Will the markets recover from the virus? – 31 March 2020

Steven Bell

Managing Director, Portfolio Manager & Chief Economist, Multi Asset Solutions

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Risk Disclaimer 

The value of investments and any income derived from them can go down as well as up and investors may not get back the original amount invested.

The information, opinions, estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.

Dividends, defaults, debt and downgrades. Steven Bell rounds up the month’s economic news and answers your questions on the outlook for financial markets.

• Global economic news is catastrophic: one statistic sums it up; over 3 million US people filed unemployment claims in a single week – 5 times the peak during the Global Financial Crisis (GFC).

• Central banks have undertaken unconventional measures: the Fed has eased the global dollar shortage, and intervened in the corporate bond market for the first time.

• None of these measures will prevent the recession – we are already in it, but they should ease the pain and support the recovery.

• Financial markets will have to face huge cuts in corporate earnings, with dividends being suspended or cut. Share buybacks, the biggest source of demand for US equities, will stop.

• Where to next?

     o News flow and markets to remain highly volatile
     o Sharp rallies are the norm in bear markets
     o The task now is to restore value in client portfolios
     o Equity and credit offer value if you hold your nerve
     o Resist the temptation to sell low and buy high!

Risk Disclaimer

The value of investments and any income derived from them can go down as well as up and investors may not get back the original amount invested.

The information, opinions, estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.

Q&A with Steven Bell

China started off in denial – the doctor who first alerted the world to the existence of the virus was arrested. But the Chinese have not been manipulating data on cases – the acceleration in cases led to senior officials in Wuhan being fired, and if you look at the chart of the profile of acceleration in cases, it is very similar to other countries, so we are pretty confident that the virus data is correct. Regarding the economic data, the numbers for January and February came in at much lower than expected, surprising many, so this is unlikely to have been manipulated.

Considering UK data, if you do not test then you have no cases, and in the UK we have not been testing, so the data is not comparable to countries where there has been widespread testing.

There has been notable worry in markets around corporate debt, and it has taken the Fed action to ease that. There remain issues – liquidity is a challenge and spreads are very wide, so it is very difficult to transact. The Fed action has improved the credit situation in the US, but in Europe spreads are still very wide as the European Central Bank (ECB) has not yet acted as the Fed has done, but we believe they will. This means that opportunities exist, but you have to be very careful what you buy as defaults will rise.

Some companies will suspend dividends, the European Banking Association is encouraging all European banks to suspend dividends, governments are saying if you are trying to conserve capital, why are you paying dividends? So, it’s a tricky one, the dividends futures market shows a sharp decline in payouts, which then flatlines. I think this is incorrect, I believe we will eventually get back to more or less to normal, after a very big hit.

The first point to note is that markets are ‘discounting mechanisms’, meaning that they look ahead. It seems likely that Q2 corporate earnings losses for the S&P500 Index will be more than the total losses for the whole of 2019, which gets released in July.  But before that, if we see that economic data has stabilised, then markets might ‘look through’ the bad earnings data that they know will be coming. Therefore, what we need to see is March and April being the worst economic months for Europe, probably April and May for the US, and that both are followed by a better month of data. This is what we have seen in China. Then by the time we get to the Q2 earnings data in July, markets will already be comfortable that economies will recover. I think the Goldman Sachs estimate is a bit optimistic – that we will see a big recovery by the end of this year, I think it will take a bit longer. However, if we get widespread recurrences of the virus, and countries have to reimpose lock downs, then the economic recovery time becomes much longer.

Things will never be the same again; as historian Peter Hennessey has talked about BC and AC – ‘before-coronavirus’ and ‘after-coronavirus’. On the consumer side, in China they didn’t have much fiscal support and they ran down their savings as they thought it would be temporary. In the UK, US and Europe, consumers don’t have the same level of savings, and any used and will need to be rebuilt, which supports consumption now but will cause a drag later. And some of the huge fiscal support that has been announced for the UK, US and Europe, will stop, and the debt that has built up will need to be addressed. Services tend to hold up fairly well, it is manufacturing that suffers as people delay investing and delay buying the consumer durables but then they will start buying again. Services that are not bought in that period are lost – i.e. air travel, but people should start buying again when things improve. There will be some permanent changes in behaviour, for example there may be more conferencing instead of business travel, but in the large part, I think a year from now we will look back on this as the aberration.

First the debt levels – in the GFC when central banks started quantitative easing, which means unfunded government deficits – i.e. printing money, many people thought that would lead to high inflation, but it would have to put demand up and wages up before you get inflation. Coming back to the valuation point, the reason we had such a strong market in 2019, in my opinion, is that real interest rates after being adjusted for inflation tumbled and there was a very good year for profits in 2018 so valuations were stretched in absolute terms but relative to bond yields they weren’t that stretched. We are in an environment of very low interest rates, if interest rates were at 5 or 6% then we would have a problem, but at current levels I don’t think equity markets will weaken significantly.

If you take the British government’s view, you can’t contain the virus so you need to lockdown, relax and build herd immunity and repeat, so you get a series of recoveries and declines, so a series of small ‘w’s. The Imperial College modelling that has formed so much of the UK government’s thinking has dramatically reduced their projections of the path of the epidemic, and with the weather we just don’t know how warmer weather will reduce transmissions. I still think the recovery will be V-shaped but not a straight line up.

The size of the US fiscal stimulus is enormous, and it doesn’t start until the latter part of April, it is conceivable that the stimulus kicks in just as the economy is recovering and supply could be curtailed due to logistics, so you could build a story around a significant rise in inflation, but inflation is not my biggest worry. There will be local shortages of supply and you may get bursts of price rises but I think these will be short lived and will sort themselves out.

I don’t have a strong view on currency, the US dollar was very strong with a big shortage of dollars, which happens in a financial crisis, but the Fed has now addressed this. I have a negative long-term view of sterling. The UK has by far and away the biggest current account deficit of the major countries – we had a tiny surplus in 1990 and have been in deficit every year after that, and we have a credit card problem in that we are paying more interest on our debt than our exports are earning, which haven’t recovered very well from Brexit. Overall, our 5% of GDP current account deficit will weigh on the strength of sterling in the longer term.

People are taking rent holidays, whether they are allowed to or not. Where the economy goes, so goes property. There is a current issue with daily liquidity against physical property. I think the longer-term outlook is pretty good, it provides a decent yield versus other financial assets.

Dealing with airlines first, airlines that are still ‘alive’ will recover, British Airways (AIG) reckon they’ve got lots of cash, if they can see this through there will be fewer competitors. In terms of targeted actions for particular sectors, it is a question of who the government will allow to fail. They have this big programme to get the banks to lend to businesses with an 80% government guarantee, it is not as simple as it sounds but it is huge support and some sectors will get help but others will be allowed to fail. It is a deep recession, it is double the size of the GFC and that was the biggest since the Depression.

I don’t have a number for US unemployment but it will be huge, but could be heading to 14 million pretty quickly. In terms of how swiftly will they be re-absorbed, I think very quickly. In the GFC, a lot of US companies had an overhang of workforce, so it took a long time to boost employment after that. But ten years later, and the evidence in the US is positive and we have a flexible labour market, and most labour markets are pretty swift when it comes to rehiring people.

Timing is critical and these are complicated plans. There will be gaps in some places. Many good, strong businesses have got zero demand and therefore, zero revenue. This isn’t a simple case of holding everything still, there will be lots of insolvencies.

The rebalancing flows have been happening for several days, and will continue for a while yet. Some funds rebalance at the quarter end specifically, and estimates imply around half of the rebalancing was completed by Monday’s close, so there is a lot more to come. And I do think there will be setbacks, because we have a market where people are restricted from taking big positions, the flows have an amplified effect on the market. I do think we have already seen the lows, 2,200 on the S&P. I think we will end the year significantly higher but not at previous levels.

I haven’t looked at it recently but I was astonished to see that Trump’s approval rating had soared – I thought it would have gone down. Various primaries have been cancelled, and Joe Biden has been eclipsed by governor Cuomo showing the kind of leadership in New York that has been absent in Washington, it is often said that leaders rise or fall in crises, so yes it will have a big impact on the election.

Listen to the full playback of Steven Bell’s latest webinar, Will the markets survive the virus? 

 

 
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