Investment Update: Making sense of the bounce
A peak in new cases is just one milestone on a still-uncertain road to recovery
Since our last Investment Update in late March, stock markets have continued to rally. The global equity benchmark is now 25% above the low point set on 23 March, led higher by the US market in particular. Naturally, we need to ask if investors have become too complacent. Are they placing too high a probability on a sharp ‘V-shaped’ recovery, where economic activity and profits start to pick up from the second half of 2020? We’re comfortable staying invested, with a defensive position, but for reasons outlined below, markets could be vulnerable to another leg down.
- Signs of a peak in new cases have fuelled investor optimism
- But this is just one milestone on a rocky, uncertain road to recovery
- Markets will look beyond what’s likely to be a record Q2 contraction
- Aggressive stimulus measures are helping, and we don’t see them leading to high inflation
- We see a 50-50 probability of a V-shaped versus protracted recovery
- The more investors price in an optimistic scenario, the more vulnerable markets are to another leg lower
Looking past the peak
Optimistic investors are pointing to the peak in the daily number of new cases of COVID-19 that appears to have been reached in many hard-hit European countries. Indeed we’ve marked a peak in new cases as an important waypoint on the road to recovery. New cases per day in Italy appear to have peaked on 20 March. Taking the nine large Western Eurozone countries together, they appear to have peaked on 1 April. But it is not clear that new cases have peaked in the US or across the world in aggregate. While not wanting in any way to trivialise the human suffering caused by this pandemic, a better measure of its peak may be death rates, rather than new cases. That’s because some countries have reportedly restricted their testing regimen (and therefore their confirmed new cases) to hospitalised patients only.
We believe a peak in the aggregate is the waypoint to watch for. The major developed economies, their financial sectors, and their stock markets are simply too globally integrated for a meaningful recovery in activity and profits to occur without an abatement of the virus and social restrictions across all of them. A recent modelling exercise from the Bank of International Settlements showed that even if a country engineers a domestic policy response that successfully limits its domestic slowdown, it will not be immune from insufficient or ineffective policies put in place in other parts of the world. For example if domestic activity in Europe were able to recover strongly at the end of the second quarter (Q2), to the extent that the initial domestically-generated shock to GDP in 2020 was only -2.5%, the total decline in GDP after four quarters would still be between 6.5% and 10% if other regions continued to suffer.
As an example of the power of global integration, remember how the subprime mortgage market in southern, coastal America in 2007 turned into what was then the biggest global recession recorded in peacetime in the best part of a 100 years?
One milestone on a rocky road
Even if the virus and its death toll do peak soon, there is still considerable uncertainty for markets to contend with. How long will lockdowns continue after the peak? How long will social distancing measures constrain consumption and investment after the lockdowns end? China, by way of example, is taking a lot longer than expected to resume normal operations. New cases peaked in February, yet the economy is still only back to c.85% of operating capacity. Schools, restaurants and large-scale events are still shuttered or operating under tight restrictions.
Furthermore, we don’t know if we will see a second peak once restrictions are eased. Or if that second peak is likely to be higher or lower than the first? What might be the policy response to it?
Investors must assess if at today’s prices potential future returns provide sufficient compensation for all the uncertainty around the estimates of tomorrow’s earnings.
The worst quarter on record
With half of the global population living under lockdown, including almost all high-income economies, it is clear that the second quarter of 2020 will see the largest contraction in GDP since at least 1946, and quite possibly since robust record-keeping began earlier in the twentieth century. Indeed, some data from March has already set new records. US industrial production contracted by more than in any month since records began in the 1950s. Surveys of business confidence in Europe have fallen to previously unthinkable lows.
With lockdowns continuing for longer than expected, economists’ forecasts have been revised down almost universally since late March. Britain’s Office for Budget Responsibility (OBR), the Treasury watchdog, has released one of the most bearish estimates, at -35% in the second quarter. This is so pessimistic because they assume that the UK will live under full lockdown until July. Yet, almost three and a half months of full lockdown seems unlikely (not least because the future death toll from the cessation of cancer screening or unemployment-related health problems will begin to gain on the number of lives saved from coronavirus). Moreover, the OBR’s estimate of the monthly impact is also at the more pessimistic end of forecasts among its peers. The National Institute of Economic and Social Research suggests -20% for each month, significantly less than the OBR’s -35%.
Turning to estimates for global GDP, the International Monetary Fund (IMF) believes the global economy will contract by 3.0% in 2020, larger than the contraction during the financial crisis, before rebounding by 5.8 per cent in 2021. So that’s still a large contraction in 2020, despite a V-shaped recovery. The IMF highlights the risk of greater downside, which we agree with. But even in a pessimistic scenario it seems unlikely that recession will continue for 19 months, as it did in the US in 2007-2009.
Forget about the second quarter
In a recent Goldman Sachs survey of institutional investors, half of the respondents did not think the economic data would matter in April (the other half were focused on central bank actions). Indeed, markets remained calm even as US weekly unemployment claims soared to levels that would be consistent with an unemployment rate of around 20% for April.
This is because, for now at least, fiscal and monetary stimulus is doing a good job of keeping firms and households liquid and solvent. For example, the US unemployment rate matters less when unemployment insurance payments are now so incredibly generous as a result of the Coronavirus Aid, Relief, and Economic Security (CARES) Act. We estimate that the average unemployment insurance benefit will be $972 a week, which is actually $29 above the median $933 wage for full-time employees in the fourth quarter of 2019. So, in most states and most sectors, the median unemployed person is likely to be earning more than the median full-time employed person for the next four months.
We are a little more concerned about the efficacy of fiscal stimulus in the UK. Here Treasury policy has tried to save jobs rather than increase the replacement rate of unemployment benefits. But there have been reports that claims for Universal Credit have rocketed by more than the government expected, and that suggests that companies are firing staff rather than furloughing them and claiming 80% of their wages back from the government. Therefore there is a risk that that the UK economy could face a larger drop in the standard of living than the US and possibly Europe. If somebody earning £30,000 a year (the median annual salary) loses their job, universal credit only replaces c.20% of lost income.
At the same time, the Federal Reserve’s vast emergency measures are set to inflate its total balance sheet to a record $9.3trillion, or 43% of US GDP, more than doubling its size. Huge quantities of liquidity are available to a myriad of international markets to keep money moving. The Bank of England’s balance sheet is likely to expand by 20% of GDP.
For now, central bank stimulus has meant that financial conditions have tightened by much, much less than they did in 2008. Bond spreads – how much firms pay to borrow above the rate at which governments borrow – have fallen markedly over the past two weeks, and our fixed income team reports much more stability in quoted prices. Very short-term corporate credit, called commercial paper, had remained stubbornly expensive, but this market has started to ease now too after central banks stepped in.
…focus on Q3 and Q4
To be sure, we expect that the sudden stop to the economy will result in more defaults than we would normally see during a recession, even if the recession turns out to be a short one. But, as we explained in our last update, that doesn’t make it a financial crisis, which would have far graver repercussions and weigh down growth for years hence.
The extent to which companies will default depends on the extent to which incomes are curtailed in the second half of the year. This remains an enigma. In the past, economies have shown at least one quarter of inertia after a negative shock. In other words, even in short lived recessions after which lost output is recouped (what we refer to as a V-shaped recovery) the rebound doesn’t tend to occur immediately.
Of course this time may be different, but in either direction. On the one hand, lockdown is a deliberate policy of artificially lowering aggregate demand and supply, so activity could bounce back more quickly than usual once the measures are relaxed, especially considering the government stimulus. On the other hand, the disruption of global value chains or the potential for consumers to remain risk averse could result in even longer drags on spending than usual. So too could the impact of potential permanent changes in the size of certain industries or consumption patterns, which are difficult to estimate.
We still don’t know if the IMF’s base case of a V-shaped recovery is more likely than a more adverse and longer delayed ‘L’-shaped recovery. That means assigning a 50% probability to each. Using some longstanding valuation frameworks to estimate ‘fair value’ in both scenarios (with the caveat that with unprecedented uncertainty, even such mathematical estimates are more art than science), the market looks vulnerable to another leg down. Equity indices are currently approaching fair value for an optimistic scenario, while getting further away from fair value for more protracted disruption. Another leg down is not a certainty of course, and we remain comfortable with an approach of staying invested, but with a defensive positioning. We would not be comfortable with adding more risk.
That said, our bottom-up analysts have identified equities, bonds and funds that appear to offer value for long-term investors. We continue to favour quality, growth-oriented companies, particularly those that may benefit from any structural changes to economies and societies that the coronavirus may catalyse.
A final word on inflation
Finally, we know that a number of our clients have been asking about the possibility that all of this monetary and fiscal stimulus results in inflation. Although equities tend to do best in periods of slightly above-average inflation, very high inflation is a threat to portfolio returns.
Some clients have even mentioned the word hyperinflation. Hyperinflation is more an institutional phenomenon than it is a monetary one. It occurs when a government abandons its credible commitment to maintaining price stability and repaying its debts without resorting to devaluation. For example, hyperinflation ended in central Europe in the 1920s a few months before the money supply stopped rising at an eye-watering rate. It ended with institutional reform.
Today, inflation-targeting central banks are still independent. And governments are allowing budget deficits to balloon only in response to an unprecedented shock to the economy. Just as in times of war, markets forgive them for such largesse. The credible commitment that prevents hyperinflation is intact.
If we do get a V-shaped recovery (and that’s already 50-50 in our opinion) it is certainly plausible that inflation may rise, but it is far from a given. Indeed we are as much concerned about the risk that inflation remains stubbornly low, even if the recession is short-lived.
Many commentators warned of sky-high inflation after central banks first expanded their balance sheets in 2008. But the lesson from 2008 to 2015 is that central bank balance sheet expansion on its own is not sufficient to induce inflation. Commentators often cite Milton Friedman, one of the few economists familiar to people beyond their field. But his ‘monetarism’ in its most simplistic form (i.e. central banks print money, inflation goes up) does not hold empirically.
Indeed monetarism is not taught in universities anymore. The best bits of Friedman have been added into frameworks that do a much better job of explaining how economies work because they consider things which independently influence the so-called ‘velocity of money’, especially the role of commercial banks (which do most of the money ‘creating’). (Indeed, ever a social scientist to be admired, Friedman himself admitted towards the end of his long life that the velocity of money is actually an independent variable, and the new research backing that up is credible). The velocity of money is the rate at which the money supply circulates through the economy. It is extremely important because it is related to inflation expectations. In other words, inflation depends not just on the money supply but on the public’s willingness to hold money. The problem today (and, indeed for the last thirty years) is that people want to hoard money, and that’s disinflationary.
Now, as we have written before, our research suggests that it is unlikely that this recession will be accompanied by a banking crisis this time, and so inflation is likely to spring back faster than it did after 2008 because we won’t be grappling with the prolonged deflationary balance sheet effects of such crises. But there will still be some things holding back the velocity of money, and so there will remain some disinflationary pressures. For example, corporate saving will likely be a little higher than usual due to the need for many companies to pay back some of the fiscal and monetary stimulus that has been dished out so far. Another important example is that governments are likely to return to austerity (especially in countries with right-wing governments – Rishi Sunak has hinted as much a couple of times). Meanwhile central banks can remove some of their stimulus if inflation does seem to be rising more than expected.
It’s also worth considering the inflation implications of any structural shifts which might be catalysed by the crisis. Most of the ones we can think of (eg. a greater shift from the physical to the digital economy, or a move away from city-centre commercial real estate) are also mildly disinflationary.
All that said, we must emphasise once again that the unprecedented nature of this shock means that there is considerable uncertainty as to how the economics of it all plays out. We will certainly monitor early indicators of inflation in case our thesis is wrong. For now, we think the risks are contained.
When the coronavirus sell-off was at its worst, we felt markets were closer to pricing in the worst case scenario. Now they seem to have swung clearly to the side of optimism. But as we said before, we don’t have a crystal ball. We can’t know what will happen in a few days, let alone a few months. We must be honest about the probabilities and remain grounded by them, investing with rigour and analysis, not fear or greed.