If we look back at our thinking in the earlier part of the year, the spread of Covid 19 has been much greater than we expected. It has led to a more draconian health policy response with shutdowns in most developed economies. The effect has been a much deeper cut to economic activity than we thought would happen. The process of reversing lockdowns is not clear either. It is looking like a gradual reversal rather than a big bang event. As a result, the recovery will be more drawn out than we expected at the start of the month. Global GDP is now likely to contract 2% - 3% in 2020 and rebound something of the order of 5% in 2021.
The offset is that policy makers have responded quickly and with a lot of firepower. This is a much larger and speedier response than we saw at the time of the Great Recession. Then it took time for quantitative easing to be implemented – and six years for the ECB to come around. This time the button was just pressed and the major economies all coordinated their efforts. The speed of this response should mean that we do not get a repeat of 2009. Interest rates will remain negative and bond yields at extremely low levels for the foreseeable future.
The fiscal response has also been significant. There are administrative hurdles to get over, but it does seem to be moving into action. Against other fiscal packages, such as tax cuts, the income supplement schemes should have a greater multiplier effect. Credit support and loan guarantee schemes for companies are likely to improve labour retention which should bolster the income line and make sure we have the infrastructure there to resume activity when the lockdowns pass. In total the fiscal response is more than double the size that was implemented in 2009 and it is not confined to China and the US this time. This significant fiscal spending will limit damage in the short term, but the positive impact is unlikely to be seen until the second half of the year.
Credit markets are crucial
In recessions, credit and equity markets become stressed. To get the recovery in motion we must first have stability in the credit markets. Looking at the experience of the Great Financial Crisis, credit markets came under increasing pressure through 2008. Investment grade spreads widened from 225bps at the start of the year to a peak of over 600bps in November. In October 2008 the Fed started its first round of quantitative easing. By November 2009 the spread was back down to 200bps. The credit market moved before the economy reached its low point – the policy actions were vital here.
Today, we have all central banks involved and we have governments extending loan guarantees and other credit support. The healing process has started in the credit market already and we expect this to continue. With corporate market bond spreads near euro crisis highs we think good value has appeared. And with the Fed now acting to support credit markets for the first time, we expect spreads to come down and generate good returns. Hence, we have reduced cash and increased exposure to credit markets.
Healing credit markets alone was not enough to turn equity markets in 2008/09, though. They kept declining until March 2009 when the economic fundamentals stopped deteriorating. We did not need to see positive figures, just less negative ones. This is illustrated by the equity market trough coincident with US labour market and manufacturing sentiment troughs. This is also consistent with prior market cycles.
The earnings factor
As with the equity market, so with earnings forecasts: they trough very soon after the trough in the data. Earnings visibility is low, but this should improve over the next month as Q1 results and company comments come through. We expect 2020 earnings to be cut by 30% in the US and larger amounts in in other regions. They should rebound a similar percentage in 2021.
We expect markets to evolve in a similar pattern to this. Central bank actions seem to have put a floor under the credit markets. It is not going to be a straight-line improvement, but a healing process should continue.
Once the economic indicators start passing their worst levels, equity markets can start a sustainable recovery. For this recession there is an event in the not too distant future – an end to lockdowns - that is going to lead to a turnaround.
People might think that things could get worse, and therefore they should sell equities now and buy back later at a lower price. However, the chance of adding material value seems low. The probability is high that economic indicators will bounce back quickly. Chinese indicators are recovering toward normal levels already, and we are likely to have the euro area PMIs moving up from lows in the near future.
Finding value
Where does valuation reside? We look at two measures. The first is absolute valuation and the second values equities against the bond market. Neither measure is perfect but using both we get a sense of whether equity market valuations are extreme.
The current trailing price-to-earnings multiple (P/E) is close to the QE (quantitative easing) era average and the two-year prospective P/E is close to the QE average. Arguably, the prospective P/E multiple should be above average as earnings will be depressed. The current earnings yield gap is close to the highest levels we have seen and are well above the QE average. A fair valuation resides somewhere in between these two measures and one can argue about where it should be. However, we can take from it that current valuation isn’t necessarily an impediment to further appreciation. It does not stand in the way of the equity market following the economic momentum.
