INFLATION
That the ongoing recession is turning out to be the steepest in living memory is not going to surprise anyone by now. A tough earnings season and off-the-chart falls in macro indicators all add to a sense of gloom. That is the Despair phase – the phase we are in right now. What is less obvious is that, as markets are forward-looking, asset prices reflect future developments before they show up in the data. Investors need to think about things that are not yet materialising and begin to position for them before they do. This means thinking about a U-shaped economic path as we transition into the Repair phase. This will be faster where liquidity is the main challenge and slower where solvency is the problem.
LIQUIDITY vs. SOLVENCY
Importantly, recessions typically mark the end of bear markets – not the start. So, as the old cycle is ending and investors realise that a new one is beginning, the key question is how to think about relative winners and losers. The important point is to disentangle liquidity challenges from solvency problems. The price of fundamentally good assets being pushed to artificially low levels by investors struggling to raise cash is a problem of liquidity. The market being worried about earnings declining and default rates going up due to weaker growth is a problem of solvency. Central banks are well equipped to ensure that the liquidity taps don’t run dry. As the private sector is shrinking, it’s the public sector that has to pick up any slack.
WINNERS AND LOSERS
One likely winner is high-quality assets currently trading at reduced valuations, such as defensive stocks and US inflation-linked bonds. Another likely winner is assets leveraged to accelerating growth in the second half of this year and beyond. This includes cyclical stocks that can make it through the recession with liquidity support and, subsequently, benefit from a recovery that, once the virus outbreak is under control and social-distancing measures are lifted, could be robust, given the amount of fiscal and monetary stimulus. Conversely, companies, industries, and countries that are very dependent on trade, tourism, travel, hospitality and entertainment will probably be the relative losers in this environment, as globalisation gets dialed back and leaves their business models, which already proved vulnerable to trade tensions, more exposed.
Governments Running Largest Peacetime Fiscal Stimulus