CIO warns that markets may have reached their limits and continued hardship could lead to rising insolvencies
Many risk assets appear detached from underlying economic fundamentals and there are deep concerns heading into what promises to be a dark winter.
That’s the view of Michael Hasenstab, CIO of Franklin Templeton Global Macro, who believes that, after a summer of optimism, financial markets have cooled with the weather and shown clear signs of reaching their limits. Equity prices have pulled back and credit spreads have widened. He expects economic hardship to persist, leading to greater cost-cutting by businesses and rising insolvencies.
Central banks’ huge stimulus programmes may have been effective at maintaining liquidity across financial markets, but he stressed their interventions do not replace lost revenues or cure insolvencies, only deepen the debt burdens. Hasenstab believes that these factors mean risk assets remain vulnerable to a correction as the pandemic persists.
He said: “Economic recoveries in many regions have recently shown signs of leveling off, demonstrating that much of the previous improvements in the late spring and summer months were rebounds from the extreme low points in March and April, not growth trends that could be extrapolated through upcoming quarters. We remain concerned that as the pandemic persists through the fall and winter months, business insolvencies will worsen with each month of stifled activity.”
Compounding this is the likely hibernation of many Canadians. As the temperature plummets, people will feel more and more compelled to stay indoors, increasing the risks for rising infections and further suppressing economic activity. The results: more market volatility. Hasenstab explained: “A global recovery is likely to remain gradual, in our view, with the potential for multiple stages of relief rallies and corrections in financial markets before a more sustainable growth recovery eventually takes hold.
“Adding to the complexity of the globally synchronized crisis is the precarious state of the world that existed before the pandemic. Geopolitical tensions, unorthodox policymaking and political polarizations have made it difficult for countries to find the collective goodwill needed to address both domestic and international challenges during the most profound economic shock in the post-war era. Geopolitical risks remain elevated as the United States heads toward an election and the United Kingdom struggles to agree to terms before its end-of-year deadline for withdrawal from the European Union.”
He also said that deglobalization is accelerating during the pandemic, adding that possible structural shifts toward domestic production and regional supply chains would have major implications for the global economy and financial markets in the decade ahead.
The CIO also cast doubt on the level of fiscal stimulus deployed by some countries from an economic perspective. How will those already burdened with high debt levels pay for massive pandemic relief programs?
“Large stimulus measures may be unavoidable in the near term, but responsible fiscal governance will be essential to debt sustainability going forward,” he said. “Unorthodox policies such as modern monetary theory and debt monetization are likely to see greater political interest in upcoming years, increasing the risks for structural damage by imprudent governments. This makes it ever-more crucial to monitor policy across developed and emerging markets alike, to identify which sovereigns have their fiscal houses in order or the ability to bring them to order, versus those that do not.”
The debt levels in the United States, Hasenstab said, will have long-term ramifications. It is projected to exceed 100% of gross domestic product (GDP) over the next decade with a fiscal deficit heading toward more than 5% of GDP by 2030. Short-term US Treasury yields are likely to remain anchored by monetary accommodation in the near term, but surging fiscal deficits, massive debt levels and inflation pressures will “eventually drive term premiums higher”.
So, what’s the strategy? How should global investors approach the current environment. Franklin Templeton Global Macro views the crisis in two phases, with the markets currently in the first phase, which is characterized by a prolonged period of elevated risk and uncertainty. It expects the second phase to feature a more sustainable recovery, shortly preceded by periods of distorted asset prices and compelling investment opportunities. This is where the opportunities are as investors look ahead.
He said: “In phase one, we are maintaining a largely defensive stance that focuses on higher allocations to safe-haven assets, lower duration exposures in select emerging markets, broad risk reductions and optimized liquidity. In phase two, we anticipate pursuing undervalued risk assets, with a particular focus on distressed valuations in higher duration local-currency sovereign bonds, emerging market currencies, and various credit sectors.
“We remain confident that these types of phase-two investment opportunities will ultimately arise, but we also recognize that the pandemic may persist for multiple quarters, potentially pushing out the timeline for when certain investment opportunities may become suitable. Until that point, we continue to glean new information and new insights amid the evolving crisis, as we monitor the global economy on a country-by-country basis to uncover current and future investment opportunities.”