With the pandemic’s exogenous shock still dominating views on global economies and asset classes, it’s instructive to look back at where things stood as we exited 2019 to emphasize how rapidly views of the future can change.
Entering 2020, last year’s recessionary fears were being forgotten. Risk assets had rallied in the fourth quarter, with rosier economic data shining through in January and February, signaling that 2019 marked a temporary slowdown, not the onset of recession.
By late January, Asian countries outside of China were reporting Covid-19 outbreaks, yet surgical lockdowns along with strong adherence to the wearing of masks, social distancing, and testing/tracking appeared to be working. Even China locked down only about 5% of its population, in the Hubei province. While fatalities in Asia remained below 1%, in today’s world of global travel, the virus continued to spread to the West. By early March the UK’s prestigious Imperial College shocked the world with unthinkable fatality forecasts, followed rapidly by overflows in Italy’s intensive care units, with resulting 7% fatality rates and doctors needing to decide who lived or died.
In contrast to the Asian experience, Western nations began total lockdowns, shocking markets by throwing their economies into Depression-like conditions. Aside from the terrible human toll of the virus, skyrocketing economic costs were threatening lasting damage. Prior pandemics had witnessed years of slowness in their wake. This time, governments and central banks quickly attempted massive offsets.
Amid the turmoil, and with our eye firmly on intermediate-term fundamentals and how risk was being priced, we adjusted our positioning stance from risk-on at the beginning of the year to a more bearish stance in the ensuing months, and then back to slightly bullish once again.
As we near the midway point, markets have been supported by extraordinary liquidity provisions and a recognition that rapid and powerful fiscal responses pre-empted financial failures and deep balance sheet recessions, which tend to be longer lasting. While the 12 prior pandemics all left consumers scarred, with rising precautionary savings for years to come, early evidence now points to the success of these monetary and fiscal offsets in diminishing what previously had been lasting damage. We are now witnessing a willingness among consumers to resume many activities while practicing social distancing.
Moreover, fears of second waves of the disease and a resumption of lockdowns are abating as the world considers examples like Japan and Taiwan, which avoided total lockdowns while suffering far fewer fatalities through diligent wearing of face masks, social distancing, and hygiene measures early on. It can be done. Concerns about the viability of a coronavirus vaccine (given past failures) are also lifting. Drug discovery can move faster today using reverse-genetic techniques, and China shared gene sequencing data for the novel coronavirus with the world. Massive funding has also been made available to dozens of firms in a race for the vaccine, contributing to optimism that a fast-tracked vaccine could become available sooner than once thought.
As economies reopen, the pace of recovery revealed by alternative high-frequency data sources is encouraging, even for travel, lodging, and restaurants. Nonetheless, policymakers’ fears of lingering or permanent damage is reason to expect them to maintain (if not expand) current monetary and fiscal support, at least until the coast is clear.
Still, many risks persist, so we remain only cautiously optimistic. After having put the virus in check first, China has become increasingly assertive on a number of contentious geopolitical issues. In a US presidential election year, both parties are taking a harder line on China. Geopolitical tensions are flaring. Many laudable fiscal programs launched to create “income bridges” for smaller businesses and to avoid layoffs and bankruptcies have expiration dates. And even without these, risks remain high that many small firms may not survive.
Also, the initial rally has been highly unusual. As opposed to inexpensive stocks (whose earnings have the most to gain from economic recovery) leading the rally, as is typical early on in economic recoveries, until mid-May the rally was being led by the most expensive, high-quality stocks, which fell the least and whose earnings have the least recovery potential – a sign that the rally had previously been driven entirely by central banks. That was a very shaky foundation, requiring central banks to continue driving the markets all by themselves. Now, with prospects improving since mid-May not only for a vaccine, but also for less enduring scars, a rotation toward less-expensive securities with more recovery potential to their earnings has begun. The foundation has shifted toward fundamentals, and is thus a stronger foundation should those fundamentals come through.
All told, while markets have priced in a fair degree of optimism, pockets of more bearish sentiment remain.
The equity market rally has been broadening out into less-expensive and more cyclical segments, as is more typical early on in a recovery. This broadening may also lead non-US equities to catch up toward their US counterparts. These out-of-recession rotations usually have strong tailwinds, with rapid earnings growth for a few years on top of attractive valuations. Yet in the current economic configuration, we expect the longevity of these tailwinds to be more limited, given structural drivers that support larger, more resilient and asset-light business models. Disruption has accelerated during the coronavirus crisis, and smaller businesses will continue to struggle to grow on an uneven playing field. While not preventing them from enjoying a narrowing of their valuation discount, the prospect of a durable recovery remains in question.
We have favored credit assets as offering the highest potential risk-adjusted returns in the recovery ahead, particularly in a pre-vaccine world with a ceiling on growth. Spread tightening has been swift as growth prospects firmed, and as the Federal Reserve began to follow through on its promised purchases of credit assets.
We still find some pockets of credit exceedingly attractive. Among them are some emerging market (EM) sovereign hard-currency credits. EM spreads have lagged the recovery thus far but will likely eventually benefit from tightening in core markets and a continued search for yield. While rate curves in all the developed countries are now repressed below inflation for as far as the eye can see, EM rate curves still offer returns in excess of local inflation. Many sovereigns have recently tapped primary markets, and the uptake has been encouraging.
Energy markets have been rapidly rebalancing, as we had expected. In fact, the pace of supply curtailment has been ahead of expectations. As highlighted above, demand recovery has also surprised to the upside. This appears to have accelerated the rebalancing, with prices reflecting these positive developments. We continue to expect further appreciation, albeit at a more moderate pace, as higher prices begin to encourage the return of supply.
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