LOOKING BENEATH THE SURFACE

The Monthly Five Author Avator

Katie Nixon, CFA, CPWA®, CIMA®

Chief Investment Officer, Northern Trust Wealth Management

November 19, 2021

Recent global government actions are top-of-mind for investors as they carefully assess how authorities are responding in their efforts to navigate an array of largely, though not exclusively, COVID-related impacts. As always, a careful look beyond the headlines and headline numbers adds critical context. Below, we discuss the implications of rising case counts in Europe, inflation in the Euro area, Japan’s ambitious new economic plan — and our own potential “Build Back Better” plan.

1

A Hiccup in the “Re-Reopening.”

The rise in the number of COVID cases across 30 U.S. states and parts of Europe has grabbed headlines recently, with fears rising that we may be headed for a tough winter season. Our premise remains that authorities have pivoted from trying to prevent infection to a focus on managing the virus — ensuring that hospital capacity remains adequate and encouraging (in a variety of ways) vaccination. This distinction is important as we believe the risk of large-scale lockdowns and related significant economic disruptions to be relatively low. That premise is being tested, however, and we are monitoring closely what is happening in Austria, which will reimpose a full lockdown on Monday and will require all citizens to be fully vaccinated by February 1st. The concern is that Germany — the largest economy in Europe and one that is experiencing a significant 4th COVID wave — would consider similar measures. Almost regardless, we anticipate that the rise in cases in Europe will be a modest headwind to growth and a possible tailwind to inflation as any mitigation measures put in place can exacerbate the well-known supply chain issues and labor shortages. In the U.S., while we see cases rising, we do not anticipate draconian mitigation measures to be put in place given now widely available booster shots, the approval of COVID vaccines for younger children and improved available treatments. We do estimate, however, that the rise in cases may delay the handoff from goods spending to spending on services as well as the anticipated recovery in some of the sectors most impacted by COVID.

2

Looking Beneath the Surface.

While we have focused the past several weeks on the relatively high inflation data out of the U.S., it has not gone unnoticed that inflation has risen beyond our shores as well. The 4.1% headline and 2.1% core inflation print for the Euro area in October represented an increase from the 3.4% and 1.9% respective pace of September, but looking at the details presents a more balanced picture. When we correct for the impact of the surprise (and temporary) reduction of the value-added tax in Germany, the headline number drops to 3.6% and core inflation to 1.9%. Importantly for investors, the European Central Bank (ECB) will not react to this data and will likely keep policy rates until 2023 at the earliest. This view is consistent with market expectations as well. The ECB will hold back until the pictures on growth, inflation, energy costs and COVID are clearer. The market view of U.S. rate hikes is decidedly different, however, with investors pricing in 2 rate hikes for next year. The release valve for the central bank divergence has been through the currency channel, and the U.S. dollar has strengthened significantly relative to the Euro, dampening U.S. dollar returns in non-U.S. investments.

While it is tempting to either try to time, or to hedge, currency exposures, investors would be well served to look over the long term and recognize that currency hedging in risk asset portfolios is ill advised.

3

The Land of the Rising Sun.

Fumio Kishida, Japan’s new prime minister, announced the details around the highly anticipated fiscal stimulus plans aimed at re-energizing the moribund economy. The $490B plan — the country’s largest to date and representing a full 10% of GDP — takes a page out of the U.S. playbook, with direct payments to households as well as support to businesses. The direct payments to households has proved a bit controversial: The plan affords one-time cash payments of nearly $900 per child under the age of 18 with some income limits, and the question is whether that is effective in a society with a high propensity to save and an aging population. This package will be financed by issuing debt in a country where debt-to-GDP is already >250%. This plan has been approved by the cabinet and now will proceed to a parliamentary vote. Japan, the world’s third largest economy, was already stumbling pre-pandemic, and the pandemic-related mitigation measures have exacerbated the strains, with GDP shrinking at a 3% annualized rate in Q3. For investors, Japan represents over 20% of the ACWI ex-U.S. index.

4

China Update.

We recently lowered our growth expectation from “surprise” to “disappoints” for China and remain underwhelmed by the policy response to what is clearly an economic slowdown. Our expectation, looking at the past as precedent, was that we would see a meaningful fiscal and monetary response designed to offset the growth headwinds that have emerged. So far, the response has yet to materialize. The economic headwinds are largely self-inflicted: regulatory crackdowns on various industries and in particular to the property sector, where the Evergrande situation has emerged as the poster child for an industry that desperately needs more oversight. The property sector in China is extremely important in several ways, but particularly as it pertains to economic growth and household confidence. It is estimated that real estate accounts for up to 25% of GDP and represents 2/3 of household wealth. As we think through this issue, the risk case has been a disorderly unwind of the highly leveraged sector; however, that risk has dissipated over the past week as authorities have worked to ring-fence the financial damage and prevent contagion. While the risk case has a lower probability, the base case of weaker growth has become stronger — meaning, the premise that growth disappoints to the downside as strong export activity is not enough to fully offset the property sector growth headwinds. For investors, however, it is important to recognize that we buy companies and not countries.

5

U.S. Fiscal Update.

The House passed the nearly $2T “Build Back Better” infrastructure plan after the Congressional Budget Office (CBO) released the cost analysis that several centrist congressional Democrats were awaiting. According to the CBO, the plan will increase the deficit by more than $367B over 10 years, a figure some question given it does not consider any potential revenue from stricter IRS enforcement, which some estimate to top $200B. Now the bill will head to a complex process in the Senate, where we anticipate revisions will be needed to shore up Democrat support, particularly from Senators Joe Manchin and Kyrsten Sinema. While Senator Sinema may vote “yes,” Senator Manchin is still signaling skepticism and a desire to hit the pause button, particularly given his focus on inflation (running high) and the deficit (expected to grow under this bill). At this point, and looking at the various components of the bill as written, we are not adjusting our growth outlook. Although this certainly represents fiscal stimulus, the timing of the economic impact and the multiplier effect are wild cards.



Please note that the Weekly Five will not be published next week due to the Thanksgiving holiday, with publication resuming Friday, December 3.

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