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:
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:
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 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:
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.
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:
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.
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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