Capital Market Line: Covid-19 Sends Us Back to an Early-Cycle Economy at Stall Speed

Author:
Michael J. Kelly, CFA
Global Head of Multi-Asset
New York

9 April 2020

We were eagerly awaiting the first quarter of 2020 to demonstrate that 2019 merely marked a slowdown, not the onset of a late-cycle recession. While we’ve been proponents of the global economy’s mid-cycle status, we had acknowledged that if a giant meteor were to come crashing down, flattening one-third of planet Earth, such a huge exogenous shock would send the world into recession regardless of where we had been in the cycle. Well, the meteor struck. We will emerge from this recession with wider output gaps than from the Global Financial Crisis (GFC). With that, we’ll be back to early in the cycle and a global economy at stall speed. What’s next?

We expect debt-to-GDP ratios to spike for the few nations fortunate enough to have the fiscal capacity to respond to this crisis. The US, for example, will probably ratchet up debt/GDP from 100% (properly measured) to more than 120%. Does this become a slippery slope where one has to worry about debt service sustainability should rates meaningfully rise? Situations like this have been followed by yield curve control, which suppressed rates from approaching inflation. Such a gap is intended to help lower the debt/GDP ratio over time.

When massive fiscal rescue packages have been invoked in the past, initial coordinated responses to put out the fire have often been followed by political fallout over who to blame and how to pay. This often results in controls that diminish the odds of a similar downside in the future, while inadvertently dragging down the upside. Pandemics have all been followed by increased precautionary savings, thereby slowing growth. Today’s fiscal rescuers may not wish to give up their newfound mantle. They might supply more of the post-Covid-19 growth financed with central bank purchases. Eventually inflation would rise, but not in the next few years, given how massive the output gap has become. Perhaps a wave of defaults can “help”?

After the fall of the Berlin Wall, many followed classical economic models of more specialization by best-of-breed suppliers wherever possible, with less regard to national affiliation, thereby fueling lower inflation, greater trade flows, and higher profitability with lower capital intensity. This worked until trade skirmishes put globalization on notice. Now the coronavirus has highlighted the risk of overly concentrated supply chains. Globalization looks to be partly unwinding, with supply chains moving to less efficient but safer configurations. However, this will result in lower margins, higher capital intensity, and eventually higher inflation.

At the micro level, the new economy has been ushering in a wave of disruption and creative destruction. Some of the new economies’ global champions have actually been helped by the economy’s sudden stop. Older, physically based business models have been dealt severe blows. Creative destruction’s winnowing of players has been accelerated by Covid-19.

Without a vaccine, even if we see a rapid partial bounce in the third quarter, output is unlikely to return to fourth-quarter 2019 levels until the fourth quarter of 2021. And once there, it will be less efficient for the reasons noted above, not to mention potential second waves of the virus. All of this affects profitability, which will take longer to regain fourth-quarter 2019 levels. Beyond this, we see a somewhat slower and less-profitable world, financial repression in the US, central banks paving the way for fiscal assertiveness, and more controls with less globalization. But not to fret too much – less-impressive cash flows should remain richly capitalized.

Capital Market Line as of 31 March 2020 (Local Currency)

PineBridge Capital Market Line

Please see Capital Market Line Endnotes. Note that the CML’s shape and positioning were determined based on the larger categories and do not reflect the subset categories of select asset classes, which are shown relative to other asset classes only.

Capital Market Line as of 31 March 2020 (USD View, Unhedged)

PineBridge Capital Market Line

Please see Capital Market Line Endnotes. Note that the CML’s shape and positioning were determined based on the larger categories and do not reflect the subset categories of select asset classes, which are shown relative to other asset classes only.

Insights From Today’s CML

The slope of our Capital Market Line (CML) steepened, and swerved concave. Somewhat slower cash flows, even greater liquidity, and much lower prices for asset classes have, in sum, steepened the line. At the same time, this exogenous shock is culling the herd. We have lowered expectations for emerging, small, and value-oriented cash flows more than others. While Europe and Japan have been locked in a low-growth liquidity trap at the zero bound, this crisis is nudging the US that way, while the new economy tugs in the opposite direction. Meanwhile, the low-risk end of the CML indicates that safety assets (unsurprisingly) are priced at a premium. This leaves the middle of the curve looking more attractive, with credit particularly attractive.

Developed market (DM) government yields will remain range-bound, supporting risk assets. Too much capital chasing too little cash flow, exacerbated by rebooted central bank quantitative easing programs, has led to even greater imbalances courtesy of Covid-19 and the sudden economic stoppages to tackle its spread (and their cash flow diminishing impacts). Without intervention, excessive capital relative to demand for capital would create market forces that shrink this excess through negative interest rates. Yet not all central banks think this is a good idea. Clearly, it degrades the strength of one’s banking system. When Europe led negative interest rate policy (NIRP) by lowering short rates into negative territory, its entire yield curve came tumbling down. While Japan followed, we believe the country now views this as a mistake to manage out of over time, with a curve just above the zero bound. The US is now converging partway toward this duo, forced by a surge in debt/ GDP that urges suppressing the yield curve below inflation for some time, in contrast with a previous desire to normalize rates a bit above inflation. Suppression encourages GDP to reflate relative to debt, thus aiding the sustainability of debt service

Moderate growth is on the horizon. Along the pendulum between emphasizing unfettered growth at one end and controls to promote greater income equality on the other, China under President Xi has shifted the balance more toward the latter relative to his predecessors in the past few decades. This has slowed growth. China has so far come through this crisis without invoking a 2010-style massive ratcheting of debt/GDP, a response consistent with the previous aim of maintaining rapid growth. After mounting challenges in 2018, President Xi has attempted to shift the balance back a bit. The world’s other bookend is private firms in the US, which are positioned well for the new economy, by and large. Meanwhile, public finances in the US will now be under more stress given the policy-induced spike in debt/GDP to partially offset economic shutdowns to isolate the virus. While the US has also been more willing to allow a jog toward creative destruction, it has spent enormous fiscal resources to ensure it doesn’t turn into a sprint. Loans have been extended to help many businesses build bridges to the other side of this crisis. Not all will survive, and the exogenous shock has accelerated the net pace of this culling of the herd.

Investment-grade (IG) credit: the new sweet spot. Financial repression encourages the private sector to lever up. Yet recent crises cut in the other direction, emphasizing conservatism for several years until memories fade. Post-GFC, a lack of confidence led to deleveraging for the first three years, followed by an eventual releveraging. The IG segment, in particular, wasn’t cut off from credit during and immediately after the GFC as much as others. While this segment spent 2012-2019 levering up, the Covid-19 shock will lead to more conservative and liquid balance sheets for several years. We begin this period with elevated spreads, ensuing conservatism, and the Federal Reserve joining the European Central Bank (ECB) in extending balance sheet growth into IG credit. Meanwhile, hedging costs have come down from abnormally high levels over the past few years, making US IG credit palatable again for large pools of overseas money. US IG spreads gapped up more than other DM IG spreads to boot. High-yield is attractive at current prices, yet we expect a default wave of uncertain magnitude in the next two years. Emerging market (EM) credit had been structurally improving before this crisis and will maintain positive real interest rates, which should once again be appealing in a world awash with capital and with negative real rates throughout DM. The search for yield should continue once the dust settles.

Emerging markets face lower structural growth than in the previous cycle. EM economies are no longer as well-positioned to benefit from tight labor forces and closing output gaps in the developed world, since this tightness has been rewound. A commitment to structural reform remains the critical ingredient for EM countries to sustain a growth premium relative to DM. Brazil and India remain prime examples of such dynamics, with above-trend growth potential in the years ahead; their potential arises from wide output gaps, political reforms, and stability, yet they face challenges to fund wider deficits. Over the cycle ahead, many EMs will benefit less from intellectual property (IP) transfers and foreign direct investment as automation costs fall and EM cost advantages erode. Demographics are generally not as supportive either. With climate change bending down the demand curve for energy, EM countries largely dependent on exporting natural resources face a tougher future. On a structural basis, EM is morphing into more of an attractive duration play than a growth play, hence requiring a highly selective approach to EM equity allocations.

Private assets remain unattractive. The insatiable demand for private assets abated somewhat in 2019. The recent crisis witnessed services declining more sharply than manufacturing. Debt in private markets has been predominantly focused on economically stable service businesses, while attempting to avoid cyclical manufacturing businesses. During the crisis, most businesses have experienced severe cyclicality. How this plays out in private portfolios remains to be seen. Marks will not bring clarity for some time. On the positive side, existing large pools of dry powder will now have more attractive investment opportunities from a valuation perspective, although the number of transactions usually declines after the type of sudden downturn just witnessed. In private credit, we have been concerned about the quality of underwriting in this opaque asset class. The current exogenous shock is precisely the type that puts illiquid exposure to weak underwriting portfolio companies at risk of impairments for more recent vintages – yet not for all, or even most. As Warren Buffet once said, “Only when the tide goes out do you discover who is swimming naked.”

The Fundamentals Driving Our CML

Deep output gaps will require persistent fiscal and monetary support. Estimates of the scale of the immediate shock to economic activity exceed those of the GFC. Having said that, forceful policy responses have mitigated the risk of this turning into a balance sheet crisis as well. These are the longer, drawn-out recoveries. Given low interest rates, the resultant output gap will require fiscal spending to nurse the global economy back to health. While billed as keeping rates below inflation, accelerating fiscal issuance will merge monetary and fiscal objectives. The primary role of central banks will be to finance this fiscal spending, as well as to serve as the buyer of last resort for a widening swath of financial assets. In turn, this soft version of Modern Monetary Theory (MMT) and its signature buildup of public sector debt will require keeping interest rates below inflation for some time to come. “Fiscal QE” is here.

A moderate growth regime lies ahead. Severe economic shocks change consumer and corporate behavior in ways that typically impede growth, with lower discretionary consumption and dampened investment appetite the primary culprits. Pandemics exacerbate these shifts by provoking higher precautionary savings, particularly in countries with limited safety nets. This usually refers to emerging markets, yet the Covid-19 pandemic has hit the US economy’s Achilles heels, namely its fragmented and incomplete healthcare system and high levels of inequality, which result in a disproportionate impact on consumption (the country’s economic backbone) should the fiscal offset prove too small or too slow. To compound matters, the US is heavily focused on the services sector, which has been particularly hard-hit and may be slower to rebound. Beyond an initial bounce in growth as lockdowns are lifted, we see lower potential growth rates for several years.

De-globalization and the restructuring of global supply chains. Covid-19 has laid bare the vulnerabilities of the just-in-time models first glimpsed during the trade skirmishes of 2019. Over the coming years, we see governments re-evaluating strategic capabilities, such as sensitive areas of healthcare and food production, and requiring local re-shoring of production deemed vital, regardless of economic costs. Concurrently, we see corporates accelerating diversification of supply chains and localization of production to serve regional markets directly and reduce risks embedded in concentrated supply chains. The result will be lower efficiency and lower returns on capital relative to the prior cycle.

Acceleration of ‘new economy’/‘old economy’ and large business/small business tensions. In the post-GFC years, several technological developments enabled the digitization of the global economy and the scaling of “new economy” businesses, creating clear winners relative to “old economy” businesses that were systematically disrupted. At the same time, the ratcheting up of regulation conspired with network effects to put small businesses at a disadvantage relative to their global competitors. The after-effects of the Covid-19 crisis will effectively accelerate these trends, resulting in rising share and return on equity for the winners. It remains to be seen whether fiscal and monetary policy can provide an income bridge for small and medium enterprises (SMEs) to avoid massive liquidations, and even if they do, we fear these companies will merely survive, rather than thrive.

China taking care of China. In response to the GFC, China embarked on a colossal stimulus path that rippled through the global economy, helping most when it was much needed. Early indications are that Beijing is taking a much more measured approach to address this crisis; policymakers are rightly questioning the efficacy of the “traditional” infrastructure-heavy model when the root of the problem is consumption and SME solvency. We expect China to avoid a hard landing but for stimulus to remain targeted and only sufficient to maintain acceptable growth and employment. The “missing” stimulus will also contribute to lackluster growth at the global level and will be particularly challenging for economies that have become overly reliant on Chinese demand. A small pivot back toward supporting the private sector is meant to shift the balance a bit, but not too much – yet it still partially offsets the overall slowdown.

Larger governments are likely to be more involved in commerce and markets. Governments have stepped up massively to address the challenge at hand, yet the “bailout” of the private sector will likely come with strings attached for corporations. Central banks’ financing of deficits may prove irresistible to politicians, who ultimately grant independence to central banks, once they note the apparent lack of near-term costs/downside in pushing for more handouts in a disinflationary environment (where many will be hurting and willing to try “another way”). The alternative path is one of more fiscal discipline, yet higher tax burdens, particularly on corporations but also wealthier individuals. Both will likely be pursued to varying degrees, yet policymakers may find the previous solution less daunting.

Capital Market Line Endnotes The Capital Market Line (CML) is based on PineBridge Investments’ estimates of forward-looking five-year returns and standard deviation. It is not intended to represent the return prospects of any PineBridge products, only the attractiveness of asset class indexes, compared across the capital markets. The CML quantifies several key fundamental judgments made by the Global Multi-Asset Team for each asset class, which, when combined with current pricing, results in our annualized return forecasts for each class over the next five years. The expected return for each asset class, together with our view of the risk for each asset class as defined by volatility, forms our CML. Certain statements contained herein may constitute “projections,” “forecasts,” and other “forward-looking statements” which do not reflect actual results and are based primarily upon applying a set of assumptions to certain financial information. Any opinions, projections, forecasts, and forward-looking statements presented herein are valid only as of the date of this document and are subject to change. There can be no assurance that the expected returns will be achieved over any particular time horizon. Any views represent the opinion of the investment manager and are subject to change. For illustrative purposes only. We are not soliciting or recommending any action based on this material.


About the Capital Market Line

The Capital Market Line (CML) is based on PineBridge Investments’ estimates of forward-looking five-year returns and standard deviation. It is not intended to represent the return prospects of any PineBridge products, only the attractiveness of asset class indexes, compared across the capital markets. The CML quantifies several key fundamental judgments made by the Global Multi-Asset Team for each asset class, which, when combined with current pricing, results in our annualized return forecasts for each class over the next five years. The expected return for each asset class, together with our view of the risk for each asset class as defined by volatility, forms our CML. Certain statements contained herein may constitute “projections,” “forecasts,” and other “forward-looking statements” which do not reflect actual results and are based primarily upon applying retroactively a simulated set of assumptions to certain historical financial information. Any opinions, projections, forecasts, and forward-looking statements presented herein are valid only as of the date of this document and are subject to change. There can be no assurance that the expected returns will be achieved over any particular time horizon. Any views represent the opinion of the investment manager and are subject to change. For illustrative purposes only. We are not soliciting or recommending any action based on this material.

The CML quantifies several key fundamental judgments made by the Global Multi-Asset Team after dialogue with the specialists across the asset classes. We believe that top-down judgments regarding the fundamentals will be the largest determinants of returns over time driving the CML construction. While top-down judgments are the responsibility of the Multi-Asset Team, these judgments are influenced by the interactions and debates with our bottom-up asset class specialists, thus benefiting from PineBridge’s multi-asset class, multi-geographic platform. The models themselves are intentionally simple to focus attention and facilitate a transparent and inclusive debate on the key drivers for each asset class. These discussions result in 19 interviews focused on determining five year forecasts for over 100 fundamental metrics. When modelled and combined with current pricing, this results in our annualized expected return forecast for each asset class over the next five years. The expected return for each asset class, together with our view of forward-looking risk for each asset class as defined by volatility, forms our CML.

The slope of the CML indicates the risk/return profile of the capital markets based on how the five-year view is currently priced. In most instances, the CML slopes upward and to the right, indicating a positive expected relationship between return and risk. However, our CML has, at times, become inverted (as it did in 2007), sloping downward from the upper left to the lower right, indicating risk-seeking capital markets that were not adequately compensating investors for risk. We believe that the asset classes that lie near the line are close to fair value. Asset classes well above the line are deemed attractive (over an intermediate-term perspective) and those well below the line are deemed unattractive.

We have been utilizing this approach for over a decade and have learned that, if our judgments are reasonably accurate, asset classes will converge most of the way toward fair value in much sooner than five years. Usually, most of this convergence happens over one to three years. This matches up well with our preferred intermediate-term perspective in making multi-asset decisions.