Europe has started 'dancing' with COVID-19

Main macro themes

While the US finally seems to have peaked, we continue to see countries struggling with local/regional outbreaks. In many European countries, such as Germany, France, Belgium, The Netherlands, the UK and Denmark, the number of new cases is moving slightly higher, although it is too early to call these second waves. In other words, we have begun the 'dancing' part of the 'hammer and dance' strategy, which we believe will probably continue until a vaccine is ready. However, we know if the situation is not handled correctly, it can quickly spin out of control, as we have seen in Australia (state of Victoria), Japan (Tokyo), Hong Kong and Israel.

More evidence emerged that Europe's economy is on course for a swifter recovery from the coronavirus crisis than the US. Euro area PMIs rebounded strongly in July, confirming the picture of recovery. However, US indicators have lost pace following the flare-up in infections (see page 3). Chinese GDP for Q2 showed a stronger-than-expected rebound to 3.2% y/y, from -6.8% y/y in Q1.

White smoke at last emerged from Brussels on a Recovery Fund after a marathon EU summit yielded a compromise on the 'Next Generation EU' package (see Flash Comment - EU Recovery Fund: White smoke at last, 21 July). Following tough negotiations, EU leaders agreed on a EUR750bn recovery fund and a EUR1,074.3bn EU budget (over 2021-27). The package received a frosty welcome in the European Parliament though, keeping some uncertainty in place.

Stimulus in the euro area and the US has not changed over the summer. At the July ECB meeting, there was no real news. In the US, the Fed maintained its current signals that it is nowhere near tightening monetary policy again and that it will continue to use all its tools to support the economy. We continue to believe the Fed will strengthen its forward guidance at the September meeting by saying that it will not hike the Fed Funds rate until inflation has been above the 2% target for some time, after several years of undershooting. Unfortunately, the negotiations on a new stimulus bill in the US are not moving forward. We expect the eventual deal to include a reduction in benefits, which would work as a drag on growth in H2 (see Research US - Not extending higher unemployment benefits would lead to a significant negative income shock, 22 July).

US-China tensions are increasing again. Most recently, President Donald Trump issued two executive orders prohibiting TikTok and WeChat from operating in the US. It looks increasingly likely to us that the two powers are heading for a new cold war (see Research China - At the foothills of a new cold war - and what it implies).

Fixed income and FX developments

Risk-on sentiment dominated markets in July, leading to higher equity prices and tighter credit spreads. Growth signals in Europe and China and encouraging news on the COVID-19 vaccine front are underpinning markets. Ongoing strong policy support from central banks also keeps spirits high. EUR/USD has moved significantly higher over the past few weeks and US and German bond yields have drifted lower (see charts on page 2).

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