The spectre of a solvency crisis for the broader economy has jolted central banks and governments into action.
Source: Financial Times
In the fight to stop the coronavirus outbreak destabilising the global economy, central banks have gone “all in” with intervention after intervention to calm capital markets.
Governments are following closely behind, announcing massive spending initiatives to shield their economies from deep recessions. When the pandemic eventually recedes, the effects of these actions will continue to be felt. This introduces another element of uncertainty for those trying to plot the course of an eventual recovery in equities and other asset classes.
In a world where countries are becoming islands and cities are becoming households, fearful investors are hoarding cash, in particular US dollars. A painful reckoning is taking place across global markets after a decade-long debt binge. No asset class is safe, apart from short-dated US Treasury bills. As their prices surged, the implied yields on these securities — seen as cash equivalents — edged below zero during this week’s frenetic trading across equities, credit, currencies, government debt and oil.
The usually reliable method of portfolio insurance, through buying gold or long-dated government bonds that do well when riskier assets suffer, has not been spared.
Some investors need cash to meet redemptions from funds they manage or to pay back collateral on positions that continue to sink below the water line. Others have clearly elected to stockpile cash while waiting for the extreme market volatility to abate.
A strengthening US dollar highlights the magnitude of this global deleveraging. Across all asset classes, the exit trade is rapacious and the flight from emerging markets is starkly illustrated by the Institute of International Finance. According to its figures, EM outflows since late January are already twice that of a similar period during the global financial crisis and much bigger than in other episodes such as the 2014 “taper tantrum”.
Investors accustomed to boom and bust may well look at the current environment and see signs of a good long-term buying opportunity. Big drops are followed by large recoveries. But this year’s events are different.
A pandemic of indeterminate length is causing a profound economic slump — one that shuts the door on businesses and their workers, particularly those in the gig economy, creating hardship for many who depend entirely on their weekly or monthly pay cheques.
Policymakers’ efforts are crucial to stem the economic damage, but this is an environment where — rather than waiting for green shoots in economic data — the only statistic that counts is evidence of COVID-19 peaking. Only then can investors really start assessing just what kind of recovery beckons and what represents fair value for asset prices.
Alan Ruskin at Deutsche Bank argues that optimism in an eventual V-shaped recovery is “next to impossible when the real economy is only starting the downside of the V at a historic pace of descent. We are too soon into social distancing to start seeing its end, which is the core metric for risk recovery”.
Calling the bottom is a daunting task. But for investors with a long time horizon, there is an opportunity to buy assets that have endured a hefty downgrade, perhaps in small bites.
Rob Arnott, founder of Research Affiliates, says those investors will have to strike in the next few months — as “once the pandemic is beginning to ebb”, he argues, the moment will have passed. “The window of opportunity will be short, but highly rewarding over the longer term.”
Another long-term challenge involves assessing the post-pandemic terrain for companies and economies.
Deep recessions often clear out the dead wood from the previous economic cycle, and that facilitates a rapid recovery. Companies that survive the coming wave of defaults will become stronger as competition withers, while the likely changes in how people work and interact with each other present opportunities for companies beyond the current crisis. That may well invigorate the next business cycle.
There is also the chance that governments and central banks do not scale back their pronounced presence in markets and the economy once the crisis passes. There is plenty of scope for central banks to monetise a vast rise in government spending, given the scale of the potential economic damage looming.
Pumping money directly into the hands of people and companies, rather than banks as was done in the wake of the 2008 financial crisis, will no doubt prove popular — particularly as it stands to boost the economic rebound. But it is also likely to create much higher inflation down the road.
Investors will adjust and find the drivers of the next bull market, but they must also navigate profound changes across the economic and financial system. In that sense, the fallout from the coronavirus outbreak will continue to loom over the investment landscape in the years ahead.