Thoughts on financial markets and their response to the Virus threat
| 13 Mar 2020
Investors around the world have faced three weeks of violent price movements as the economic impact of the COVID-19 virus ripples out across financial markets.
On Thursday the S&P 500 posted its worst day since 1987, while in Europe, the decline was possibly the largest on record, as world markets reflect the severity of the synchronised containment measures. These in turn will trigger a sharp contraction in world GDP which will likely fall to zero, or more likely, negative growth for the first time since the 2008-09 Global Financial Crisis. With the economic impact will come a series of earning downgrades for global companies, which in the worst affected areas will be severe.
Three things though are worth remembering. First, the current 27% fall from 19 February when the world equity index peaked probably discounts much of the damage we have described, and while the recovery will certainly not be V-shaped, there will be a rebound. Second, the government and central bank response will be massive and yes, while much of the monetary tool kit is exhausted (interest rates are close to or below zero in all developed markets), the fiscal response (which is necessarily slower and more ‘political’) could be very large. Chancellor Sunak’s aggressive and confident budget, which added a stimulus 1.3% of GDP and a ‘whatever it takes’ clause in relation to health spending, may now become something of a global template. Finally, central banks and regulators learnt a great deal from the last crisis about the value of liquidity and business continuity. Expect very proactive measures to support the financial system, with the Federal Reserve’s massive $1.5b trillion liquidity injection into money markets yesterday likely to be the first of many market interventions (even the ECB’s distinctly underwhelming policy statement contained within it is well targeted with aggressive liquidity support to banks and businesses).
But what of the longer term effects? Looking forward, the COVID-19 crisis will surely leave some longer-term scars on the world economy and, for a while, we must expect, at best, an L-shaped recovery across many regions. The damage in Europe for example will be concentrated in the service sectors (tourism, accommodation, travel and retail) where output is not easily recovered once lost. Attitudes to social distancing will also take time to reverse and it is very difficult to anticipate how long it will take consumer behaviour to normalise. But these behavioural changes also promise exciting new priorities for the global economy – more home working, greater awareness of bio-diversity, support for truly universal healthcare and a determined drive for digital and cloud-based business models – all are outcomes that are welcome and for our clients, thoroughly investable. Massive fiscal programmes will also transform public services and infrastructure, while much of the implementation will occur in the long-term framework of a carbon-neutral global economy. For our clients, these opportunities offer a promise of sustainable profitability and dividend growth that will underpin portfolios in 2021 and beyond, against a backdrop where much of the economic damage expected over the next 12 months is already reflected in this month’s sharp equity market declines.
The impact on the global economy
The global economy is, temporarily at least, powering down, as COVID-19 containment measures restrict activity and curtail demand across an increasing portion of the globe. The impact is synchronised and is transmitted unusually as both a demand and supply shock. In the former, demand falls sharply, as consumers and businesses worldwide defer consumption, travel and capital expenditure. In the latter supply contracts, as capacity is shuttered, labour restricted and supply chains disrupted as part of the ‘containment phase’ of the crisis. In our last investment report we started to model this in the Chinese economy – we estimated that up to 25% of working hours may be lost in Q1 due to production shutdowns and draconian quarantining measures. We concluded that the economy will contract in Q1 and that 2020 growth could fall from our previous forecast of 5.8% to 4.5% or at worst 2.5% annual growth (if there is more permanent damage to spending patterns).
With the epicentre now closer to home we have repeated this exercise for Europe, bearing in mind that forecasting is obviously very difficult and policy makers are only now starting to announce quarantining measures, as well as stimulus measures to help alleviate some of the costs. We have looked at GDP from a sector perspective, focusing particularly on retail, transport, accommodation and tourism. This sector is particularly high as a percentage of GDP, around 20% in Italy and Spain and 20% in Portugal. The impact here is very severe. Lorenzo Codogno (the Italian Treasury’s chief economist from 2006-15) estimates that tourism and transport services may have fallen by 90%, with retail ex-food sales declining by 50%. Our work shows that even with the impact focused mainly in Italy to date, the hit to growth is enough to drag the whole Eurozone into recession this year (2020 growth falls to -0.5% GDP), with Italian GDP declining by a massive -3.9%. Note that with so much of the impact felt in the service industry much of the growth lost will be hard to recover – if you don’t go to a café for a month you don’t drink twice the amount of coffee next month to make up.
Our base case then is for global growth, as measured in USD, to fall to 0% in 2020, driven by sharp contractions in Q1 and Q2 followed by only a modest recovery in the second half of the year. Moreover, we do not expect a V-shaped recovery in the second half. Instead, the global economy will experience a permanent loss; services not consumed in the first half of the year will be lost. We also expect that a weak form of ‘social distancing’ will continue in the second half of the year as a result of scarring from the health crisis.
There is a final impact of all the above that in our view contributed to the severity of market falls – namely a fear of a cash flow and liquidity squeeze as business contracts, suppliers go unpaid, and lay-offs grow. In this respect, it is unhelpful that the collapse in world oil prices has been greatly exacerbated by a supply war between two of the largest producers – Saudi Arabia and Russia. This adds further stress to credit markets where the high leverage of the US shale producers is particularly vulnerable. At present, credit spreads have widened (especially for high yield, emerging markets and Italian debt) but are not yet at levels approaching anything like the stress we saw in 2008-9. We would expect policy makers and central banks to focus on limiting spread widening in core markets, and of course targeted lending programmes (as Germany has just announced) that will focus on the inevitable cash flow squeeze among small and medium-sized businesses.
How is Sarasin positioning portfolios?
The work we have done modelling the virus impact on the Chinese economy last month prompted us to reduce our equity overweight positions to neutral a few weeks ago. We lowered our more cyclical positions, especially those linked to travel, and, where we had not done so already (as in our ESG mandates), we took our fossil fuel exposure at or close to zero. With the proceeds, we added to gilt positions and cash, both of which added defensiveness in this week’s market declines.
In general, we believe portfolios, both equity and balanced, have proved relatively defensive this month, helped by:
- Low energy, materials and emerging world exposure (particularly in our responsible and climate-active mandates) – this has contributed to relative equity outperformance
- A defensive bond portfolio with average credit ratings around A+, longer duration (in Charity Endowments) alongside very little exposure to high yield or emerging market debt.
- Equity portfolio protection in the form of MSCI world index puts with maturities in late March and June, introduced as part of a rolling programme when equity volatility was a fraction of today’s levels. These programmes cover up to 20% of our equity exposure in our Target Return mandates and lesser but still significant levels in our other balanced mandates.
- Alternatives assets where our largest positions are physical gold ETFs
For our clients, recent moves in markets are particularly disorientating because of the speed of declines (the peak of the US market was as recent as 19 February 2020). Note the average time to enter a bear market is, according to Dow Jones 136 days –this time it took little more than 20 trading days. In part, this suddenness is explained by the sharp realisation of how dire the impact of containment strategies will be on global GDP – after all, stock market declines normally reflect rising recession risks. Therefore, markets may already have discounted much of the likely impact of the downturn and, while we are not calling a market bottom, we do see that today’s valuations for high quality, liquid and broadly thematic stocks incorporate a lot of bad news. If we are right and ultimately we rebuild a new, more robust world with better global healthcare and sustainable infrastructure, then with government bonds around the world yielding less than one percent, our clients can afford to wait in the equity of companies that are central to achieving that vision.