In the first quarter of 2020 the Dow Jones Industrial Index declined 23%, which makes it the worst quarter in its 135-year history. However, the Dow declined 38.4% from February 19th till March 23rd before a rebound in the last week of March. Markets have never dropped this far this fast before.
A month ago, there was still hope that the Coronavirus outbreak could be brought under control before it would paralyze the global economy. Since then, the number of new, recorded COVID-19 cases has mounted every day and outright fear prevails.
At the moment, a painful global recession is underway. Consumers are not spending; firms are facing a cash crunch and potential bankruptcy. And globally employment will be slashed. The next few quarters could result in some of the worst Gross Domestic Product (GDP) growth numbers since the Great Depression.
Risk assets have very quickly discounted this dire scenario. The global stock-to-bond ratio has collapsed by 47% since its peak in January. 10-year US bond yields temporarily fell below 0.4%. The dollar has rallied against every currency and even gold traded below $1500 an ounce. Brent crude trades below $30/bbl.
In this context, investors must assess if risk asset prices have declined enough to compensate for the economic hazards created by the COVID-19 pandemic. If the massive amount of monetary and fiscal stimulus announced can turn around the economy in the second half of the year, then stocks and risk assets are attractive. Otherwise, they are still not cheap enough.
Historical Market Comparisons
It is important to remember this is a medical crisis and the situation is not comparable to the Global Financial Crisis (GFC) of 2008 or even the 1930s depression. While the shock is of unknown depth and duration, what we do know is that the containment measures and social distancing almost automatically bring economic activity to a halt. The impact on economic activity will likely be sharp and deep.
We see the shock as akin to a large-scale natural disaster that severely disrupts activity for one or two quarters, but eventually results in a sharp economic recovery.
The Organisation for Economic Co-Operation and Development (OECD) released its estimate of the economic impact of COVID-19 lockdown policies around the world. The sobering conclusion of the OECD’s work is that the initial direct impact of the shutdowns could be a decline in the level of output between one-fifth to one-quarter in many economies.
Put differently, the OECD’s estimates imply a decline in annual GDP growth of up to 2 percentage points for each month that strict containment measures continue. If the shutdown continued for three months, with no offsetting factors, the OECD’s research suggests that annual GDP growth in OECD economies could be between 4-6 percentage points lower than it otherwise might have been.
Fortunately, monetary and fiscal authorities are responding forcefully to the crisis, but the length of the lockdowns remains a major source of downside risk to the economy. We see encouraging signs from major central banks and governments that monetary and fiscal response is starting to take shape.
The pledged policy response has been swift, and we expect total fiscal stimulus to be similar in size to that of the global financial crisis but compressed into a shorter timeframe.
At this moment, global governments have pledged an amount of economic stimulus equal to 5% of global GDP. In the US, the Coronavirus Aid, Relief, and Economic Security (CARES) Act provides for fiscal spending on the order of 10% of GDP, the majority of which is likely to be spent this year.
The global economy is now in recession and this has occurred because policymakers saw it as the lesser of two evils. They judged, with good reason, that a temporary shutdown of most non-essential economic activities was a price worth paying to contain the virus.
Outside of China, the level of real GDP is likely to be down 1%-to-3% in Q1 of 2020 relative to Q4 of 2019, and down another 5%-to-10% in Q2 relative to Q1. On an annualized basis, this implies that GDP growth could register a negative print of 40% in some countries in the second quarter, a stunning number that has few parallels in history.
Growth in China should stage a modest rebound in the second quarter, reflecting the success the country has had in containing the virus. Nevertheless, the level of Chinese economic activity will remain well below its pre-crisis trend, with exports increasingly weighed down by the collapse in overseas spending.
A One-Two Punch
The “sudden stop” nature of the downturn stems from the fact that the global economy was simultaneously hit by both a massive demand and supply shock. When households are confined to their homes, they cannot spend as much as they normally would.
This is particularly the case in an environment of heightened risk aversion, which usually leads to increased precautionary savings. At times like these, businesses also slash spending in a desperate effort to preserve cash. All this reduces aggregate demand.
On the supply side, production has been impaired because of workers’ inability to get to their jobs. According to the Bureau of Labor Statistics, less than 30% of US employees can work from home. Since modern economies rely on an intricate division of labor, disturbances in one part of the economy quickly ripple through to other parts. The global supply chain ceases to function normally.
The fact that both shocks have been concentrated in the service sector, which represents at least two-thirds of GDP in most economies, has made the situation even worse. During most recessions, the service sector is the ballast that helps stabilize the economy in the face of sharp declines in the more cyclical sectors such as manufacturing and housing.
This time is different.
The Night Is Always Darkest Just Before Dawn
“The night is darkest just before dawn. But keep your eyes open; if you avert your eyes from the dark, you’ll be blind to the rays of a new day…So keep your eyes open, no matter how dark the night ahead may be.”
― Hideaki Sorachi
Right now, we are fighting an invisible enemy that is ravaging the world. However, victory might be in sight. The number of new infections has peaked in China and South Korea. We should watch Italy closely. If the number of new infections peaks there, that would send an encouraging signal to financial markets that other western democracies will be able to get the virus under control.
While it is too early to be certain, this may be happening: Both the number of new cases and deaths in Italy have stabilized over the past week. Of course, there is still the risk that the number of new infections will rise again if containment measures are relaxed prematurely. Nevertheless, it is likely that global growth will begin to rebound in the third quarter of this year.
President Trump signed into law the Coronavirus Aid, Relief, and Economic Security (CARES) Act. The bill provides fiscal stimulus of $2.2 trillion (or 10% of GDP), with at least 46% of the spending taking the form of direct funds for households and small businesses including $290 billion in direct cash handouts to middle-class households.
For investors, the passage of the law shifts the question about stimulus from “how big?” to “how effective?”. It is difficult to answer that question with high confidence because it depends in large part on the duration of the physical distancing measures in place.
But at least two factors argue in favor of its effectiveness: the total size of the plan is large relative to other countries and relative to the fiscal stimulus that occurred in 2008/2009, and the plan will disproportionately benefit lower-income Americans who will likely need assistance the most. And U.S. politicians have already hinted that a second stimulus package might be a possibility if necessary.
The Fed has also dusted off the whole alphabet of programs created during the financial crisis to improve proper market functioning, and has even added a few more to the list, including a program to support investment-grade corporate bonds and another to support small businesses.
The good news is that there is no limit to how many dollars the Federal Reserve can create. The Fed has already expanded the supply of bank reserves by initiating the purchase of $500 billion in treasuries and another $200 billion in agency Mortgage-Backed Securities (MBS) since relaunching its Quantitative Easing (QE) program on March 15th. Further MBS purchases will be especially useful given that mortgage rates have not come down as quickly as Treasury yields.
The Shape of Recovery: L, U, or V?
Provided that the number of new infections around the world stabilizes during the next two months, growth should begin to recover in the third quarter. What will the recovery look like?
From the perspective of sequential quarterly growth rates, a V-shaped recovery is inevitable simply because a string of quarters of negative 20%-to-40% growth would quickly leave the world with no GDP at all. However, thinking in terms of growth rates is not the best approach. It is better to think of the level of real GDP.
The following chart shows three scenarios:
1) A rapid V-shaped recovery where output quickly moves back to its pre-crisis trend.
2) A sluggish U-shaped recovery where output slowly rebounds starting in the second half of the year.
3) An L-shaped profile for real GDP where the level of output falls and then remains permanently depressed relative to its long-term trend.
In the end it will depend on how long it takes before the world will be able to go back to work. But when it does, the amount of fiscal stimulus will likely help the global economy to rebound in a way that is in between a V and U shape.
In other words, we are more positive on the economic rebound than the majority of the current media reports
Government Bonds: Deflation Today, Inflation Tomorrow?
As noted at the outset of this report, the current economic downturn involves both an adverse supply and demand shock. Outside of a few categories of consumer staples and medical products, we expect demand to fall more than supply, resulting in downward pressure on prices. This deflationary shock will be enlarged by rising unemployment in the short-term.
Looking beyond the next 12-to-18 months, the outlook for inflation is less clear. On the one hand, it is possible that the psychological trauma from the pandemic will produce a permanent, or at least semi-permanent, increase in precautionary savings. If budget deficits are reined in too quickly, many countries could find themselves facing a shortage of aggregate demand. This would be deflationary.
On the other hand, one can easily envision a scenario where monetary policy remains highly accommodative and many of the fiscal measures put in place to support households are maintained long after the virus is eradicated. In such an environment, unemployment could fall back to its lows, eventually leading to an overheated economy, which would lead to higher than expected inflation.
Our View of All This
In our view we think that the more inflationary scenario will unfold over the next 2-to-3 years is more likely. Interestingly, that is not the market’s opinion. For example, the 5-year US Treasury Inflated Protected Securities (TIPS) breakeven inflation rate is currently only 0.69% and the 10-year rate is 1.07%. This means that a buy-and-hold investor will make money owning TIPS versus fixed coupon Treasuries if inflation averages more than 0.69% per year for the next five years, or 1.07% per year for the next decade. That is a bet we would be willing to take.
Where to for the Equity Markets
In order for equity markets to find a bottom and start a more sustainable recovery, markets need to have more visibility on the potential economic outcome. Right now, the market does not see the light at the end of the tunnel but that could change quickly if we see the growth rate of the number of new infections starts to decline, especially in the U.S.
If and when that happens investors can start to estimate the length of the showdown and equity markets will quickly start to discount any recovery.
As mentioned before, we think the outlook is not as dire as the market now thinks. The extraordinary amount of fiscal and monetary stimulus will limit a lot of the current damage. And the market is discounting a lot of damage at this moment. It is hard to say if equity markets have reached their bottom or that there will be further downside in the coming months, but we do think that equity markets are likely to be higher on a 12-month basis.
Some of the sector that had the largest selloffs like energy and financials could become outperformers in such a rebound.
The recent market volatility has been extreme, and it was made worse by the fact that liquidity in the market was severely disrupted, which led for example to a large selloff in investment grade fixed income Exchange Traded Funds (ETFs) and funds.
Only when the Fed stepped in and announced effectively unlimited liquidity operations, markets started to normalize.
In such volatile markets we decided to stick to the strategy and not make any changes.
Given the large movements in the stock versus bond ratio we do think equities have a much more attractive long-term expected return versus fixed income and a rebalancing of the portfolios back to their strategic allocation will be opportune once market volatility calms down.