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Investors and analysts are carefully examining economic tea leaves for signs of what is to come, but confusion still reigns. Only two things can be said with any confidence.
- The economic shock to the global economy is very bad, and for now remains unmeasurable and unpredictable.
- The data fog is slowly beginning to lift, indicating that the path forward will soon become more measurable and predictable.
The extreme volatility in recent financial markets was a sensible reaction to the unprecedented uncertainty. However, with increased visibility on the future path, markets will then be able to find a bottom and begin a recovery. We believe signs of both will emerge in the coming weeks and months, and that the key to identifying opportunities will be analytical flexibility rather than dogmatism.
The end of the beginning, but not yet the beginning of the end
Markets have suffered a triple shock tsunami in the past two months, but the initial wave is showing signs of cresting. The three blows have come from the reduction in economic activity in response to Covid-19, from the financial stress on the oil market from the oil price war, and from the extreme uncertainty that has helped to further paralyse activity. In all three cases the pressure has begun to ease, suggesting a bottom might be in sight, though a recovery is still far away.
The tragedy of the Covid-19 virus and the collapse in economic activity will end, one way or another. Either a vaccine is developed, or a global herd immunity evolves, or the world comes to accept some degree of increased mortality as a fact of modern life. Ultimately it is likely to be a combination of the three. As social distancing measures become ingrained, as infection rates show signs of peaking in Europe (though not yet the United States), and as scientists race to develop treatments, the worst of the economic impact of the viral outbreak is being felt, or is at least in sight.
“The oil industry will almost surely be permanently changed.”
The oil price war between Russia and Saudi Arabia erupted at the same time as the Covid-19 outbreak and has added further stress via the energy sector as prices have swiftly plunged at a record pace. Prices have now reached a level where higher cost production will be curtailed, whether by agreement or by bankruptcy. The conversations being held by US, Russia and Saudi Arabia about organising production restraints could amount to a de facto “OPEC++”, which, as we have discussed in the past, is the most plausible path for the long-term relevance – indeed, survival – of OPEC. In any case, regardless of whether or not the three major producers can agree a production cut (possible) and whether or not such a potential cut will rebalance the oil market in the near term (unlikely), the oil industry will almost surely be permanently changed after a period of consolidation with price spikes less likely as spare “peaking” capacity from shale producers stands ready to cap the market over the long term. The outlines of this future oil industry structure are now beginning to come into focus, and as such have helped the oil markets to find a floor.
The speed and severity of the selloff has been as much a function of uncertainty about what will happen as it has been about what has happened. In financial markets as in nature, when an inexplicable threat emerges, activity freezes. However, as the character of the threat becomes known, responses emerge and activity (of a sort) gradually resumes. In the case of the recent economic shocks, the first point of uncertainty was whether the financial seizure would lead to a systemic crisis in the global financial system. The overwhelming correlated (if not coordinated) response by central banks has laid those fears largely to rest, allowing occasional bouts of risk appetite to re-emerge. The monetary easing has also reassured markets that, even if liquidity cannot counteract a demand shock like we are enduring, at the very least there will be no borrowing constraint to impede the eventual recovery. In a similar vein, the enormous sums that have been promised as fiscal stimulus around the world have also encouraged markets to expect that the demand side of the economy will at least be kept on life support during the crisis, and thus be better placed to recover more quickly when the pandemic passes.
The end of bad news is good news, but the path ahead remains uncertain
The unprecedented volatility of the past two months has a been a perfectly sensible response by the financial markets to the crisis. When the virus was largely confined to Wuhan, markets could look to the SARS experience as a guide. When the virus emerged in Italy, the markets very quickly (and correctly) realised that this pandemic could potentially become a crisis for which there is no historical guide. Thus, abrupt and indiscriminate selling of any risk asset by individual investors made sense, even if collectively the sharp selloff amplified the risks to the financial system.
“The shock will be the worst recession in modern history.”
It is clear that we are in a severe recession, though the data as yet are unable to provide much guidance as to the depth and duration of that recession, much less the eventual recovery. Just two months ago, the average forecast for global GDP growth by four investment banks – UBS, JP Morgan, Morgan Stanley, and Goldman Sachs – was extremely consistent at around 3.2 per cent per quarter at an annual rate through the end of 2021. The same firms in their latest forecasts now see on average a 15 per cent decline in global growth to start the year followed by sharp recovery later in the year – and this includes the support from fiscal and monetary stimulus. The timing and magnitude of each firm’s forecasts vary substantially, but where all agree is that the shock will be a multiple of the 2008 global financial crisis, the worst recession in modern history.
The 2008 recession resulted in a peak loss of global GDP versus the pre-global financial crisis trend of 5.9 percentage points. By contrast, the current recession is expected to result in a peak loss of 8.8 percentage points. Moreover, the current recession is projected to have a much steeper decline and recovery than 2008, with two quarters of negative growth as opposed to three quarters in 2008-09. Thus, the emerging consensus is for a sharper and deeper but shorter recession than in 2008.
However, these kinds of forecasts – and forecast changes – must be heavily discounted because of the degree of uncertainty in the current environment. The uncomfortable truth is that the modern world has never experienced a shock of this nature and magnitude, and neither has it witnessed a fiscal and policy response on this scale.
What is the data telling us? Not much, as of yet
Financial markets have to make decisions about earnings expectations for equities and default risks for bonds in real time based on data that is inherently backward looking. The more the world today resembles the world in the past, the easier that decision. Today, the world looks nothing like the past – this shock, in speed and scale, is simply unprecedented.
Because of the inherent limitations in economic data, the key message for financial markets is still that “we just don’t know – yet”. Interpreting the data in the current environment is made difficult for three reasons – the lag between data measurement and economic activity, the geographical pattern of the epidemic, and the incomparable scale and speed of the moves. Thus, anybody who insists they know what is happening based on the data has only demonstrated that they don’t know what they don’t know. As a result, markets are still trading on conjecture, not measurement, though gradually the fog is beginning to lift.
“Markets are still trading on conjecture.”
The highest quality “hard” data (e.g. counting widgets produced, profits reported on tax returns) is reported with a lag, and thus is somewhat backward looking. More timely but lower quality “soft” data is available, but this is generally survey based (e.g. sentiment, PMI) and thus volatile and often distorted. The highest frequency, but least reliable, economic indicators are the financial markets themselves (e.g. equities, rates), as they embed not just expectations for future activity but also investor psychology, risk and liquidity constraints, and other sources of noise.
Additional complexity is added by the rolling geographical nature of the outbreak. China was the initial epicentre and thus is the first to report data, but Chinese economic data is widely regarded as extremely unreliable. US economic data is generally seen as the most complete and accurate, but as the US has been one of the last countries to be hit by the virus there is as yet very little data on the impact.
Finally, as these events are without contemporary precedence, there is no reference point against which to measure and thus interpret the data we do have. Looking for patterns to match with the data from the past is of no use. Instead, financial markets will need to focus on conjecture and narrative rather than measurement and data for the coming weeks.
What data we have gotten is grim
At the moment, we have had a lot of reaction from financial markets, a few soft data points, and hardly any hard data points. The initial market reaction to the spread of the coronavirus from China to Europe and beyond is well known – the sharpest risk-off move in global markets in decades, followed by the swiftest partial recovery in years in part because of an unprecedented correlated (if not coordinated) collection of fiscal and monetary stimulus measures.
On the soft data front, the news has been grim, with one glimmer. The China PMI surveys for February were closely watched as the first major soft data report from an affected country, and they showed an unprecedented decline reflecting the temporary closure of large parts of the economy. PMI reports for March show a sharp decline in Europe and the US, with forward looking indicators pointing to further downside. However, the PMI’s suggest a rebound in activity in China, and thus a glimmer of hope that the end may be in sight. However, we remain cautious. A PMI survey is a useful indicator under normal circumstances, but these are not normal circumstances. The PMI basically asks firms “do things look better than they did last month”; the survey doesn’t even try to ask “how much better”. In China last month, many (if not most) firms had shut down. This month, many have reopened. Thus, if only one customer has come through the doors following a month of closure, that will show up as a positive response on the PMI survey. For this reason we remain cautious despite the glimmer of good news in the Chinese data.
As the soft data surveys have rolled westward to Europe along with the virus, the news gets grimmer. The composite PMI for Germany for March, for example, plummeted from for 50.7 to 35, broadly consistent with the decline in China from February. The ZEW business survey confirms the message, as do business and consumer surveys throughout Europe.
In a single week the US has seen a tenfold increase in jobless claims.
The US as world’s largest economy was one of the last to be hit with full force of the coronavirus, and yet the US is also the source of one of the only hard data points yet available. Weekly jobless claims in the US soared to the 6.7m last week, which is so large it was previously unimaginable. In the 60-year history of the series, US jobless claims have never gone above recession highs of 700k, and yet in a single week the US has seen a tenfold increase. The abruptness of the change has also been dramatic. The change in jobless claims reported on 26 March was a 220 standard deviation move, and the week following was “only” a 20 standard deviation move. From a statistical perspective, such a move would be considered “impossible” a priori, and yet here we are.
In weeks and months to come we will continue to get more clarity on the extent to which global economic activity has seized up, but given the severity and swiftness of the shock the data will continue to have little historical precedent and thus remain difficult to interpret. Thus, investors will have to develop new playbooks, rather than pulling out patterns from old playbooks.
Work stops, governments spend, central banks lend
While the current crisis is unprecedented in scale and speed, so also is the policy response. Broadly speaking, governments around the world have mandated an economic freeze in order to reduce the spread of the virus. In order to maintain private consumption despite the halt in productive activity, governments are increasing spending massively, which they are paying for via borrowing from central banks.
The clearest measure of fiscal stimulus is the primary balance, or the government deficit adjusted for interest payments. The global primary balance in 2020 is expected to exceed 8 per cent of global GDP – and this is likely to increase as and when additional stimulus measures are announced. Thus, the stimulus will likely prove to be twice as large as that from the 2008 recession.
This stimulus is being paid for not through future taxation but through monetization. Around the world central bank policy rates have declined, and the GDP weighted average policy rate in the developed markets is now slightly negative. Moreover, central banks have ramped up their quantitative easing, and in some cases (e.g. the US) have placed no hard limit on the amount of liquidity they will provide.
In the near term, this public sector response to the collapse in economic activity will probably work. With zero borrowing cost, governments can hope to grow their way out of the debt. Eventually, if necessary, those countries lucky enough to borrow in their own currencies can simply monetize the debt. However, the long term consequences may prove problematic.
Narratives, not data, are the focus at present
In the weeks ahead, we believe there are three key narratives that investors will focus upon. The first is the course of the epidemic, the second is the extent and effectiveness of the policy response, and the third is the depth and duration of the economic downturn.
“The virus will remain a concern until a global vaccine or herd immunity is developed.”
The primary narrative at present surrounds the coronavirus – how fast it is spreading, whether it is peaking, and how far we are either a vaccine or herd immunity. There are tentative signs that the infection rate may be peaking in parts of Europe, and a peak in the US will be a welcome sign for markets. However, investors will remain wary of the potential for infection rates to rebound as and when social distancing measures are relaxed. Accordingly, the virus will remain a concern until a global vaccine or herd immunity is developed.
The second narrative that investors will attend to is the rollout of the stimulus packages, both fiscal and monetary. Globally, some $5tn of fiscal stimulus packages have been announced, with only China (with somewhat less fiscal room to manoeuvre) left to join. Broadly speaking, work by Morgan Stanley suggests this is likely to push the G4+China cyclically-adjust primary fiscal balance to around -8.5% of GDP. This compares to -6.5% of GDP in 2009, in the depths of the “Great Recession”, and a more normal range of -2% to -2.5%. While the size of the stimulus is thus massive, so also is the gap to be filled by the slowdown in the global economy. What remains to be seen is if the stimulus will prove big enough, if the distribution of funds will be effective, and the long-term impact of the surge in public sector debt.
On the monetary front, we have seen a massive injection of liquidity from central banks around the world, with balance sheets at the Federal Reserve, European Central Bank, and Bank of England expected to expand by about $6-7 trillion. We believe the goal here is not to stimulate activity – if people are quarantined and businesses are closed, low borrowing costs won’t get consumers into shops or get factories producing goods – but rather to mitigate the liquidity shock of the sharp sell-off in risk assets and to allow for an unimpeded (by liquidity) recovery when the virus shock recedes.
“The coronavirus has prompted the economic equivalent of a medically induced coma.”
The final narrative concerns the extent and the duration of the global economic downturn. The coronavirus has prompted an unprecedented event, the economic equivalent of a medically induced coma. Historical patterns in the data won’t provide much guidance in the current environment. Instead, logical reasoning and economic theory will have to underpin analysis until enough data is collected to validate or invalidate hypotheses. For this reason, markets are likely to remain difficult to forecast for some months – resulting in both risk and opportunity for those who have patience and capacity to act.
Past performance is not a reliable indicator of future returns. Forecasts are not a reliable indicator of future returns. If the information is not listed in your base currency, then the result may increase or decrease due to currency fluctuations.
If not otherwise indicated, all graphs are sourced from Dolfin research, April 2020.
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