State Of The World

It has been nearly six months since we learnt about a new Coronavirus (COVID-19) spreading in China, and four months since COVID-19 evolved into a global pandemic, an ongoing tragedy resulting in significant loss of life. The response to the outbreak led Governments to lockdown their countries in order to arrest the spread of the disease and allow their health systems to cope with the growing number of infections. These actions have brought with them a significant economic cost, the magnitude of which remains unclear. It weighed heavily on capital markets in the first quarter of 2020, with equity markets losing a third of their value in just four weeks.



State Of The World

Taking a Step Back

It has been nearly six months since we learnt about a new Coronavirus (COVID-19) spreading in China, and four months since COVID-19 evolved into a global pandemic, an ongoing tragedy resulting in significant loss of life. The response to the outbreak led Governments to lockdown their countries in order to arrest the spread of the disease and allow their health systems to cope with the growing number of infections. These actions have brought with them a significant economic cost, the magnitude of which remains unclear. It weighed heavily on capital markets in the first quarter of 2020, with equity markets losing a third of their value in just four weeks.

The policy response from Central Banks and Governments to this economic shock has been unequalled in size and speed, and dwarfing what was put in place during the global Financial Crisis of 2008-09. This in turn has helped asset markets recover from their lows. Whilst the lockdown has triggered a recession with tens of millions out of work, offset by a monetary policy response that has been called ‘Project Zimbabwe’, by hedge fund manager Harris Kupperman and, while the big guns at the Central Banks may ultimately emerge victorious, there are likely to be many potholes and bumps along the way.

As we move into the next phase of living with COVID-19, there are a number of issues and areas to focus on – what is the roadmap for growth going forward? Do Central Banks have the tools to provide further support if needed? What are the social and political repercussions? And what does it mean for globalisation, and US-China relations?


Economic Outcomes

Looking at a set of outcomes, it is rational to consider a hyper-cautious approach and fear the worst, but it needs to be remembered this situation, where Governments deliberately turned their economies off for health reasons, has no precedent. Therefore, no one can tell you based on history what the economic outcome might be, as there is so much we do not know about the damage caused to the global economy, how much scarring there may be or what its capacity might be for bouncing right back. More recently, investors have taken heart from the apparent re-opening of economies without a renewed pick-up in virus cases, in turn raising hope that economic conditions can recover quickly.

Nonetheless, some such as Dr Woody Brock, the American economist, argue that market optimism is badly misplaced, and that the market will fall back down. To wit, “As reality sets in, endogenous risk will dramatically increase. This is that component of market risk that is not due to news about fundamentals, but rather to the reaction of investors who realize that they have misjudged matters – made mistakes – and who then panic and stampede out of the proverbial movie theatre when someone yells ‘fire.’ That is, endogenous risk is what is commonly known as ‘overshoot risk’. Such risk represents well over 70% of overall market risk, as Stanford’s Mordecai Kurz pointed out when he formalized this concept in 1993.” 

The greatest fear for economists and institutional investors now is the risk of significant economic scarring, with permanent output losses which have adverse consequences for the labour market and public finances. An economic depression is an event that leads to secular changes in consumer behaviour, which makes it distinct from a recession, and this is one such outcome from the COVID-19 shock that led to the Government directed economic shutdowns everywhere. A second wave of the virus would be particularly damaging in this regard.

As we shift into a period of post-lockdown, worries are building over the arc of the recovery and how Governments will pay for the protective measures that were put in place. However, it appears Governments cannot repeat the austerity of the recent past. Consequently, we may be about to enter a period of intensified financial repression, which the next evolution of monetary policy, Eric Lonergan proposes, suggests a period of negative rates.

There are equally alternative views to the perceived worst outcome, such as this counterview put forward by Jeffries Bank market strategist, David Zervos. He notes that, “…suffices to say that ANYONE who was out there in 2018 and 2019 (or even earlier) calling for a US recession via ‘natural causes’ got it completely wrong. This virus will of course cause a recession, but it has nothing to do with any of the economic or financial-market ‘excesses’. More importantly, it has been the resiliency of the risk asset markets in the wake of the Fed’s ‘Go Big, Go Early’ policy approach that actually proves just how wrong these doomers really were.”

“We have had some 30 million forced job losses along with millions of businesses forced to shutter in the US. If there were sooooo many imbalances and fragilities in the US economy, which were just about to send us into a deep recession, wouldn’t there have been much more market distress?”

“The Fed’s balance sheet certainly has shown them its incredible power to heal wounds. But maybe the other important storyline here is that this economy just started from a strong place. We withstood the shock of a once-in-a-century flood and came out swinging (with some strong monetary policy supplements, of course). Even for someone like myself who was quite optimistic heading into 2020, the resiliency and strength of the US financial markets in face of this shock has been an amazing sight to see.”

In summary, this view endorses ‘don’t fight the Fed’ mantra, a strategy which has proved beneficial for investors on numerous occasions post 2008-09, and before.


Policy Backdrop

Naturally, if economic conditions were to weaken further, questions would be asked about what other measures could be taken to provide some support. Despite the significant stimulus to date, further action could be taken. For example, focusing on the Bank of England, which has already taken interest rates close to the zero bound.

“Funding could be provided to banks at deeply negative rates subject to them repricing their existing loan books so stimulus is not contingent on loan growth if there is no marginal demand. Similarly, there should be an innovation with tiered reserves with the interest rate on required reserves should be raised on the requirement that banks pass some of the increase in net interest margin on to depositors, such that you get a bit more interest on your savings account” – Eric Lonergan, economist.

Central Banks could start to target the interest rate borrowers will pay. For example, the Bank of England could lend to banks at an interest rate of -3% or -4% for 18 months, contingent on the banks repricing mortgages at -1% and small company loans at 0%. The Central Bank could simultaneously raise the interest rate on bank deposits held at the Central Bank, which are growing rapidly due to Quantitative Easing, and require that these rates be passed onto savers.

Given the uncertainty engendered by COVID-19, we may need to see persistent monetary policy stimulus. The Bank of England could, therefore, launch a programme of perpetual zero interest rate loans for all UK adult citizens. This is money that would be automatically deposited into a bank account or provided to non-banked citizens via a pre-paid debit card. To summarise, Central Banks are not out of bullets, and have continued to take action in recent weeks to provide additional support despite the recovery in asset values.


Social and Political Repercussions

Thinking about social and political repercussions, economist Thomas Piketty has a new book out titled ‘Capital and Ideology’. For those wanting to understand the shock of Brexit / President Trump, the backlash against ‘globalisation’ and the ‘culture wars’, which have had consequences for markets to date and will do so for future investment returns, the book contains some trenchant observations:

“The disadvantaged classes felt abandoned by the social-democratic parties (in the broadest sense) and this sense of abandonment provided fertile ground for anti-immigrant rhetoric and nativist ideologies to take root.”

The book concludes, “…if redistribution between the rich and poor is ruled out…then it is all but inevitable that political conflict will focus on the one area in which nation-states are still free to act, namely, defining and controlling their borders. And so, in the United States, a pro-market party that claims to defend rural, white, Christian America [the Republican party] faces off against a pro-market [Democratic] party that embraces the image of a diverse, cosmopolitan, urban America. To the half of the population that has known only stagnant incomes and increasing income insecurity, one party offers modestly beneficial economic policies bestowed by a technocratic elite; the other promises to restore their faded glory by winning trade wars and expelling immigrants.” 

This could create the prospect for more volatility around election results, with more non-mainstream type candidates and policies, which will feed through to a potentially wider dispersion of portfolio returns in the resulting aftermath, albeit these tend to be temporary in nature, unless they fundamentally alter the backdrop for global growth.


US-China Tensions

Recently, tensions between China and the US have resurfaced, primarily in response to COVID-19, and President Trump’s desire to act tough going into the US Election in November. So how could this escalate further? China left its currency fixed at an unrealistically weak level for several years after it acceded to the World Trade Organisation in 2001. After 2005, it agreed on a swift appreciation, which halted in the spring of 2008 as the credit crisis took hold.

In 2010 it was allowed to resume a steady climb. Since its shock devaluation in 2015, which caused a minor global crisis, the trend has been toward letting the currency weaken, particularly when China might want to send a message – as it did when the fix reached its previous post-2008 low in the days after the US announced new tariffs on China in August last year. A weaker currency tends to make China more competitive, and makes life harder for US exporters. So this can be seen as a very provocative gesture. Could China conceivably be prepared to let the Yuan move all the way back to 8.0 per Dollar? If so does it herald Cold War 2.0?


Key Takeaways

Pulling all of this together, the definitive point we would look to draw out from above is just how polarising the views are about what happens to the World economy and markets next, and what prospective solutions could come to the World economy’s aid, how radical these ideas appear and what little is known about the long-term consequences. It would indicate that as we emerge from this crisis the macro backdrop could resemble that seen over the past decade – one characterised by low growth, high and growing debt levels and low interest rates.  

In addition, history shows that Governments, when faced with a crisis of epic proportions, seek to pay down their debts by capping interest rates or forcing investors to hold their bonds. Now we have Central Banks monetising Government debt, which could ultimately be cancelled, the prospect for inflation coming back is rising.

For investors, this has a number of repercussions. First and foremost, in an era of rising inflation, coupled with very low interest rates, cash is unlikely to preserve capital in real terms. Low interest rates, as a function of their role in valuing future cash flows, typically support higher valuations for equity markets, which will remain the key driver of returns for investors over the long-term, where time in the market is more important than timing the market.  

Very low or negative interest rates reduce the attractions of conventional Government bonds, and multi-asset investors should, therefore, have some exposure to areas which can provide inflation protection – such as index-linked Government bonds and gold. History has also shown that equities can remain a good source of returns in certain inflationary environments.  

The complexity of the environment will present numerous opportunity and challenges, strengthening the case for active management. In recent months we have taken measures to eliminate our exposure to assets which will struggle in this environment, and focus on those areas which can survive and thrive, in both our Multi-Asset and Equity-Only Investment Strategies.