WHERE DO WE STAND?
COVID-19 is taking an unprecedented toll on the socio-economic fabric of society.
The ability to have confidence in the future is key to stability – both in economies and in capital markets. As anxiety amongst the general population builds, it becomes harder for economic actors to look past the short term.
The pandemic has triggered a tectonic shift in equity valuations, and has wiped out $25 trillion from global stock markets in just 25 days. As investors wrestle with their predictive models, they look for confidence in more favourable asset valuations. Concurrently clients, friends and family alike are clamouring with questions. How far do we have to go? When will it turn?
G10 governments and global central banks have responded by flooding the market with liquidity and announcing unprecedented support measures for both companies and individuals. The global stimulus pledge is currently estimated to be over USD 4 trillion. We expect commitments may need to reach close to 5 trillion to compensate for the virus’ effects.
WHAT ARE WE FOCUSING ON?
It is necessary to focus on governmental actions designed to counter the virus’ economic impacts, as well as their attempts to contain its spread through measures such as enforced social distancing.
We are tracking announcements and their subsequent implementation. Notable recent actions include:
- Monday’s announcement by the US Federal Reserve (Fed) that it will make unlimited purchases of US Treasuries and agency mortgage-backed securities. In addition, the Fed will purchase long-dated corporate bonds to avert a wave of corporate defaults and ensure functioning capital markets.
- Monday’s German cabinet spending plan, totalling EUR 756 billion, of which EUR 156 billion to finance higher social spending and EUR 600 billion of loans and guarantees to virus-hit businesses.
- Last week’s UK budget which included over GBP 300 billion of loan guarantees and a commitment to do whatever it takes, to create a socio-economic safety net.
- Agreement by US lawmakers on 25 March on a large USD 2 Trillion package, worth 10% of US GDP, with a mixture of direct fiscal measures for consumers and loan guarantees for businesses. The agreement has yet to go through the Senate and the House, but is good news for the economy and markets.
With regards to the virus’ proliferation, the evolution of the Chinese and the Italian infection growth rates post lockdown measures will help other governments identify the right path ahead.
China and Italy have two very different governmental regimes and have taken different approaches and actions through the delay and containment phases. This provides us with a spectrum of possible outcomes to aid our modelling of other affected countries. The effectiveness of the respective measures and timeliness of the improvements inform investors on the possible trajectories for the global economy.
In China, where the containment measures were most draconian, it took approximately four weeks for the number of daily infections to peak. Currently China’s daily rate of new infections is very low - well below 100 new cases - and most of them are imported cases from abroad which are isolated at the point of entry. Eight weeks after putting the country on lockdown, China has announced it will reopen the most troubled areas (Hubei and Wuhan) in the next 10 days.
Italy and the US paint a different picture. Italy, which has been on effective lockdown for over 2 weeks, is now seeing a falling infection rate.
If the US can use Italy’s experience to inform its approach and apply strict lock-down rules, we could witness a material slowing of infections in the next six weeks. Some states have also been on effective lockdown (California) for longer than others, so parts of the country could improve quite quickly. California going back to work swiftly is important as it is the world’s fifth largest economy. For the market to move forward, further evidence that the US’ infection rate is contained is required given the US’ economic size and importance to global financial markets.
In times such as these we must look beyond traditional economic data sources, which tend to aggregate activity with a considerable time lag. Even traditional leading indicators have been thrown out the window given the unprecedented nature of the shock we are experiencing. Instead, we look at high frequency economic indicators to determine the possible economic and corporate earnings impact.
For example, online restaurant booking platforms indicate that restaurant reservations, across multiple countries, are down in excess of 80% compared to this time last year. Retail footfall data suggest year-on-year declines ranging from 20% to 70% across Europe. A real-time picture of economic activity can be built up by aggregating additional sources such as cinema bookings, traffic congestion statistics, and internet search data.
This analysis has led us to broadly agree with the economists of Goldman Sachs who, for the US economy, now forecast double digit falls in GDP growth in Q2, followed by double digit rebounds in Q3 and Q4. This scenario assumes that the pandemic effect is transient, with a sharp economic rebound following in the second half of the year and into 2021.
THE NEXT MOVES IN YOUR PORTFOLIOS
How should we position our portfolios and when will we adjust our tactical views?
We entered this period of market turbulence with a moderate risk-on stance, combining a slight preference for equities with diversifying assets such as government bonds (both UK and international), and foreign currencies.
We are now evolving the composition of the diversifiers, increasing allocations to gold and the Japanese Yen. We are strengthening our quality focus within equities, by increasing exposure to technology and healthcare.
We now find ourselves in a situation where markets have corrected meaningfully and where we have the capacity to add more risk. Unfortunately, we do not think conditions are yet right to do so, because:
- The valuations for equities are not sufficiently cheap in absolute terms. Most markets trade currently between 13-16x future earnings compared to trough valuations of 10.5x in 2008; it is a similar story in the corporate bond world where spreads are half what they peaked at in the Global Financial Crisis.
- Financial stress remains high and momentum across risk assets deeply negative.
- Although we take comfort in the fact that policy makers have shown their commitment to fighting the negative economic impact of the virus, it remains unclear whether the fiscal measures will prove effective to save jobs and businesses from a collapse in demand.
We will continue to actively monitor and analyse developments on the aforementioned factors before making further changes. Until then, markets are likely to remain volatile and driven by two-way headline risk. We are watching the virus developments carefully in the US and economic impact. We believe such clarity is required for equity markets to recover.
Please contact your usual Brown Shipley Adviser should you have any questions.
The Investment Office