Vues d’Iggo

Vision à moyen terme

The economic data is awful and the macro-outlook is potentially bleak. However, the worst of the shock is behind us. Policy has stabilised things and the slow emergence from lock-down is underway, with activity starting to pick-up. There remain uncertainties though and investors need to be patient in building a medium term strategy. Focus on the policy outlook and how that might continue to support markets. Then think about how some of the near-term news will suggest a bottoming-out of activity and some positive momentum. More importantly, we need confidence on the interaction of “lift-off” with the pandemic’s evolution. Finally, we need to try and understand winners and losers. Equity market averages may be at the right level or not but the market does provide opportunities for long-term gains either from recovery plays or the structural growth winners.

Declining R?

The lack of clarity as to how lockdowns are to be removed is an issue for investors trying to assess the strength and timing of the recovery in economic activity. Here in the UK, for example, the official guidance on how social-distancing can be relaxed is confusing. Differences in execution across countries don’t help as it suggests little agreement globally on the best course of action, particularly with respect to opening schools, encouraging people to go back to work and relaxing guidance on travel and social interactions. At the same time the economic reality has become clearer. We are now in the full throes of bad economic data releases. In addition, policy makers are hammering home the view that recovery won’t be easy and that there will be long-lasting damage. Moreover, there is not that much evidence that the rate of new infections is falling quickly enough to allow a significant rise in consumer confidence in most countries. While some in society have continued to flout social distancing rules, the majority are still likely to be fearful enough to prevent behaviour returning to pre-crisis normal for a long time. Common to all these themes is the risk of a secondary wave of the pandemic and scientific leadership messages that often miss the public mood.

The macro is bad

Back in March, with hindsight, it was easy to take relief from the rapidity and enormity of central bank and government action. They cut off the left-tail of the distribution of outcomes from the rapid global spread of the disease. Now, it is hard to take a lot of comfort from the execution of lift-off strategies and the ability of the policy framework to remain in place for as long as it needs to. Credit and equity investors need to think carefully about what the US Federal Reserve Chairman, Jerome Powell, said on a webinar hosted by the Peterson Institute this week (here for the prepared remarks). He warned that, over time, liquidity problems can become solvency problems. The rise in corporate leverage is an illustration of this risk. When companies become insolvent, they default on their debts and productive capacity and employment is lost, sometimes permanently. Big sectors such as airlines and retail are clearly at risk of going down this route, but so are smaller companies with bank credit lines and other liabilities that they might not be able to meet once short-term lending based assistance from central banks is no longer available. Powell’s message was clear – the Fed has done a lot, it might be able to do more, but fiscal policy will have to shoulder the longer-term burden of sustaining aggregate demand through spending and borrowing. He was also probably preparing the grounds for a shift in the priorities of the Fed from short-term market functioning and liquidity focussed policies, to longer-term policies with clear macro-economic monetary objectives. The longer-term driver of the Fed’s balance sheet will remain quantitative easing, primarily to keep long-term interest rates low, to ensure ample monetary growth and to allow the Federal government to continue to borrow at record levels.

Four pillars of a constructive view

Confirmation of the extent of the economic damage and warnings of its longevity shouldn’t be a surprise, yet they probably should mark the benchmark for expectations. That benchmark is a relatively bearish one which suggests limited investment exposure to risk assets where the return / volatility trade-off might not be good for some time. However, investors do need to build a more positive view of the outlook over time. In order to do so there are four areas that I think are important in framing expectations. These are policy setting, the mechanics of the recovery, the health management profile and “changing economy dynamics”.

Policy

It is always going to be possible to find faults with the policy setting, especially in a challenging and dynamic environment such as the one faced today. The European situation is a case in point. So far, the EU has failed to find a solution to debt-mutualisation. Last week’s ruling by the German Constitutional Court has raised some fundamental doubts about the constitutional settlement of the EU relative to sovereign states by essentially challenging the European Court of Justice. It is hard to see how this plays out and most market participants expect the ECB to continue to do what it is doing and keep on buying assets. However, the GCC decision raises questions about European unity. The survival of the EU and the Euro as a single currency depends on the recognition that the current constitution of Europe lacks the supra-national firepower to confront systemic and existential threats. This should have been more fully recognised after 2012 but here is a much bigger and threatening reason to recognise it. The establishment of some supra-national vehicle for mutually combating the economic impact of the crisis would be a giant leap forward for Europe. Hence the importance of establishing, at a minimum, the European Recovery Fund.

Whatever it takes 

Progress on the European policy front remains to be seen and any optimistic scenarios might have to be left to the imagination as the status-quo prevails. As such the focus will remain on the ECB as the most powerful influence on the recovery in Europe and there is always more it can do. Same with the Fed. While Powell ruled out the use of negative interest rates in the US, this and other options are potentially available at some future point. Similarly for the UK, with BoE Governor Bailey also dismissing, for now, the use of negative rates. It is true that the evidence on the efficacy of negative rates is mixed - there are negative side-effects and other steps have to be taken to ensure that the transmission mechanism is effective (see the article by Kenneth Rogoff on Project Syndicate here). But in the extreme, central banks could charge banks for holding reserves, encouraging them to lend to the real economy at extremely low rates with other policies used to discourage the hoarding of cash and to incentivise companies and households to borrow and invest. There has been an argument put forward by a number of economists for some time that the real neutral level of rates is well below zero and that central banks should try to set policy to be consistent with that (meaning even more QE or even more negative interest rates). Central banks could broaden the assets they purchase to ensure that companies can continue to manage their liquidity and solvency profiles and to preserve a level of wealth for society. It is not beyond the realms of possibility to see more central banks buy high yield bonds or even equities if necessary. “Whatever it takes” should not be just for the period of immediate shock, it needs to be something that always allows investors to be positively surprised. If monetary policy is constrained by a zero floor or limited ability to really take rates lower, then helicopter money or tax cuts should compensate if the economic risks call for it.

Turnaround

The mechanics of the recovery also need to be understood and will, at times, generate positive sentiment. The worst of the economic downturn is behind us. Activity levels today are already higher than they were in mid-March, based on signals from big data sources like Google’s community mobility reports (here). Purchasing manager reports are keenly watched to provide evidence of business conditions in various economic sectors. These are generally diffusion indices that measure the balance between what firms are saying is improving versus staying the same or deteriorating. If there were deeply negative readings in March and April based on a rapid rise in things getting worse, then May will see a rise in the diffusion indices even if things are just staying the same at depressed levels. Even if things improve a little from last month, there could be a marked uptick in the headline indices. It is cold hearted but the change in trend is important – this week saw 2.98m Americans file for unemployment insurance. That is a shocking number, but it is less than the numbers seen over the last seven weeks. JP Morgan said in a note this week that both the downturn in GDP in Q1&Q2 and the bounce higher in Q3&Q4 are likely to set records. Of course a more sophisticated view will need to see more than just a change in trend with the breadth and strength of the recovery needing to be assessed. But the data flow is likely to improve relative to the last two months and that helps build some positive investment sentiment.

Test and trace

This won’t mask the fact that we are facing significant issues with unemployment, inequality, supply disruptions, social problems and the inability of some sectors of the economy to re-open quickly. On the current guidance it will still be some time before hotels, bars and restaurants can fully open, before most shops can go back to normal and before restrictions on both domestic and international travel are lifted. This is where we need to see progress in the third area of my four-point framework for a more optimistic investment view - the health management environment. It seems in those countries that are the more successful in exiting lockdowns there have been, and continues to be, much higher levels of testing and tracing than is the case in Europe and the US. Having a greater share of the population tested and having the means to trace the sources of infections is essential to the re-opening of high social contact activities and businesses. There was news of the development of a highly accurate test in the UK this week, which will be helpful when rolled out. Beyond that, the search for vaccines and anti-viral remedies goes on, with a huge level of collaboration within the biotech and pharmaceutical industries and with research departments in leading universities. Sectors of the economy will open at varying rates, but all will have a better chance of getting closer to normal if the health risks are controlled. However, a warning. There is a lot of hype around drug development and research and expectations are high. A truly significant breakthrough on controlling the coronavirus may not be just around the corner and when it comes it will need to demonstrate that it is the real deal.

Is the equity market rational?

Finally, long-term investors will need to focus on the changes in the economy, to business models and consumption patterns that will evolve from the current crisis. These are already evident in the market to a large extent. To some there may be a disconnect between the current level of equity prices and the economic situation. The fact that it was announced last week that the US economy lost 20m jobs in April but the S&P500 rallied 3.5% during the week will sit uncomfortably with many observers. If people think there is a disconnect then they will also conclude that equities are overvalued and set for further declines. That may well be the case. However, there is more to it than that. The S&P500 has already lost more than $2.5trn in market cap this year. The US economy is expected to shrink by around $900bn by contrast. Those sectors that are most hit by the crisis and lost the most jobs in the last two months are sectors that are not significantly represented in the stock market or in terms of their direct contribution to GDP. The best performing sectors in the market have been wireless services, internet retailing, food retailers and internet based home entertainment – not surprising to anyone that has been on lockdown for the last seven weeks. The one’s hit the most were department stores, hotels and restaurants, airlines and anything oil-related. That dispersion has even been reflected in earnings announcements so far. Tech and pharmaceutical companies have fared much better than bricks and mortar retail or hospitality. Does this mean the equity market is rational? I would say that the level of the market is not much more than a barometer of investor sentiment. Within the market is where the real economic impact is being felt. One can be bearish on equity markets but still make money actively investing in stocks.

Active focus

These trends won’t persist to the same extent beyond the pandemic. Once people go out more they will be watching less streamed movie and television. Once restaurants become a choice again, there will be smaller weekly grocery orders. Yet some changes to behaviour will persist – like working from home and utilising more channels for online commerce. I’ve said it before, but society will demand to be better prepared for future health problems in a number of countries. Thus technology and healthcare will remain on a strong structural growth path. Market averages won’t tell all the story and active management of equity strategies will be more important once the policy support for markets and businesses fades away. There will not only be the opportunities provided by the natural winners but also the opportunities provided by those bombed out businesses that can recover. People will find ways to travel and stay in hotels again. Finally, there will be those sectors that will struggle in a post-COVID-19 world either because of pre-existing trends or a changed environment – oil and energy, some airline companies potentially and financials in economies where negative interest rate policies are used as a blunt tool. Picking the winners and avoiding the losers is never easy, but there will be massive clues and although valuations might make one wince, it is better to go with growth than go with averages.

Patience

The macro baseline is very troubling. If you look at a chart of GDP dating back to just before the last recession (end-2007) you will see that the recovery was far from a V-shape and, in the case of Europe, it wasn’t a straight line either. Recessions cause balance sheets to weaken, inhibit risk-taking and dislocate resources. This one won’t be any different. But investors need to give themselves the best chance. That means understanding the extent and the limits of the policy support. It means understanding that economic momentum can shift even if the absolute level of activity remains depressed for some time. It means following the removal of the lockdown and how that interacts with the management of the pandemic. Finally it means focussing on the longer-term winners as the global economy changes. In the short-term the policy framework supports better quality credit markets. This is necessary but not sufficient conditions for more sustained improvements in other risk assets. It remains the case that we need to see a successful interaction between opening up economies and managing the virus and then progress on a more permanent solution to that threat. We aren’t there yet. As a result, we should expect continued volatility in equity averages and risk metrics because it takes a lot of other good news to trump the bad macro. But patiently adding risk over the next few months seems the right thing to do.

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