It is now clear that the world economy is experiencing a sudden stop without precedent in peace time. In fact, during wars economies generally operate at a flat out pace, and in the UK the WWII induced return to full employment post the 1930s Depression necessitated higher taxes, not only to fund the government deficit, but also to prevent inflationary pressures in an economy where disposable income was growing but there were few goods available to purchase.
The rally in markets in recent days has shown that investors have accepted this downturn and started to look across the valley at the world which will emerge on the other side. This will depend entirely on how fast the Coronavirus lockdowns can be reversed. If, for example, the reverse to market consensus earnings estimates lasted only one year, even if these earnings declined by 50% in 2020, using DCF models a one year setback even on this scale on its own would justify a market fall of not much greater than 5% as share prices clearly take in more than one year’s corporate earnings. This of course is likely to be far too optimistic, but is used to illustrate the point that after the severe market setback it is the prospects for corporate earnings 2, 3, 4 and 5 years forward which will drive markets going forward from here.
Major economies and regions have entered suppression/lockdown strategies at different times. First of all it was China, with more limited suppression measures adopted in other Asian countries such as Hong Kong, Singapore, and South Korea, followed by Europe and lastly the US. Whilst the New York lockdown has captured the media’s attention, this is not typical of what is occurring across the whole United States, with especially in more sparsely populated areas restrictions on people remaining limited. Around three quarters of the population are in a very light shelter-in-place regimes, whilst around one quarter have no restrictions at all. Looking at some of the forecast economic consequences there are estimates that the annualised rate of decline in global GDP in Q1 2020 could approach minus 20%, triple that recorded in the worst quarter of the Great Recession in 2009. The latest US forecasts from Goldman Sachs show the trough of recession being reached in the second quarter of 2020 with GDP likely to be 11-12% below the pre-virus reading. This would involve a dramatic decline at an annualised rate of 34% in that quarter. The OECD has stated that the Group of Seven leading high income countries could see declines in GDP of 20-30% and estimate that every month large parts of economies stay closed annualised growth will fall by around 2%. There is also academic work illustrating that costs are unequally shared with unskilled workers suffering worse from loss of jobs, whilst those able to work online continue in jobs.
Whilst some have suggested that the emerging world could be a safe haven, this rarely proves true at times of crisis, and today many emerging and developing countries are being hit by falling commodity prices, especially oil, together with collapsing external demand and unprecedented capital flight looking at the level of outflows from emerging market assets, including bonds, which are far in excess of that which occurred in the Financial Crisis. In the oil and commodity price collapse of late 2015/early 2016 commodity exporting current account deficit countries had some of the worse performing stock markets in the world. They are also having to manage the pandemic with highly inadequate health systems. In Africa, for example, Sierra Leone has 18 ventilators for a population of 7.5 million, and the Central African Republic 3 ventilators for its 5m people. There are estimates in India that the national lockdown has put 50m jobs at risk in textiles, shoemaking, jewellery, and other consumer goods sectors. It’s abrupt and poorly planned lockdown has compounded problems by leaving shipments stranded in trucks alongside highways or at ports. Many overseas buyers are also citing force majeure to cancel orders. Lockdowns are especially brutal in countries with limited or no welfare states, with many in emerging economies relying on subsistence earnings working within the informal economy.
As the worst ravages of the disease, in terms of death, start to ease in the developed world, the focus will then turn to exit strategies as the current level of economic damage will not be sustainable for long periods, and arguably risks causing significant damage to the health of large proportions of the global population, albeit over a longer time period. While lockdowns are justified in the short term, if kept up indefinitely not only will there be huge personal suffering, but social and economic damage. This is likely to be especially true where governments cannot afford the stabiliser effects of costly social protection measures. In Germany now there are calls for a risk-adapted strategy. In other words, some sort of trade off which will minimise economic damage together with avoiding large numbers of untimely deaths. Whilst many governments have adopted a temporary universal basic income this is unlikely to be maintained permanently.
The market rally in recent days, led by the States where case numbers in their major cities have shown signs of plateauing, have occurred as investors believe GDP will start to rise, albeit gradually, during the second half of this year, even if the pre-virus levels are not reached before the end of 2021 at best. Even two wasted years in the US would not justify market falls of 25%+. Whilst the latest data from China have shown a partial economic recovery (the Fulcrum now cast data for China shows a rebound in month on month annualised growth to +4.6% in March compared with -2.0% in February) there is concern that China’s export orders are weakening and will remain weak as foreign markets decline sharply. Chinese industrial output growth is still very negative compared to a year earlier. To date, central expectations on economies are for a strong global recovery to commence in Q3, following the pattern of China and Hong Kong after the Sars crisis in 2003. Economists generally believe epidemics to be temporary events that do not cause long-term structural damage. The Coronavirus, however, is clearly having larger effects than Sars, Mers, Ebola or Swine Flu, partly because the global economy is more integrated, the disease itself is a global not localised event, and also the emerging world has been the driver of global growth in the post crisis period.
As discussed previously, the American Enterprise Institute has provided a road map or milestones for ending lockdowns, suggesting a clear pattern of 14 consecutive days of declining case numbers, together with capacity in the health system, justifying a re-opening on a phased basis of an economy. There is always the risk, however, when this does occur that any flare-ups in disease levels will result in further crackdowns, or the re-introduction of restrictions, as has been the case in both Hong Kong and Singapore. As a result recovery is likely to be stop-start at best this year, certainly until a vaccine is produced.
The US market may also have been encouraged by the supposed indicative success rate of the cocktail of hydroxychloroquine, the anti-malarial drug, mixed with azithromycin an antibiotic, which in Donald Trump’s view could be “one of the biggest game changers in the history of medicine”. While this is as yet unproven, the turnaround time in New York hospitals for patients contracting COVID-19 does seem to have been quicker than in Europe, with less patients needing to move on to ICU beds. The relative outperformance of the US over Europe can also be explained by the continued lack of a coordinated economic response in Europe to the crisis.
Suppression measures have successfully reduced the reinfection rate (r) from carriers to other people quite dramatically. The UK was slow to put measures in place and there are some estimates that this reinfection rate had been as high as 6.0x at one stage and has now fallen back to around 1.8x. In other words at the worst of the outbreak in the UK 6 people were being infected by every carrier, and this has now dropped to 1.8 persons. Whilst the number may seem large, looking at the packed London Underground trains at the height of the crisis, it should not be surprising. There are suggestions that the rate of reinfection in the US has dropped to 1.5x and is only around 0.5x in Australia today, with the lower density of population in cities, lower levels of smoking, a younger population and the fact that in the southern hemisphere it is still summer put forward as explanations for this. Australia has also quarantined anyone, even its own citizens returning from abroad, in hotels now being used as quarantine centres. Estimates for transmission rates in Italy and Spain now suggest that these have successfully been suppressed to below 1 to around 0.8x.
One part of the stock market which has suffered a severe hit, having previously proved defensive has been property companies or Reits, and whilst there has been significant publicity of the non-payment of rents on retail space, there is also evidence emerging this is occurring in offices and in Australia, some property companies have already reported significant downgrades to asset values on portfolios which are not wholly retail orientated. Clearly some big downgrades to NAV are likely to occur.
Markets have gone into the second quarter, placated by the huge fiscal and monetary packages provided and with some evidence that peak intensity of cases (in the developed world) is now occurring, focused instead on potential exit strategies. If economies can return to some level of normalisation by the end of the year, albeit with a caveat that travel and leisure sectors are likely to be impacted negatively for longer, markets will be able to continue to make progress. Year to date the Chinese and US stock markets have been the best performers, and this seems justified by the economic policy response in both cases. China is now emerging from an authoritarian lockdown which appears to have successfully stemmed the spread of the disease, whilst in the States the policies of the administration, whilst looking to contain deaths, remain focused on avoiding long lasting economic carnage. Markets will now be highly sensitive to how the prospects for recovery pan out in practice, and until this becomes clear, may well settle into a trading range. Any positive news, either on vaccines or potential cures, even if only widely available many months ahead, will be viewed as positive news and today markets rapidly discount future events at an unprecedented rate. This was seen with the most rapid decline into bear market territory in history, and after last nights gains, which has left the S&P 500 23% off its intraday lows, one of the most rapid rebounds into bull market territory.
To date the market has played out the recession copybook in classic fashion with cyclicals and highly geared companies the hardest hit and in fact it is these companies that have rebounded the most over the past 10 days. After the initial rebound in these hardest hit stocks market attention is likely to refocus on who will be the long-term winners in the post Coronavirus world. Whilst in a typical recession earnings declines of up to 50% do occur, in general stock markets take 12-15 months to move from peak to bottom, rather than the four weeks which has just happened. Studies of previous downturns show markets typically recover in 2-3x the period it took them to fall. In other words, a 12 month bear market takes 2-3 years to regain all the lost ground under this formula, but with the level of uncertainty persisting, it would be unrealistic to expect a full recovery in only three months. However, even if the economic recovery is sluggish, being more U-shaped than V-shaped, one lesson from the GFC is that stock market recoveries can be very different. Despite the fact it took a decade for the global economy to return to more normalised levels of economic growth, in contrast the stock market rebound was V-shaped and today with the influence of quantitative trading and risk parity funds, markets are likely to anticipate and take on board positive or negative future news flow at a much faster rate than has occurred in the past. Positive news on vaccines, drug treatments, or successful containment of the disease once lockdown measures are relaxed, could well result in a V shape stock market recovery even if the economic rebound is more muted.
Strategy Team IRC 09.04.20