Signs of stabilisation | Top Down

26 March 2020

The surreal trauma of the coronavirus pandemic continues to ripple across the globe. The impact on financial markets has been severe and world equities are down almost 27% over the last month. Both the scale and the speed of the price falls have taken people’s breath away. The rapid spread of COVID 19 and the degree of economic shut down across the developed world have led to massive cuts to economic forecasts. For the second quarter it looks like the global economy will shrink by over 10% on an annualised basis, which will leave the world in recession for the year. A recovery is expected to take place in the third quarter but there is disagreement about whether it will be a U-shaped recovery or a V-shaped recovery – in other words, how long the recession will last before growth resumes.

But the coronavirus shutdown was not the only thing undermining financial markets. At one stage the price of all asset classes – equities, bonds, gold, etc - were falling at the same time. There was a rush to raise cash, which unnerved investors. This created a real fear that there was some sort of liquidity shortage and that a stressed financial system would feed back into the seriously weakened real economy.

Policy makes an impact

What we needed was a large and loud policy response and that is what we got. The scale and breadth of the measures being implemented by the central banks is phenomenal. All of them are now engaging in the corporate debt market and the Fed has announced that its quantitative easing programme is now unlimited.

The short-term reaction to these measures has been encouraging. Corporate credit and peripheral spreads have moved in by about 100bps. While we undoubtedly will have some other fearful days, confidence is being restored in the credit markets and we are likely to have only a limited feedback loop from the financial markets into the real economy.

We have also seen a significant fiscal policy response. This has been faster, bigger and more widespread than in the past. In addition to the US and China, euro area countries have also announced significant fiscal packages to off-set the economic impact of the shutdown. Income support schemes are now typical across the developed world.

The fiscal packages also contain measures that will likely help the credit markets as well, such as loan guarantee schemes, extended tax deadlines and more generous regulatory treatment of loan payment terms. The total fiscal injection amounts to 2.6% of global GDP. It was 1.6% in the worst year of the Great Recession.

The path to recovery

The two big questions now are: when will the shutdown and how quickly can things rebound. While the worst appears to be over in China, we are still in the early stages in the developed world. There is still no definite evidence of a sustained improvement in Italy – the first western country to be hit – so we are no wiser about when lockdowns will end.

What about the speed and strength of the recovery? The Chinese example indicates a relatively quick bounce-back. Companies there are saying that production is back to 80% - 90% of pre-crisis levels. This is supported by coal consumption at power stations which are back to 90% of pre-crisis levels. The challenge for China is now dealing with the scale of external demand rather than the speed of resumption.

Corporates batten down the hatches

Companies will have very different experiences going through these events. Some will see little impact, a few might benefit a bit, but most will be nervous. They do not know how bad it can get or how quickly things will recover. Most have moved onto cash conservation, halting dividends and share buy-backs. We have seen some implement temporary salary cuts. This last move is important as are government decisions provide various form of income support. The initial aim is to soften the blow to income while also preserving employment, so that when the infection passes, production can resume relatively quickly.

These are very stressful times we are going through and the behaviour of financial markets reflects that. A couple of weeks ago it was looking very grim as there were signs of real liquidity problems in the credit markets. Now credit markets are stabilised and corporates are drawing massively on credit facilities, all on the assumption that economic activity will rebound before long.  Governments are meanwhile borrowing to fill the demand gap, which is also assumed to be largely temporary. Confidence will undoubtedly waver and things will stay volatile. Uncertainty is still very high and there is much bad news yet to come, even in a good scenario.

Yet we expect the policies from central banks and governments to work. There have been large corrections in some fixed income markets as well as equity markets. We have had low fixed income exposure for a long number of years and will be increasing that exposure now.

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