March Investment Strategy - Preparing the recovery

Key points

• Lockdowns seem to work against the covid-19 pandemic, but as they generalise, they will trigger a steep global recession in the first half of 2020. We have taken our forecasts down, again.
• The magnitude of the rebound will depend on the quality of the policy support put together now. We have the building blocks of a very decent package, but some questions linger on implementation.
• Market valuations will stabilise once investors have fully digested the policy stimulus and more tangible good news will emerge on the epidemic front.

Global recession is unavoidable – it does not need to be protracted

The extension of the covid-19 pandemic is forcing a growing number of countries into “lockdowns”, which will have a very significant impact on economic activity since the worst-hit sectors (restaurants, hotels, recreational activities ) will see their output fall to nearly zero, while the rest of the economy will be impaired by the generic disruption in day to day life and deterioration in confidence triggered by heightened uncertainty.

What is key is how long the lockdowns will take to get the epidemic under control. They seem to be efficient. In Italy – which we use as a benchmark to gauge the impact on complex, democratic Western economies, the daily growth rate in the number of cases in some of the worst-hit locations in the North which went into lockdown early has fallen below 5%. But for the country as a while, while it has abated, propagation is still on a two-digit pace. Consequently, we retain as our baseline that normalisation in the world economy cannot start before Q3. Indeed, we will need to wait until all economic regions are past their epidemic peak, otherwise global trade will continue to be impaired by demand or supply-side disruptions are a point or another of the value chain.

On this assumption, we would expect both the US and the Euro area to go through a steep recession in the first half of 2020. We see GDP falling by 0.4% this year in the US and by 2.1% in the Euro in annual average. The US outperformance would merely reflect a difference in trend growth and a stronger carry-over effect from 2019. The covid-19 shock is symmetric across the Atlantic, to the tune of about 2% of GDP in annual average in 2020.

Our rebound in the second half of the year is dependent on a strong policy stimulus to nip in the bud the second-round effects stemming from business defaults and rising unemployment. The response is becoming commensurate with the task. Fiscal packages worth up to 5% or even 10% of GDP are being set up in the US, the UK and Germany. The ensuing rise in deficits will be absorbed thanks to the extraordinary steps taken by the central banks.

The Federal Reserve (Fed) has committed to unlimited quantitative easing (QE) and plugged some holes in its emergency toolkit by starting to buy corporate bonds (for the first time) and even lending directly to businesses. The European Central Bank (ECB) has disposed in practice of its self-imposed “limits” for the duration of the covid-19 crisis while pledging more than one trillion euros in additional purchases this year. These are truly historic decisions.

Implementation will have to be closely monitored. It will take some weeks to translate the policy decisions into action, especially since central banks and governments are themselves operating under the same organisational constraints as everyone else under the “lockdowns”. Some of the aspects of the monetary stimulus still needs to be more detailed (e.g. what would be the pricing of the Fed’s new intervention tools. Still, we have the building blocks of a very decent protection capacity for the world economy. Now, while implementation is being beefed up, we need to hear some good news on the epidemic front.

Markets looking for this good news

Looking to markets, attempts to formulate a short-term view are hostage to the ongoing high levels of market volatility and uncertain news flow. Daily information on the evolution of the epidemic is crucial for investors. As is the flow of policy initiatives. Both these sets of factors will determine the shape and veracity of the subsequent recovery. As we note, there are already decent building blocks in place.

However, investors are understandably struggling to evaluate the impact of the crisis. The economic sudden stop makes it impossible to value corporate assets as the trajectory of cash-flows for many businesses and sectors will be unknown for a while. To us, the Fed’s most recent package of policies is good news for the US corporate bond market. It essentially provides a massive financing facility for the corporate sector. This is positive for US companies and the US economy, particularly when combined with other initiatives. Ultimately this will be beneficial for stocks too, but for now it is a credit backstop and equity investors must still factor in a big drop in earnings.

Attempting to look ahead

Some signs of market stability are beginning to emerge. However, we can’t rule out further losses across asset classes. Corporate bond spreads are not yet as wide as they were in 2008. The fact that the central banks have moved quickly may prevent those levels being tested but it can’t be ruled out as the scale of the economic disruption becomes clearer. On the equity side, earnings forecasts will continue to be reduced and multiples have yet to reach the high single digit/low double-digit levels they got to during 2008.

Valuations will stabilise once the full impact of the policy moves is combined with better news on the epidemic. Yet the legacy will be a very different economic landscape. Central banks will own huge shares of the government bond market and will be the lender of last resort to the entire economy. Governments will have socialised numerous economic activities and businesses. Estimating true economic value across asset classes will be a hard job for years to come. Repaying official loans will become a claim on cash-flows over the long-term. Some business models will be changed forever, some for the good and some for the bad. Growth focussed investors will look for those companies that adapt to changing patterns of demand and much altered supply chains.

Unprecedented policy interventions and radical changes to our economies will not come without costs. Equity investors are unlikely to be able to rely on share buy-backs or dividends to be drivers of returns. Government bond holders will find returns in that market dominated by the biggest buyer and seller both being different agencies of government. Investment strategies that have relied on leverage might have been terminally impacted. More than ever, the changes in our economy and in how we assess companies will require active investment management.