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COVID-19 crisis - economies, markets and policy responses

The reaction of financial markets to the spread of Covid-19 has been dramatic and, as economic statistics roll in over the coming weeks and months, and companies report their earnings, the actual scale of the damage will become clearer.

Whilst acknowledging that the situation, and the authorities’ responses to it, are changing by the day, we have put together our current thoughts on the economic and financial impacts and also suggested some possible policy actions that could be deployed to counteract the crisis.

Multiple economic strikes make this crisis more challenging

Economists point out that there are two important characteristics to note about the economic impacts of the Covid-19 crisis, marking it out from previous economic shocks:

  • Due to the speed of the virus’ progress across the globe, the shock has hit China and all the G7 nations simultaneously.
  • The medical impact is undermining economies at multiple levels. Every sector of the economy is impacted at once. In addition, significant additional healthcare spending will be necessary, which will draw resources away from other areas.

Explaining this further, economic shocks can be seen on three main fronts: the temporary hit to output due to sickness in the labour force; containment measures aimed at flattening the coronavirus curve; and, the expectations shock as consumers and companies defer expenditure.

The flow of money is disrupted

Practically speaking, the normal functioning of the “economic machine” is being disrupted in several ways. In simple terms:

  • Households in aggregate suffer a reduction in income and therefore reduce their spending on goods.
  • Less money flows from households to the government and to businesses.
  • Imports fall and the flow of money to manufacturing nations declines.
  • As foreign nations suffer a fall in incomes, so export sales are put under pressure due to waning foreign demand.
  • The drop in demand and/or direct supply shocks lead to disruption to international and domestic supply chains.
  • The hit is exaggerated by the “wait-and-see” behaviour of people and firms.

Debt and corporate zombies

The rapid accumulation of (non-financial) corporate debt in recent years adds to the risks faced by the global economy. The trend for super-efficient balance sheets and the popularity of share buy-backs, notably in the US, leaves some companies with only a narrow margin of safety to withstand more challenging times. This means that, at best, CEOs will now be forced to pull in their horns. In addition, less robust and so-called “concept” businesses, that have only survived this far because of readily available capital, will be vulnerable as financial conditions tighten and risk appetite evaporates.

Therefore, at this time of sudden economic shock, there is likely to be a greater volume of bankruptcies than would otherwise have been the case, creating yet further disruption to the flow of money.

Financial market impacts

Given that the scale of the economic dislocation cannot be estimated at this stage of the crisis, it is very difficult for the market to price in its effects. This is a recipe for extreme volatility and the likelihood is that last week’s trauma will be a recurring theme in the coming weeks/months. Indeed, there was no shortage of dramatic headlines, with some price moves unprecedented:

  • The S&P 500 index fell by 20% in a matter of 16 days, its quickest fall on record.
  • US small caps fell by 30% in three weeks - once again, the fastest fall in history.
  • The FTSE All-World index is back to where it was in October 2007.
  • The VIX index saw the second highest close in its history.
  • The FTSE 100 index dipped to levels seen in the late 1990s.
  • Sovereign bond yields collapsed, before staging a sharp reversal.
  • Credit spreads blew out dramatically in both investment grade and high yield markets.
  • A badly-timed spat between Russia and Saudi Arabia completely undermined the oil price.
  • The US dollar was sought out for its safe-haven status, as well as liquidity demands from the “sell everything else” trade.

The extent to which bonds, stocks and commodities sold off in tandem was unique: bond fund outflows were significant, notably from ETFs; risk parity funds were forced to de-lever, incurring substantial losses; even gold was not immune as investors sold whatever they could from all corners of their portfolios. All in all, it was the worst weekly loss for a portfolio of bonds and stocks since the global financial crisis.

Thoughts on current valuations

For now, we have to make the working assumption that the medical shock is transitory and that the authorities understand the scale of intervention now required to cope with this economic dislocation.

Given that corporate earnings for 2020 have to be dismissed, thoughts on the pricing of risk assets must be taken with a longer-term perspective. In the absence of a reference point for earnings, it is necessary to resort to starting valuations. In this regard, the good news is that the bulk of the world’s equity markets were not expensive ahead of this crisis and they are certainly substantially cheaper now.

However, the same cannot be said for the US equity market. The S&P 500 index rose by over 30% in 2019 (in US dollar terms) but this was achieved with barely any accompanying earnings growth. Therefore, the P/E multiple of the market expanded further as it re-rated. Despite the declines already witnessed, the US stock market remains expensive, especially as it is faced with an earnings vacuum.

One particularly troublesome issue is that the biggest buyers of US equities in recent years have been corporates themselves in the form of share buy-back programmes. Such activities will hardly be a priority in this time of crisis. Confirming this point, major US banks have just suspended buy-backs for the time being, pledging to use their capital and liquidity to support individuals and businesses.

The response required to prevent chaos

As we reflect upon the challenges ahead, the scale of the response from global authorities is critical. Breaching the gap between the beginning and the end of the economic dislocation will require a furious mix of fiscal and monetary policy. Delayed responses will be punished - see last week for reference.

Central banks are now opening the spigots in the form of interest rate cuts, asset purchases and other measures and importantly, they are working in a co-ordinated fashion. It is crucial that the authorities use the full force of their monetary and fiscal toolkits to avoid, at all costs:

  1. Credit markets seizing up.
  2. Banks calling in loans, instigating a large number of corporate failures.
  3. Individuals being made financially vulnerable through no fault of their own.

To our minds, we need to see the equivalent of a global business bail-out, similar in scale to the banking bail-out of the global financial crisis, with a focus upon the hardest-hit industries; airlines, tourism, retailing, restaurants are likely to be the prime candidates. Any concern for the moral hazard implied by such actions needs to be suspended, much as it was for the banking sector in 2008.

The fund manager response so far

In our various calls with fund managers last week, the focus was upon the strength of corporate balance sheets, competitive positions and the quality of management. Clearly, the main aim is to be invested in the survivors, as they will emerge from the crisis in a stronger position.

Although cyclicals may appear to be cheap, most managers are unwilling to jump in at this point. Any buying has been concentrated in the traditional defensive sectors, such as healthcare and food retailing. The beneficiaries of stay-at-home requirements have also been relatively robust - think Netflix.

Bond managers have been improving the quality of their portfolios in recent months, but liquidity is now at a premium.

We would also note that ahead of this crisis, few managers had significant cash allocations, which means that it will be challenging for them to take full advantage of any recovery.

Conclusion

Having navigated several crises since the 1990s, we have found that valuation is the only framework upon which to rely at such times.  With this in mind, we make the following observations:

  • Sovereign bonds: government bonds are priced for a crisis and if they remain at these yields, they assume a Japanese-style outcome for the global economy.  Governments now have the latitude to spend liberally and we suspect that they will take full advantage of this opportunity. It is very likely that the green deal becomes a healthcare deal, which will be equally palatable to the population at large.  In short, you cannot make an argument for sovereign bonds on a valuation basis unless you believe in a continuously bleak scenario.
  • Credit: on the assumption that the global authorities understand the need to secure corporate balance sheets and provide the funding required, a significant credit spread widening does not have to turn into a complete crisis. However, the illiquidity in credit markets has the capacity to exaggerate any moves and so we must hope and pray that central banks grasp this point. We anticipate further spread widening, but we do not have to see a repeat of the 2008 experience, unless significant policy errors are made.
  • Equities: the over-valuation of the US remains a significant challenge. The market has not been cheap for a decade and the scale of this crisis implies that it should de-rate much further. On the assumption that the authorities understand the sheer scale of the required response, we should see a relief rally, notwithstanding further re-tests of the lows in the coming weeks. If not, we anticipate further significant losses in US equities.

Outside of the US, most other equity markets are either cheap, or at worst, on the right side of fair value and are already discounting a degree of chaos. However, as we know, when the US stumbles, the rest of the world falls over.

Strategy

If you feel you are already over-exposed to equities, take advantage of any relief rallies to reduce your allocation.

If you are under-exposed, it would not be unreasonable to start accumulating positions on days of weakness. Emerging markets are potentially interesting as they were unloved and under-owned before this crisis began.Equally, selected European and UK equities are beginning to offer value. However, given heightened volatility and the likelihood of further bouts of weakness, we suggest an incremental approach to any buying.

We were keen on allocations to real assets prior to this crisis and it is quite clear that gold has a place at this juncture.

In the longer term, we believe that the governments of the world will lead a global reflation trade, the likes of which we have never witnessed before. In such a highly leveraged world, there is now no alternative but to inflate or write off the debt in the future.

In short, a very different and more complex investment landscape is likely to emerge in the next few years.

Peter Toogood, Chief Investment Officer, The Adviser Centre Limited and Embark Group

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