A global recession seems unavoidable
The world economy now faces the deepest slowdown and only the second contraction since the Second World War as government enforced measures drive a cessation of activity across large swathes of the global economy. A severe global recession is widely expected and appears unavoidable. As the extent of the pandemic becomes clear, and governments seek to minimise loss of life through social distancing measures, economists have downgraded estimates for 2020 global growth to expect shrinkage of 2-3%. While such estimates do not appear, at first sight, to be dramatic they incorporate declines in activity in major developed economies for the second quarter which may run to annualised rates of 50%. A halving in economic activity in many areas in the current quarter is no longer an outlandish estimate.
Governments and central banks move to counter the slowdown
Massive monetary and fiscal stimulus has been announced to accommodate the economic shock, but these measures will not prevent the serious downturn we see currently unfolding. Action from central banks has included cutting interest rates to new record lows and the resumption of quantitative easing and asset purchases. Much of their focus has been on ensuring that credit and funding markets remain open and that companies can continue to access liquidity. In addition, the Fed has reopened swap funding lines to ensure that demand for dollars can be accommodated, further alleviating funding stress.
Fiscal policy has been unveiled to include a package amounting to $2trn in the US and we are routinely seeing national stimulus deals which equate to 5-10% of a country’s GDP. One can think of social distancing measures as treating the disease, putting the patient into an induced coma, while monetary and fiscal policy are intended to maintain the lifeblood of the economy during this phase and, once activity resumes, to minimise permanent loss of function. Practically, this means that the state is now underwriting, or nationalising, a large component of both credit and wage risk in their economies.
It is important to note the speed and scale of policy action has already exceeded that seen during the Global Financial Crisis. Fast and aggressive action is intended to prevent a human and economic catastrophe from turning into a full-blown financial crisis and economic depression. While much has already been achieved it is entirely likely that more stimulus will be forthcoming. We should prepare for the likelihood of a changed economic orthodoxy going forward – a bigger state with fiscal policy facilitated by monetary means. This idea was already gaining traction in certain academic circles and could, in due course, be the perceived antidote to more than a decade of secular stagnation.
For investors, uncertainty never seems to have been higher. While it may be that we are getting a clearer sense of how deep this downturn will be there is little clarity on how long the economic malaise will persist and how quick economies, and companies, may recover.
Signs of encouragement from Asia
On the question of the duration of the economic downturn, the answer currently lies with
government policy. Policy will be driven by progress achieved through aggressive measures to drive infection rates down and to flatten the curve of this pandemic. Here, there are some encouraging signs of improvement in Asia as well as in some of the worst affected countries in Europe. In general terms, most countries are following a familiar path, with moderation of infection rates and subsequent deaths occurring within weeks of the introduction of social distancing measures.
Normality – how long till we get there?
Even with the virus under control, however, the question remains over how long it will take for economic activity to return to normality. Here, while still early days, the experience of China would suggest that lockdown measures can be relaxed but social distancing measures maintained for some time after. We should expect months or quarters of reduced economic activity as a function of ongoing management of the situation. Hopes for a quick vaccine seem premature with mid 2021 the most realistic date for the optimists. Nonetheless, wide scale testing of populations, on the assumption of immunity post infection, may enable a more rapid resumption of activity than pessimists fear.
A gradual recovery seems likely
In summary, there remains considerable uncertainty over when the recovery will occur and how vigorous the upturn will be. Much debate is occurring between the ‘shape’ of the upturn – whether we see a sharp ‘V’ or an elongated ‘U’. Based on the data that we have available today and the experience of those economies first into the pandemic there are some grounds for optimism. Despite this, one needs to be realistic. There will be a permanent loss of output from the enforced shutdowns and fiscal largesse will not be able to bridge the gap. In addition, it does not appear credible to expect that we will emerge from this episode in a few weeks and resume life as normal. There will be a process which may extend into 2021, where activity resumes gradually. Governments are prioritising the protection of their citizens from COVID-19 and any sense that control has been lost will lead to swift measures, to the detriment of economic activity.
Reasons for optimism
For investors, the future is always uncertain, but the current crisis is unlike any event seen in modern history. Nonetheless, in the near term we should focus on the following four areas to guide an assessment over whether equity markets have found a floor. Thankfully, at present in each case, progress has been made.
- First, policy action. As discussed, the substantial and timely fiscal and monetary action is welcome and designed to preserve economic function post crisis and ensure the orderly functioning of markets.
- Second, valuations. Here, we have seen global markets fall by around a third from their peak to levels consistent with recession and material earnings contraction. So, arguably, a lot of bad news is priced in. Depending on the severity of the downturn, equities may offer long term value. Indeed, on our base case estimates we do see longer term value at current levels.
- Third, volatility. While market volatility is inversely related to prices it is usual for volatility in markets to peak prior to a market trough. Many investors become forced sellers of risk assets after volatility spikes and, while the lag can be months, we have already seen volatility surpass historic highs.
- Fourth, and most importantly, infection rates. This is the critical factor for markets at the present time. Markets need to have a clear sense that the pandemic is under control before they can have confidence in recovery. Here, as noted above, there are signs of progress from Asia and Europe but, even post the peak, we need to be mindful of a potential second wave of infections and resultant government action.
Like many, we have been blindsided by the COVID-19 shock. We entered 2020 with a sanguine view on the global economy and a constructive view on corporate profits and on equity markets. This optimism has clearly been misplaced.
We continue to reassess our base case scenario
We need to be mindful of the speed with which events are moving and the prospect that our central case is proven wrong. Indeed, we are cognisant of the various scenarios which may unfold and how they will impact our portfolio. That said, current equity pricing does appear attractive on the assumption of a resumption of growth in the second half of this year and a reasonable recovery into 2021. While our base case suggests a good outcome from long term investment at current levels of equity markets, we do expect that the newsflow on infection rates will get worse before it gets better in the short term – particularly in the US – and this will keep investors nervous and markets volatile. Indeed, it is entirely possible that equity markets retest recent lows as is often the case as part of a bottoming process.
The risk case, where markets fall materially below recent lows, would involve a longer full economic lockdown (two quarters or more rather than one) leading to weaker global growth, weaker earnings, a potential 40-50% decline in earnings and a commensurate short-term decline in equities (from February highs).
Despite the risks, history would suggest that bear markets which are driven by an exogenous shock tend to be both shorter and shallower than those arising from a conventional end of the cycle recession or a financial crisis. We should take confidence from policymakers’ actions which are intended to contain the impact of the pandemic from turning into a systemic financial crisis but recognise that their actions can only go so far in mitigating the human and economic cost.
Diversification and long-term thinking are key
This past quarter has been one of the most difficult in recent decades for investors and, following several years of excellent returns for shareholders, it is disappointing to see declines in the value of our underlying assets and a widening of our discount. In terms of our asset exposure, we remain well diversified and, while we cannot tell with certainty when the current crisis will end, we do believe that there are good opportunities emerging for the patient investor. Indeed, our financial position puts us in a very strong position to take advantage of further opportunities in the event that there is wider financial distress. We have also taken the opportunity to buy back some of our shares in the open market as this is accretive to our Net Asset Value and adds value for shareholders.
A prudent approach pays dividends
We are conscious that a number of listed companies are now beginning to announce substantial cuts in their dividend payments. Indeed, we expect that 2020 will see substantial declines in our revenue as companies choose, or are compelled, to reduce payments to shareholders. Fortunately, due to our conservative policy, we came into 2020 with both a covered dividend and with very healthy levels of revenue reserves. These reserves are one of the unique benefits of investment trusts and enables us to provision in the good times for when we need to make up on a shortfall in our revenue account. Practically, this means that we are extremely well placed to continue not only paying dividends for our shareholders but, as stated in our Annual Report, it remains our intention to continue to raise our annual dividend for shareholders this year.
The current crisis represents an existential threat to many businesses and is unlike any of the challenges which we have faced in recent times. Nonetheless, F&C Investment Trust has a tremendous advantage through our corporate structure which makes us well placed to withstand further market volatility. As always, we remain focused on the long-term opportunities, for the benefit of our shareholders.