation outturns shows us just how much catch-up there is still to be done, even by 2023, the end of the forecast horizon. As such, its new "dot plot" projections include a "median" view for no rate rises to take place over this period. In light of this shift in strategy and the updated guidance, we now see the funds target on hold right through until mid-2025. In the meantime, the Fed may even opt to top up its level of policy support through a step-up in the pace and quantity of QE, currently running at around $120 billion a month.

We judge that the Fed would favour taking any first tightening step by starting to shrink the balance sheet first, albeit not for a good few years yet. With the Fed having set out a plan that sees no movement on interest rates for several years, investors have become more absorbed by what the 3 November election will bring. Implied volatility in the dollar-yen exchange rate peaks in November and has risen between August and September as election nerves have come into sharper relief. Uncertainty relates partly to who will win the presidential race. Bet data currently sits 54-44 in Mr Biden’s favour, with support in swing states showing the Democratic nominee with a solid lead. However, uncertainty relates to a more complex set of questions.

Firstly, dollar investors view the Senate race as extremely tight. Depending on the outcome of this contest, Congress could be very chaotic in responding to post-pandemic challenges. However, if the Democrats win the Senate and Biden takes the presidency (the House looks set to stay under Democratic control), investors will need to weigh up Biden’s less aggressive US-China stance against his less market-friendly tax platform. Further questions also stem from the scope for the election result to be challenged altogether. For the record, our projections see the dollar at $1.17 versus the euro by the end of this year, but with the dollar weakening to $1.25 by the end of 2021.

While Donald Trump's condition has improved enough for him to return to the White House, should his illness deteriorate, the US order of succession states that the vice president would take over the presidency. With Mike Pence having tested negative, that would be a possibility should Mr Trump become incapacitated, even if only for a short term.

However, the election would be a much more complex affair. Congress does have the power to delay an election date, but with the Senate and House in separate hands, this may not be straight forward. The inauguration date of 20 January is set in stone and cannot be moved. There would also be a question over who would be the Republican presidential candidate should Trump no longer be able to stand. The Republican Party has already nominated Trump, and while there is arguably still time to nominate a different candidate if the situation deemed it necessary, Trump would still be on the ballot paper in many areas given some have already been sent out. If the president were to recover quickly, the big question would be over how his battle with the disease has impacted his standing with the electorate. In terms of the current polls, Mr Biden still leads nationally by 8% and by about 4% in the top 6 battleground states.

Since April's lockdown-induced nadir in economic activity, there has been a clear rebound as restrictions have eased. In the industrial sector, euro-area output fell 26% between December and April, but it has since to leave July output just 5.6% lower. Most notable has been the recovery in Italy which had suffered the biggest fall of the "core 4", but rebounded the fastest. Meanwhile, the Eurozone's powerhouse, Germany, has lagged. One question is whether this pace of recovery hit a bump in August. High-frequency mobility data from Google points to individuals in the workplace falling back in August, as some tightening in restrictions took place.

This looks set to dampen industrial output. However, Google data for retail and recreation has not suffered to the same extent, remaining steady and even rising in some cases, for example in Germany, over August and September, offering some offset to any industrial sector weakness.  The path of coronavirus restrictions still represents the critical risk to economic activity. The latest data are worrying in this context; daily cases have surpassed April's peaks in certain countries (e.g. Spain, France and the Netherlands). However, unlike April, governments are opting to avoid wholescale lockdowns partly due to deaths not rising to the same extent, yet. Less punitive restrictions are evident in Oxford's stringency indices which have not materially changed over August and September.

Even in France, which has seen infections rise sharply, the Stringency Index stands at 49, only marginally higher than the 41 seen in July and way below the 88 seen in April. The point here is that unless necessary, governments will avoid the harshest measures such as those used earlier in the year to protect the economy. So while Covid-19 remains a risk to the outlook, we do not see another sharp downturn in growth in response to the latest virus numbers. Our GDP forecasts stand at -7.1% for 2020 and 5.6% for 2021. Notably, the ECB’s adverse scenario, even under a resurgence of infections, did not envisage a second sharp drop in GDP. Instead, growth is expected to flatline across 2020-21.

With risks to the economic outlook tilted to the downside and inflation below target, further ECB easing is a distinct possibility. This was underlined by the ECB’s latest set of projections which saw headline HICP inflation in the fourth quarter of 2022 at 1.4%, a figure short of the "close to, but below 2%" target. Additionally, ECB Governing Council members have expressed concerns over low inflation becoming entrenched in expectations with core HICP having averaged just 1.1% over the last ten years. The question is what policy tool the ECB might turn to in any further easing. At present, QE is the policy of choice with €1.47 trillion sanctioned since March.

But with €800 billion remaining under the ECB's Pandemic Emergency Purchase Programme (PEPP), purchases can continue until mid-2021. The ECB's third series of targeted longer-term refinancing operations (TLTRO III) could also be adjusted to provide even more attractive funding. However, the big question is whether the ECB is prepared to cut the deposit rate again. Certainly, there appears to be a reticence to use it given it has remained at -0.50% since September 2019, despite the extraordinary stimulus since March. The broad view of the Governing Council is that it remains an option, with the "reversal rate" yet to be reached, but that is not a uniform view, with German opposition to negative rates well known. Markets see it as a risk, with the Euro Overnight Index Average (EONIA) fully pricing in a 10-basis point cut in 2021. However, we suspect that the ECB will instead opt for a step up in the monthly pace of purchases under the Asset Purchase Program (APP) to €30 billion (currently €20 billion) when the PEPP ends in 2021.

Ultimately, policy is set to remain accommodative for a prolonged period. How long may depend on the ECB's strategy review, which may not be finalised until mid-2021. But in terms of staging, we would suggest that the ECB will raise rates - we forecast that in the fourth quarter of 2023 - before unwinding QE given concerns over the side effects of prolonged negative rates. Meanwhile, in the short term, the euro has become an unwanted headache for the Governing Council given the 10% rise in euro-dollar since May, prompting President Christine Lagarde to make her first verbal intervention. The tone was softer than that of her predecessors and reportedly toned down, given some Governing Council concerns over stoking a currency war with the US. We see the euro ending the year at $1.17, easing the pressure for tougher rhetoric, and rising to $1.25 in the fourth quarter of 2021.

After a benign summer, Covid-19 infections in the UK are climbing again. Even before the recent spike caused by the addition of more than 15,000 missing cases, the seven-day average of daily reported cases stood above 6,000 at the start of October, higher than the previous peak in April.

One reason for this increase is the expansion of testing, particularly as this is picking up milder and asymptomatic cases that would have remained undetected earlier in the year. Also, evidence shows the virus spreading most rapidly among younger people, who tend to suffer milder symptoms. However, infections are also rising among older people. Relative to the peak back in mid-April, daily death rates remain low (around 50), but are increasing, as are hospitalisations, and the experiences of France and Spain offer worrying lead indicators.

In addition to regional measures, the government has now also imposed national restrictions such as a 10pm pub curfew. Official economic data, for now, remain buoyant, reflecting the previous easing of the lockdown and the release of pent up retail demand. GDP rose by 6.6% on the month in July, after June’s 8.7%, while surveys point towards another punchy increase in August. Subsequently, growth is set to slow sharply as the direction of the measures swings the other way and as the Coronavirus Job Retention Scheme (CJRS) ceases at the end of October. We have trimmed our GDP forecasts to -9.0% for this year and +6.4% next (previously -8.4% and +6.8%), but a more material downgrade is a risk if the government judges more draconian measures are required.

We have not changed our view of the course of UK monetary policy and still expect the BOE to sanction a further £75 billion of asset purchases in November. The central bank also confirmed it would begin "structured engagement" with the Prudential Regulation Authority (PRA) to discuss operational considerations to deploy a negative interest rate if deemed necessary. Such an outturn is not our baseline view. But it is gaining ground in UK markets with markets now pricing in a 50% chance of a 25 basis point cut to -0.10%. Interestingly, bank lending to corporates fell back in July by £2.4 billion. There was, though, a clear split between large companies which have begun to repay loans and small- to medium-sized enterprises (SMEs), which are still hungry for cash.

Reports suggest an extension of the various government-backed lending schemes to support firms hit by the coronavirus. On broader fiscal matters, Chancellor Rishi Sunak hinted that he would also take "creative" steps to prevent an economic cliff-edge once the CJRS comes to an end. But rumours abound over tax rises in the future, including a Corporation Tax hike, higher Capital Gains Taxes, and more restrictions on tax relief on pension contributions. Looking at the fiscal metrics shows why. The deficit looks set to exceed £300 billion (16% of GDP) this year and net debt has already reached £2 trillion. But while Mr Sunak may at some point want to announce some tax clawbacks to reinforce the UK's fiscal credibility, economic uncertainty points to an expansionary budgetary stance for now.

Indeed, work by the International Monetary Fund (IMF) suggests that growth is more sensitive to fiscal policy changes when rates are low. Mr Sunak would prefer to ditch the "triple lock" on State Pension increases (max of 2.5%, CPI inflation and earnings growth) on cost grounds. But this would break a manifesto pledge. An idea is to suspend it for a year. Why? The answer concerns the quirks of the triple lock system. This year inflation is low, pay growth has slumped due to the CJRS, but the 2.5% guarantee will protect pensions. In 2021, pay growth will rebound sharply due to the CJRS "base effect", with pensions uprated by as much as 6%, an additional cost close to £6 billion.

Sterling slumped from its recent high close to $1.35 to a low of $1.27 in late September before recovering a little. The catalyst for the weakness was the UK Internal Market Bill. Ministers admitted that this contradicted parts of the Northern Ireland Protocol in the EU Withdrawal Agreement, thus breaking international law, risking a mass Tory rebellion in Parliament. Although a compromise was reached in Westminster, progress on a trade agreement with the EU remains slow and uncertain. In the latest developments, Mr Johnson and European Commission President Ursula von der Leyen agreed to 11 days of “intensified” talks to finalise a deal in time for the European Council summit on 15-16 October.

Our base case is still that the pound will remain unloved until a workable agreement is struck (just) in time for an orderly departure from the transition period at end-year. However, the risks of ‘no deal’ and of a further sell-off in sterling have clearly risen.