An update on the financial markets and the Coronavirus
An Atypical Global Recession
Bear markets typically happen when we experience a global recession. Looking back in history global recessions typically cause equity Markets to fall 30% from peak to trough. The 2008 global financial crisis was a special one as the whole banking system was falling apart under too much leverage and the global equity market dropped 55% from the peak in November 2007 to the low in February 2009, a 16-month period. In the last 4 weeks the Morgan Stanley Capital International (MSCI) World¹ has dropped 32%, with certain emerging markets dropping by 50% or more. The speed of stock price declines suggests the global economy most likely is already contracting quickly.
Therefore a global recession is now a certainty. The only question is whether there will be a technical recession lasting a couple of quarters, or a more prolonged downturn that produces a sizeable increase in unemployment rates.
This will be a unique recession because in postwar history, all recessions are typically caused by financial crises or bursting asset bubbles as a result of Fed monetary tightening.
In this COVID-19-led recession, however, the sequence seems to be precisely the opposite: output contraction may come first, as the fear of contagion has begun to scare off consumers, triggering a fall in their spending. This fall could lead to spreading bankruptcies, a rising unemployment rate and potentially, escalating financial stress or even a crisis.
Different Sectors Will Have Different Effects
While it is possible that spending will remain broadly depressed even after the panic subsides, this seems unlikely. Private-sector finances were reasonably strong going into the crisis, while ultra-low government bond yields will incentivize increased fiscal outlays. Spending on leisure travel and public entertainment will remain subdued well into 2021, but much of this demand will be redirected to other categories of discretionary consumer purchases, particularly in the e-commerce space. Health care expenditures will also increase.
Central Banks Quantitative Easing
What is also unique in this recession is that already at the very start of the economic contraction Central banks have loosened monetary policy tremendously by cutting interest rates and/or injecting huge amounts of liquidity into the system through Quantitative Easing (QE). While at the same time governments are not wasting time announcing huge fiscal stimulus packages.
In a virus-led downturn, it is the authorities’ job to act quickly and with overwhelming force to provide businesses and consumers with the necessary financial relief such as tax breaks, loan guarantees, subsidized credit, etc. These measures are aimed at removing solvency risk, allowing companies and people to prepare for economic recovery once the public health crisis is over. In other words, policy support is not designed to stop the economy from falling into a recession, but to help businesses and consumers through this difficult period.
This is the only way to prevent a liquidity crunch from becoming a solvency crisis that leads to rising bankruptcies and unemployment. This secondary damage is more difficult to heal than a temporary fall in spending. In this vein, the Fed’s aggressive rate cuts and massive liquidity injections via repo operations and a resumption of QE are absolutely needed to ensure ample liquidity as demand for credit lines increases quickly.
The list of large spending packages proposed by governments around the world is only growing longer. Some countries, like France and Spain, have already announced guarantees and allocations measured in hundreds of billions of euros. The German state bank KfW has half a trillion euro available to support small businesses. The White House is talking about a $1.2 trillion support package. This week China cut rates again and is ready to open the fiscal and credit taps in a fashion similar to 2008.
These measures are designed to avoid a freeze up of the credit market and make sure small businesses and individuals are not bankrupted for no reason of their own making. This increases the odds that economies will be able to rebound once the worst of the pandemic is behind us. While in the short-run, those announcements are positive, in the long-run, they greatly increase the risk that inflation will comeback.
Recessions and Rebounds
Many COVID-19-ravaged economies in the world are going through economic recessions. They include China, Korea and Italy. It is too early to draw any generalizations of these virus-led recessions, but China’s experience is that the economic contraction is sharp but can be followed by a quick rebound as indicated by some early economic data.
The unfortunate reality is that the U.S. economy, the largest in the world, is dealing with an early outbreak, and the number of infections will escalate rapidly – especially as official testing numbers begin to increase. The actual numbers of infections could be a multiple of the reported. There is no way to estimate how long the recession will last for the U.S. economy. It will largely depend on how quickly the outbreak can blow over. It could be anywhere between two to three months, according most experts on pandemics.
COVID-19 Can Be Stopped
Recent experience suggests that COVID-19 can be stopped, even after community contagion has set in. The number of new Chinese cases has fallen from 3,892 on the 5th of February to 6 cases on the 17th March. South Korea seems to be getting the virus under control. Japan and Singapore also appear to be succeeding in preventing the virus from spreading rapidly.
Why Is It Different From the 2008 Global Financial Crisis?
This virus-induced recession is most likely a transitory shock. It is different from the 2008 Global Financial Crisis (GFC), when banks were collapsing, depositors ran for cover and over-leveraged consumers were facing foreclosures. It has taken more than a decade to repair the damaged balance sheets of consumers and lending institutions as the result of the 2008 crisis.
This is not the case today, with much-reduced consumer debt and well-capitalized banks. The corporate sector capital structure is much more leveraged than before due to share buybacks, but the very subdued capital investment over the past few years suggests that most companies are not dealing with over-extended balance sheets or mounting bad investment. Besides, borrowing cost is falling fast and the Fed is vigilant on financial stress. Therefore, there is nothing blocking the economy from potentially recovering quickly once the spread of the disease is contained.
The violent sell-off in the last 3 weeks means that the equity market is already pricing in a lot of bad news. The so-called Stock-to-Bond ratio is now at the same level after the 2001 bear market and is approaching the lows of 2009.
We do not know how far equity markets can fall before we see a more sustained recovery, and although painful, we should keep in mind that there WILL be an end to the COVID-19 outbreak. At that point, the world economy will be left with plenty of policy stimulus, much reduced interest rates and bond yields, very low energy costs and large amounts of pent-up demand of consumers wanting to buy.
The recent fall in bond yields and collapsed oil prices, lowers costs for households and companies and has historically always led to a rise in economic activity. Asset prices usually rally before an economic recovery.
Furthermore, the speed of a stock market rally could mirror how prices have fallen. This is the key reason investors should neither try to time the market bottom, nor sell into the panic.
As always if you have questions or would like to review your portfolio, your plan or goals, please contact us directly.
We shall be sending further updates this week as we monitor market conditions and news.
This newsletter contains general information that may not be suitable for everyone. The information contained herein should not be construed as personalized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.
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¹The MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets.
Sources: BCA Research