April 2020
Markets have experienced extreme volatility in recent weeks. US equities suffered their fastest bear market in history, commodity prices have collapsed, the USD temporarily surged amid a shortage of US dollars and credit markets have experienced major dislocations. However, since late-March equities have rebounded, initially on aggressive policy measures from global policymakers, and subsequently, on hopes that we may be nearing an initial peak in the crisis.
Investors are now considering two key questions: what will drive markets in the near term and what will be the longer-term implications of the current crisis for asset allocation?
The four phases of the coronavirus crisis in markets
From a markets’ perspective, the coronavirus crisis has evolved in four distinct phases.
Table 1: Asset class performance in the four phases since 20th January 2020^
Source: Bloomberg & Abbey Capital.
* Index definitions can be found In Appendix.
^ Abbey Capital have deemed 20 January 2020 as the first day coronavirus fears began to impact financial and commodity markets.
Phase I: China-focused supply chain shock (20 Jan – 21 Feb)
In Phase I the potential impact from the coronavirus was seen largely in terms of the supply chain disruption of closing Chinese factories. The impact on markets was for commodities, like crude oil and base metals, to sell off. Bonds and gold rallied and, although they briefly dipped in late January, US equities largely shrugged off concerns about the coronavirus. Corporate bonds and the USD also rose.
Phase II: Global demand shock (24 Feb – 6 Mar)
In Phase II investors became more concerned about the global impact on demand after the sudden increase in reported coronavirus cases in Italy. In this period, we saw a typical risk-off response across asset classes to the threat of an economic downturn, with equities and commodities declining but bonds and precious metals rising. Investment grade bonds rose and the USD weakened.
Table 2: Correlation to S&P 500 21 January to 17 April 2020
Source: Bloomberg & Abbey Capital.
Phase III: Financial market stress (9 Mar – 23 Mar)
Phase III was marked by an extreme rise in market volatility. As more and more countries introduced social distancing measures to contain the spread of the virus, the likely severe hit to global demand became increasingly apparent. Saudi Arabia’s decision to flood oil markets in response to OPEC’s failure to reach agreement to supply cuts added further stress to markets. Investors worried about a possible wave of corporate defaults and the impact of lower commodity prices on the ability of emerging economies to service debts, particularly dollar-denominated debt. Pronounced declines in equities triggered a general liquidation of assets; in this period, precious metals and credit suffered losses alongside equities. Unusually, although US Treasuries and equities have been negatively correlated over the full period (Table 2), the US 30-year bond index declined in this period, while the S&P 500 was down -24.7%. Interestingly, amid the flight to cash, the USD emerged as the safe-haven asset, rising +6.8% in the period.
Phase IV: Stabilization and rebound (24 Mar – 17 April)
The severe stress in financial markets was critical in prompting an even more aggressive policy response, particularly from the Federal Reserve (the “Fed”). These were aimed at (1) easing the USD shortage and (2) intervening in credit markets to circumvent a potentially vicious cycle of defaults and economic depression. The Fed’s announcement of unlimited bond purchases, coupled with the intention to purchase corporate bonds, on March 23rd was the turning point for equities, credit and gold. Interestingly, credit and gold had a negative correlation to equities in Phase I but this flipped in Phase IV with both assets rebounding in line with equities. The surge in the US dollar also reversed. In April, announcements that some countries were moving to ease lockdown measures raised hopes that the peak of the pandemic may at least be close. By Friday April 17th the S&P 500 had bounced +28.5% from its lows.
What is likely to drive markets in the near term?
The recovery in risk assets suggests investors are betting that we may see a peak of the crisis in the coming weeks and a re-opening of the global economy. The gradual relaxation of measures which has begun in China and will soon begin in Austria, Denmark and the Czech Republic has raised hopes that other countries will shortly follow their lead. In this upbeat scenario, markets and the global economy experience a V-shaped recovery where most of the economic damage is experienced in Q2 and the global economy shows signs of recovery as we move into Q3.
However, there are several risks to this seemingly upbeat assessment. For one, even if it is the case that the peak number of new cases and deaths is experienced in the coming weeks, the relaxation of social distancing measures will likely be very gradual and a full return to “normality” with international travel and large scale public gatherings may not be feasible until well into 2021. Much may depend on the sophistication and efficiency of the ‘test and trace infrastructure’ to allow a larger number of people to emerge from lockdown, while simultaneously enabling timely detection of the coronavirus.
Second, even if the peak of the current episode is reached in the near future, there remains the risk of a second wave later in the year (as was the case with the Spanish flu in 1918), which could conceivably prompt the re-instatement of social distancing measures. Such a scenario would require further support measures from policymakers and increase the ultimate economic cost of the coronavirus, which could weigh on equities later in the year.
Spanish Flu, UK weekly combined influenza and pneumonia mortality: June 1918 to May 1919
Source: Taubenberger, J. K., & Morens, D. M. (2006). 1918 Influenza: the mother of all pandemics. Emerging infectious diseases, 12(1), 15.
Third, although policymakers in the US, in particular, have taken aggressive steps to prevent a vicious cycle of debt defaults compounding the economic downturn, there remains the risk of significant second order effects elsewhere in the global financial system. In particular, emerging market economies face considerable challenges in meeting debt repayments and rolling maturing debt; it remains to be seen what impact this may have on any global economic recovery.
In assessing the outlook, these risks have to be balanced against the policy impact from support measures. Whatever the near-term outcome, when thinking about asset allocation investors also need to consider the longer-term implications of the current downturn and the associated policy response.
What are likely to be the longer-term knock-on effects from the crisis that investors need to consider?
Although there is considerable debate amongst economists about the severity of the economic downturn, and the timing of recovery, the consensus is that this is largely a policy-induced recession (economist Paul Krugman has likened it to putting the economy into a temporary coma). Therefore, the economy should be able to bounce back relatively quickly whenever social distancing measures are fully relaxed. That said, we will have witnessed an economic downturn and associated policy response without parallel in modern economic history, so investors need to consider what the longer-term unforeseen consequences of the coronavirus may be.
The three themes for investors to consider are:
I: Higher government debt levels
National governments have responded to the crisis with measures to support incomes, extend and expand unemployment assistance and indirect measures such as loan guarantees. In the US, the $2trn fiscal package amounts to approximately 10% of GDP and further policies are under consideration. Across the world deficits and government debt levels are expected to increase by between 10-20% (source: Capital Economics). The ultimate increase in debt levels will be heavily linked to how long these economic supports remain in place.
Chart 1: US Federal Government Debt/GDP ratio: 1940- 2020
Source: Bloomberg.
Many economists draw a parallel between the current scenario and the substantial increase in government debt during World War II. Although debt sustainability is not a consideration, for now, at some stage the issue of debt sustainability may emerge as a theme particularly as debt/GDP levels will also be boosted due to the contraction in GDP. This is particularly the case in countries like Italy where the starting point is already a government debt/GDP ratio in excess of 100%.
II: More coordination between monetary and fiscal policy
One of the consequences of higher debt levels is that we may see greater coordination of monetary and fiscal policies. We are already seeing this with the ECB and the Fed’s commitment to buy large amounts of government debt at a time when issuance will have to rise. Indeed, in the UK the Bank of England has agreed to temporarily finance government spending directly. Given the likely rise in debt levels there is likely to be pressure on central banks to maintain interest rates at low levels and maintain asset purchases.
In the decades after World War II, debt levels were brought back to more manageable levels by keeping interest rates low (a process known as financial repression). This could take the form of direct yield curve control by the central bank (something which has been aired by some Fed officials, and is already the policy of the Bank of Japan). The implications for investors would be that real returns on government bonds would be negative as nominal yields would be suppressed below inflation levels to help reduce the real value of debt over time. Such a development may prompt investors to seek alternatives to the conventional 60-40 portfolio.
III: Deflation now but possibly inflation later
The immediate impact of the coronavirus is evidently very deflationary as consumers will reduce spending due to job losses or from being forced to stay at home. Substantial declines in commodity prices will also exert a deflationary influence on consumer price indices (“CPI”). The most obvious parallel to the current economic downturn is the Great Depression. Back then, the US CPI contracted at a 10% annual rate for a period. The current deflationary period is unlikely to be as severe but with the IMF forecasting a -3.0% contraction in global GDP this year, it’s clear that the immediate risk is for deflation. That’s reflected in the current low level of government bond yields and in 1-year USD inflation swaps.
Chart 2: US Consumer Price Index YoY: 1914-2020
Source: Bloomberg.
Looking ahead, economists are watching the pattern of behaviour amongst consumers in economies emerging from lockdown, such as China, for signs as to whether we will see more caution from consumers in response to the pandemic, or a surge in spending from pent-up demand. More generally, the extraordinary stimulus measures of recent weeks could boost broad money growth, over time, which could translate into higher inflation. Although inflation did not pick up following major stimulus measures during the Global Financial Crisis, the current measures, particularly from the Fed, have been more aggressive and are much more targeted at getting cash into the real economy whereas quantitative easing was aimed at supplying the banking systems with excess reserves.
Chart 3: Federal Reserve Balance Sheet ($Bn) – January 2000 to April 2020
Source: Bloomberg & Abbey Capital.
Although in theory central banks would respond to higher inflation by tightening policy, before the coronavirus there was already a debate underway amongst policymakers about the possibility of letting inflation run above target following periods of below target inflation. Higher inflation would also help reduce the real burden of debt. Higher inflation would most obviously be negative for bonds but could also have significant implications for commodities and currencies, particularly if we saw greater divergence in inflation rates across countries.
Conclusion
The 2010s was a decade characterised by low inflation, steady economic growth and low interest rates. In turn financial markets experienced unusually low volatility and strong performance for equities and the traditional 60-40 portfolio. The emergence of the coronavirus has radically changed the near-term economic outlook and precipitated a surge in market volatility, in some markets to levels in excess of those experienced in the financial crisis.
While investors are currently focused on the immediate question of whether the recent rebound in equities can be sustained the longer-term implications for asset allocation are arguably of greater significance. A world which could be characterised by higher debt levels, more unconventional monetary policies, deflation in the near term but possibly inflation over the longer term highlights the potential benefit of investors developing robust diversified portfolios with exposure to a range of assets and strategies with the potential to deliver returns in different markets environments.
Indices
S&P 500 Index (Start Date: March-1957)
The S&P 500 Index is an index of 500 US stocks chosen for market size, liquidity and industry grouping, among other factors. It is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in its aggregate market value.
iShares iBoxx $ Investment Grade Corporate Bond ETF (Start Date: July-2002)
iShares iBoxx $ Investment Grade Corporate Bond ETF seeks to track the investment results of an index comprised of US dollar-denominated investment grade corporate bonds
ICE BofAML Current 30-year US Treasury Index (Start Date: December-1987)
ICE BofAML Current 30-Year US Treasury Index is a one-security index comprised of the most recently issued 30-year US Treasury bond. The index is rebalanced monthly.
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