Markets’ rollercoaster moves often create a misleading picture on what is actually going on in the underlying economy. Global growth has been in gradual decline for two years due to lower Chinese investment, the trade war and an overbearing strong US dollar. As 2020 began, market volatility was very low and valuations ridiculously complacent in risk markets and so in our mind a set-back was just around the corner. As soon as Covid-19 arrived in China, the fragile margin for error for global growth was breached and a market swoon was inevitable. The well-known liquidity risks in global markets only heightened our concerns. In no way, however, did we expect it to get this bad.
Four months on from the first cases in China and the world is a starkly different place. Almost without exception, the developed world has locked down, shut up shop, printed money, written blank cheques and followed in the footsteps of the Chinese.
No freedom from suppression
Most developed markets have been rewarded, in the near term, by shutting down their economies and if you plot market volatility it has fallen very closely in line with the decline in new COVID-19 cases. But of course, there is still plenty that could go wrong.
Clearly, for one, the jobless claims could keep rising above and beyond what policymakers are prepared for. Perhaps the greatest threat, though, is the complete debunking of the V-shaped recovery. The most likely cause of this is a large increase in cases after the lockdown ends, with the market needing to price in rolling lockdowns (as seen in Hong Kong and Beijing) until a vaccine is found or local populations reach herd immunity. Another could be a botched, uncoordinated effort to re-open economies, which feels entirely possible in some jurisdictions given the way the outbreak was handled.
Policymakers in developed markets may have overused Draghi’s ‘whatever it takes’ line, but they have backed this up with extraordinary policy measures. If they can help it, no good business will go under and the markets can continue to look through the growth decline. Our base case remains for a recovery over the next two quarters that could elicit negative growth in line with the U-shape that the market is beginning to price. Given the recession we are now in, solvency issues and protracted pain at the riskier end of the spectrum are clearly going to happen but there are gains to be had in good assets given the policy response and some increased clarity we are getting on the virus path ahead now.
An emerging challenge?
The more immediate concern lies with emerging markets, whose external dollar borrowing gives them added fragility – and like developed markets also need financial support – but from outside sources.
Capital has flown out of EM funds, with the IMF estimating the figure to be US$90bn. Some larger emerging market countries have cut rates aggressively and even tried QE, leading to an aggressive downdraft in their exchange rate. Emerging markets, particularly corporates, have gorged on US debt since the last crisis and, given emerging markets account for around 60% of GDP, the global recovery from this will tepid at best until this is resolved. This will require a massive increase in the IMF’s lending, which does seem to be forthcoming but clearly time is of the essence.
What do we do now?
We entered this crisis with a highly-liquid, defensive portfolio that enabled us to avoid the worst of the drawdown. The response to this pandemic, however, has gone some way to creating the conditions necessary for a reflationary bounce in the medium term.
The Fed is printing US dollars in huge quantity and doing its utmost to send them wherever they’re needed. We expect them to do even more and some form of explicit yield curve control seems likely. This could result in dollar weakness as financial repression kicks into full swing, especially when many nations are engaging in long-awaited fiscal stimulus. In the end, the huge stimulus needs to be paid for and inflation is likely to be most politically-expedient way to do this.
We still see government bonds as a good investment in the months ahead but by nature of the policy response the real return on bonds might suffer if the central banks are successful in their aims. In this instance we have plenty of other options to add returns by owning corporate bonds, inflation-protected securities and currency un-hedged foreign bonds. Shrinking the portfolio’s sensitivity to interest rates is also an option, if economic fundamentals start to pick up by shorting long-maturity bonds.
Most recently, as market stress rose and liquidity faltered we increased our exposure to risk assets while keeping exposure to duration. Liquidity in the portfolio still remains at high levels. We have de facto ‘yield curve control’ in all developed markets as central banks pin down the risk-free asset, and increasingly try to control parts of the credit market. The portfolio has therefore increased its allocation in highly rated corporate credit, predominantly by removing credit hedges and selectively adding new issues.
Our process allows us maximum flexibility in whatever investment environment we find ourselves in; consequently, we don’t think you need to roll the dice with illiquid investments to get high returns, especially as policymaking enters unchartered territory.