Staying Home

To paraphrase The Smiths, “I would go out tonight, but I haven’t got a mask to wear”. The unfolding economic crisis is the result of people staying home, not travelling or going to work either because they are ill or because they fear getting ill. Another Smiths song was “Panic” and that is certainly playing a role. Yet there are real economic issues – supply and demand are both being disrupted and that is reflected in financial markets with equites pricing in increased recession risks, and bonds pricing in more central bank easing. There is no short-term visibility and markets are being driven by news headlines of more cases in more locations. Until that dynamic changes we could see further equity losses and lower bond yields. Taking a more medium-term view, we are getting to relative valuation levels that in the past have provided good entry points for stocks. Q1 2016 and Q4 2018 are recent guides. Another 5-10% on equities, a Fed rate cut, a slowdown in infections as the northern hemisphere moves into spring and we could be off to the races. But travelling to that point is likely to see more pain.      

Home alone

Are we on the verge of a recession caused by people staying at home? It seems we might be, as the direct response from the spread of the covid-19 virus has been to restrict travel over long and short distances. This is having material consequences for the provision of goods and services.  The global economy is facing both a supply and demand side shock. The supply of labour and goods is being disrupted and at the same time expenditure is being curtailed as people become ill or stay at home because they fear they will become ill. Quite clearly there will be some very negative economic and corporate earnings numbers printed in the coming weeks. It won’t be a shock if some countries post declines in GDP in Q1 and corporate earnings fall rather than post the long-awaited climb higher. Depending on how long it lasts, recession risks have risen. We are in the perfect storm of a shock that is seemingly out of control causing panic and negative feedback loops. 

Fed to cut rates

There are many issues to ponder in such an environment. For investors two of the more important should be whether or not there will be a policy response and what are the longer-term investment prospects once there is some clarity about how long the epidemic/pandemic lasts. Now central banks can’t cure diseases, but they can address issues of financial stability and lean against a tightening of financial conditions. Given that the S&P500 index is down over 12% from its recent peak and over 7% year-to-date it is no surprise that rates markets are now a 100% convinced that the Fed will cut the Fed Funds rate in March, which I must say seems entirely reasonable given how quickly the outlook has changed for the worse. There’s not much of a trade left in that US rates view though, as the market is now pricing in almost 4 cuts this year compared to an unchanged rate implied in the most recent Fed DOTS forecast. This does not mean we have seen the low in bond yields though. Safe haven buying will drive government bond prices higher no matter what the monetary policy path looks like.  

Global policy?

Outside of the US there is less room for monetary easing but there is lots more talk about fiscal policy being used to counter the impact on economic activity – even from Germany this week. Governments will be forced to spend more money on disease prevention and management, including on staff at medical facilities and on medicines if and when a cure for the virus is found. Fiscal policy was going to be loosened anyway in a number of economies. The response to the virus just makes this even more likely. At some point this will have to be reflected in government bond yield curves, but not yet. The key driver of bond markets is fear and the need to hedge risk. I would be cautious about expecting much co-ordination on macro policy however. The Fed is really the only central bank that has fire power and co-ordinating a fiscal response doesn’t quite seem to fit the current global zeitgeist. However, these are extraordinary times and the world is close to a state of panic. At some point governments and central banks might agree to act in tandem cutting rates, expanding liquidity and boosting government spending. Who knows? Co-ordinating containment policies, which might mean more draconian restrictions on travel is a greater shorter-term possibility however.

Difficult short term

The bond market is betting on a policy response, but the equity market is not convinced that this will be enough to stave off a significant downturn in activity and earnings. The moment, investors can’t bet on the recovery. The dynamics of the virus changed this week to more new cases being reported outside of China. The good news is that new cases in China are falling but there have been reports of new infections in more locations globally, some of which don’t appear to have clear links to either China or previously infected individuals. It is too early to speculate on when the peak will be and there does not seem to be much agreement that warmer weather will halt the progress – it’s quite warm in Singapore and Brazil after all. Until the numbers show a clear trend towards fewer new cases in multiple locations, longer-term economic projections are going to keep being revised down. A number of banks have slashed their 2020 corporate earnings forecasts and equity markets are responding accordingly.

Recession risks

The supply side and demand hits are negative for equity markets. Businesses that rely on people travelling (airlines, airport operating companies, travel companies, hotel operators) or congregating in public spaces (restaurants, shopping malls, cinemas and so on) are getting severely impacted. Manufacturers along the supply chain are reporting difficulties meeting production targets given that component supply is being impacted. There are few places to hide at the moment. Utilities and healthcare are traditionally defensive equity sectors and have performed best but financials are being hit by lower rates and growing credit concerns. If the market is pricing in the Fed responding to increased recession risks, the stock market is pricing in the effect of a recession on the corporate sector. While valuations are getting more attractive, the S&P is only back to its early December level and is still trading on a 20x multiple. If you are worried about the short-term, it is not yet the time to buy. However, longer term investors with cash should be looking at this window of opportunity to put money into the market. Whilst this may sound distasteful, the current virus does have a relatively low mortality rate, is being seriously addressed by governments and is likely to run its course at some point. Add to this another round of monetary easing and medium-term prospects look better. The problem right now is the uncertainty over the duration of the outbreak, its breadth and how much damage it’s caused the global economy. The central bank put might be harder to execute in this environment.

Diversification again

It’s instructive to look at market moves across asset classes. I have calculated total returns for the month of February to the close of markets yesterday (see the chart below). Equities have suffered their worst performance since the great financial crisis. Long duration bonds have done very well and there is a mixture of assets that have done a good job of capital preservation. Equities are down across the board. In local currency terms, the US has seen the biggest hit followed by Japan, emerging markets and the FTSE-100. The most defensive equity markets so far have tended to be in continental Europe with the Euro Stoxx index down the least of the major developed markets. Mirroring the equity moves have been long-duration fixed income assets. The S&P500 composite is down 7.5% in total return terms this month. The US Treasury 10-year and over index is up 4.25%. Long duration bonds have done what they are supposed to do – provide a hedge (not a 100% hedge, but a good hedge) to equity markets. The group of assets that have been capital preservers (total return for February between -0.5% and +0.5%) are mostly cash and high quality short to intermediate fixed income assets. The US market has done particularly well because of the pricing in of aggressive Fed rate cuts, but sterling and Euro fixed income has also held up, as have dollar and sterling asset and mortgage backed securities. To me there is not much that is surprising in these numbers. I was advocating short duration fixed income strategies at the start of the year given where the general level of yields was and have been a huge advocate of having long duration bond assets alongside equities as a core investment strategy. A 60:40 equity-bond strategy in the US would have been down less than 3% this month, and in Europe that would be less than 2% (using S&P500, EuroStoxx and the 10-year and over indices of the US Treasury and German bund market).

 

Yield gaps

As I write on Friday morning there is no end in sight to the market rout. European equities are down between 3% and 4% and bond yields are lower again with the 2-year US Treasury yield falling below 1.0%. Credit indices are wide and European peripheral sovereign debt is underperforming significantly. This is a not a market for carry trades. Technicals are starting to play a role with chartists pointing to the size and speed of the equity markets and month-end pressures probably leading to some participants capitulating. We are also in an equity market dominated by passive investing, ETFs and algorithms and it is difficult to gauge the overall impact of these changes in market structure, other than that they will contribute to even higher volatility.  The VIX equity volatility index is close to record highs, meaning that the cost of buying further protection on equity losses has become extremely expensive. Insurance is always most expensive after the event and that seems particularly apt at the moment – bonds being a case in point. And that may be the thing to focus on. Bonds are now super expensive and equities much cheaper. The trailing dividend yield on the FTSE All-Share index is now 5.11%, almost 3 times the yield on the UK corporate bond index. In France, the equity yield is 3.44% compared to corporate bond yields of 0.36%. Another 10% or so on equities would create one of those once in a every few years types of buying opportunities. 

Better football

I have resisted writing about Manchester United in recent weeks given some very poor performances around the turn of the year. I hope I don’t jinx them but recently performances and results have improved, and the signing of Bruno Fernandes from Sporting Lisbon might be just what is needed to push on to a top four position by the end of the season. United remain in two cup competitions and are only three points behind Chelsea who occupy fourth position at the moment. So, despite Liverpool romping to the title, the season might not be a total disaster for the Manchester reds. Or maybe the Premier League decide to abandon the season and award no trophies or titles if the health crisis continues. Now that would go down well on Merseyside!