If you went to sleep on the last day of 2019 and just woke up now you would be forgiven for thinking that we had gone through some mild economic turbulence this year rather than being in the middle of the sharpest - albeit shortest - recession on record. Fixed income markets would catch your attention. Interest rates are 0% or lower across the globe and the US 10-year yield is not much above 0.5%. You would certainly think that something had changed in monetary policy. But with world equities down just 7% and the Nasdaq around its all-time high, you would not conclude that anything especially disruptive had happened.
But something major has happened
The question we hear most from clients is this: How can equity markets have recovered so much so quickly, especially where there is a chance of lockdowns being imposed again? Even in Goodbody we have been surprised at the strength and speed of the rebound – and we have maintained a relatively optimistic view from the start of the crisis.
One positive factor since the onset of the recession has been the policy response of central banks and governments. The Fed cut interest rates practically to 0% and moved rapidly to unlimited quantitative easing. The ECB has little room to reduce interest rates but has re-engaged in QE with two packages introduced since the onset of the recession. The Bank of Japan and the Bank of England also followed with larger QE packages. All the major central banks are purchasing corporate debt, too - unheard of in any past recession. It looks like interest rates will not be going up for the next couple of years and it would take a large spike in inflationary pressures to change that.
Generally, in a recession there is always stress in the corporate debt market as defaults and insolvencies start rising. Banks then come under pressure and this creates a second round of weakness. Central banks have almost eliminated this risk by moving into the corporate debt market has almost eliminated that risk. The central banks engaging in large QE programmes allows governments space to implement fiscal stimulus, as the central banks stand ready to buy the new bonds that must be issued. Capping interest rates means all asset values can rise, the discount rate is lower, and investors will move into higher yielding assets to get returns as long as interest rates remain at 0% or in negative territory.
Governments are much more active this time
In the last recession, both the US and China implemented significant fiscal stimulus but elsewhere the response was either neutral or to tighten fiscal policy. Here in Ireland we had to implement austerity just as the economy was getting into difficulty and Germany passed its balanced budget amendment. What a difference this time. Germany has passed two fiscal stimulus packages and agreed to partake in an EU-wide recovery package. Fiscal support for the global economy is running at close to 4% of world GDP. In the last recession it barely got over 1.5%.
And they do not seem to be finished. The US government is contemplating another fiscal package aimed at infrastructure investment. In the UK the government is considering further measures, such as cuts to VAT, to support distressed industries. In the euro area we are starting the negotiation process for the recovery package. Governments have also helped to avoid any credit crisis with loan guarantee schemes introduced in all the major economies.
It seems to be working. When countries went into lockdown, we knew there would an enormous drop in economic activity. We then faced the hurdle of how soon restrictions would be lifted. Now we are facing the question of how quickly economic activity will start to recover.
Over the last month the signs have been good. In all the major economies most of the economic indicators have come in better than expected. The fiscal measures seem to have worked. Now there surely is an element of pent up demand, so we are likely to get some disappointing releases, as well – after all, things never go up in a straight line - but the world economy is in recovery mode and that is important.
That means we are looking at a different type of investing psychology. If it becomes widely accepted that we are in an economic expansion, then the tendency among investors is to buy risk assets during setbacks rather than to prepare for the setback - the ‘buy the dip’ mentality.
There are still risks
The COVID virus is still in our communities. As we re-opened there was always likely to be some level of increasing infection and hospitalisation. The risk for financial markets is if they get to a level that forces governments to impose restrictions again. So far this has not been the case and there does not seem to be as much social or political will to bring them back. The US is the one area that is causing the most concern as the number of new cases is accelerating. This, obviously, must be watched but the will to reimpose restrictions nonetheless seems low.
As a result, we are cautiously optimistic. There has been increasing evidence that the global economy hit its trough sometime in April or May and is now getting onto a sustainable growth path. Thus, we have been reducing cash across our models. We increased our corporate credit exposure after the actions of the central banks and well over half our fixed income exposure is in this area. We had a reasonable level of equity exposure already when this all started, so we were not under pressure to buy into a rising market. Equity markets were quick to discount the good news so there were not any gaping opportunities without taking significant risk, so we have held our overall exposure constant.
We can be patient and use the ‘buy the dip’ mentality to our advantage. We have changed our equity mix, however. Usually after an economic recession the sector leadership changes in equity markets. The industries that drove the last cycle do not drive the new cycle. This recession feels more like an economic correction - short and sharp - rather than the ending of a cycle. If that is the case, then the industry leadership is not going to change. This is what we have been doing with our equity exposure. Buying more service industries than production industries, and making sure that the companies we buy are well-positioned for a digital world and have more than just the economic background to drive their growth.