Now, these are judgement calls clearly which are open to debate and I would certainly not argue against the lasting impact of COVID-19 in many aspects of our daily lives. Certain segments of the economy will no doubt see a substantial reduction in activity levels and there will be bouts of anxiety over a return to growth more widely and ‘normality’. Nonetheless, based on the recession being ‘voluntary’ and driven solely by government choice, a resumption in activity is now underway.
The Bank of England has talked about ‘scarring’ on the economy and there is, again, little doubt that segments of the economy will really struggle to remain viable and that there will be a rise in personal and corporate bankruptcies, but actions of policymakers will materially dampen both the scale and impact.
Strategically, a big question relates to how we extricate ourselves from the debt which is being accumulated to pay for support packages. Here, governments have more options than personal debtors. As well as the option to default (a popular choice in Latin America historically), governments can raise taxes, pursue financial repression or simply roll over the debt at very low interest rates. In due course, taxes will most likely rise from here for corporates and consumers, but it is very likely that we are in for an extended period of easy fiscal policy, low nominal borrowing rates, negative interest rates in real terms and, in due course, modest rises in inflation.
In the near term, inflation is nowhere in sight (apart from perhaps in food prices) and deflation appears more of a risk but, under the academic fig leaf of Modern Monetary Theory, we are probably entering a long period of fiscal spending being funded by monetary means. Perhaps, in due course, this will be a cure for secular stagnation. In the meantime, however, we may see overt caps on government bond yields (to keep borrowing costs low) as is currently the case in Japan, and more recently Australia.
Strategically, the environment may be one that supports higher valuations for equity markets and, within equity markets, higher valuations for growth assets. This is uncomfortable for valuation bears who assume a reversion to the mean or who rely on long run yardsticks to assess fundamental value. Furthermore, while it is difficult to position for such a ‘non-fundamental’ outturn, this environment could well lead, in due course, to a valuation bubble in equities and in growth equities. For clarity, I do not believe that we are at this point yet.
Contrasting some of these strategic considerations is the shorter-term perspective. Here, the picture is even less clear as some of the relevant long-term drivers may well be subordinate to a resumption of economic growth and of some extremes that we can currently see in terms of the value of value stocks. Indeed, this crisis has been unusual in that growth stocks led into the downturn and outperformed initially in the recovery phase. Normally we would expect value to outperform coming out of recession and, indeed, this has started to happen in recent weeks.
Meanwhile, low-quality, indebted ‘junk’ has been rallying as investors price out some of the distress from beaten down segments of the market. Here, the direct and indirect effect of policy may well be to keep distressed companies afloat that may otherwise have folded due to lack of cashflow. Underwriting wages and the provision of cheap credit is benefiting many of the worst-affected companies. Policy is clearly having a profound impact on and within the market.
The Fed, through their recent actions to directly buy credit issues, could perhaps be implying a move away from direct yield curve control and an attempt to reduce credit risk for the most impacted sectors in the market. It may suggest (contrary to my earlier comments) a desire to avoid negative nominal rates or yield curve targeting which would have been viewed as detrimental to the banking sector. In short, the Fed’s recent move to target credit stimulus may prove to be bullish for banks and for value at least in the short term. Potential outcomes appear relatively binary at present.
In summary, having seen one of the sharpest downturns in history, we have now had the fastest and steepest bounceback in equity markets. These events correspond to the deepest recession of modern times and the largest stimulus packages ever deployed by governments and central banks across the world. From here, risks are more two-way on a shorter-term basis as we will, no doubt, have some testing times in terms of economic, corporate and COVID-19 newsflow in coming weeks and months. Longer term, markets are looking forward to better growth and recent data is suggestive of a decent upturn in activity, which should accelerate from here. There is always a temptation to argue that recessions will fundamentally change the corporate landscape. I believe that the virus will have lasting impacts on all our lives, but perhaps corporate change will be less profound than many assumed a matter of weeks ago. Recessions typically accelerate existing corporate trends and perhaps, when we reflect on the eventual outcome, this will be the legacy of COVID-19 for financial markets.