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The long term, interrupted

24 March 2020

Establishing a framework for navigating the coronavirus outbreak is helpful, says GAM Investments’ Julian Howard, along with a recognition that market narratives, like human ones, tend to overshoot, leaving opportunity for careful additional investing on a medium to long-term horizon.

Markets have fallen into an extended decline this year with the advent of a new virus that has rapidly spread around the world. Most of Europe is in lockdown. The 2020 Tokyo Olympic Games have been postponed. Amid the noise, trying to understanding the possible economic and market impacts is as difficult as modelling the course of the virus itself. However, investors need to make some sense of the situation and maintain some core principles to guide them through. 

Assessing the potential severity of the economic impacts from the coronavirus at least sets a baseline to work from. In theory, the impacts could become very severe indeed. The difference between the coronavirus and more traditional demand shocks like the 2008 global financial crisis is that supply is also being threatened. While service sector employees and knowledge workers can often work remotely, many vital sectors like manufacturing, transportation, healthcare, and their associated supply chains, still require a physical presence in order to function. UK investors may recall the fuel strikes of 2000 which were characterised by panic buying, a meltdown in logistics chains and a total economic cost of GBP 1 billion. The myth of the ‘weightless economy’ was firmly debunked that year. Supply shocks are also challenging because they tend to complicate policy response. Looking further back to the oil and food crises of the 1970s and early 1980s, inflation got out of control and the Federal Reserve’s response under Paul Volcker was to aggressively increase interest rates, see chart 1. This was risky and the period was characterised by recession as demand was impacted. This time around, if inflation spikes as a result of constrained supply of labour and materials – and the US inflation-linked bond market has started suggesting it might – then global central banks might have to suddenly reverse course on policy easing, with adverse consequences for markets and the real economy. Regarding the latter, the combination of a supply and demand shock may also see unemployment spike as firms do what they can to remain solvent through the crisis, resulting in a cash crunch as mortgages and loans go delinquent. There would be knock-on effects for the wider financial system. I believe a recession looks all but inevitable in this scenario, with global growth stalling altogether. 

Chart 1: Policy challenge: supply shock of the early 1980s saw interest rates violently cranked up:

 

Source: Bloomberg. Past performance is not an indicator of future performance and current or future trends.

In markets, we believe equities would be the most obvious victim as the future earnings prospects of companies decline along with those of the economy. Credit to large firms via the corporate bond markets would come under severe stress as lenders demand an ever-higher premium or ‘spread’ for extending finance to companies operating in a recessionary economy. Government bonds though would likely continue to rally given the way in which the 10-year US Treasury yield coolly broke below the 1% barrier without any resistance. And other sources of ‘crash protection’ like gold and the Japanese yen would likely also fare well as investors panic and scramble for perceived safety. 

This paints a bleak ‘floor’ of what is possible, but we do not feel that this is probable. Veteran economist Robert Shiller recently coined the term ‘Narrative Economics’ to describe how stories transmit and mutate around the world like viruses, affecting human behaviour and ultimately, economic and investment outcomes. For example, after Austria-Hungary declared war on Serbia in July 1914, the US and European bourses reacted by shutting shop, which increased panic and saw steep falls in market prices as well as the withdrawal of gold out of the US back to Europe. Today, the coronavirus story includes a strong human behavioural element. Panic buying - this time of toilet roll and paracetamol - has again been reported in the UK despite the UK government’s chief medical advisor stating that “There is nothing in the current environment that would rationally lead someone to want to go out and stock up on stuff”. Similarly, face masks are being worn in the worst affected countries despite no evidence of their efficacy. Efforts to mitigate risks in some instances look misplaced and even counter-productive. Transmission of these behavioural excesses is aided by social media. 280 characters leave little room for nuance, instead encouraging hysteria and equally impulsive reactions. Crucially, panic in the absence of evidence is seldom sustained. 

While predicting the course of the virus is an unenviable task, the summer months could see a simultaneous decline in new cases as well as the development of a new vaccine. Context is king here. The virus does not have the virulence of the Black Death or the Plague, the latter’s potency being such that strains are kept under armed guard at the UK’s Ministry of Defence Porton Down laboratories. The norovirus gastroenterological bug kills 200,000 every single year, putting into context the near 15,000 killed by coronavirus as of 23 March. At some point this story will become ‘just’ a dark episode of the past like so many others. In the meantime the responsiveness of the authorities should not be underestimated. While interest rate cuts may not make much difference to the spread of a virus, they should ensure pent-up demand bounces back and they play a role in supporting corporate funding. Furthermore, direct liquidity assistance from the banks to consumers will be forthcoming just as it was during the recent US government shutdown when many major US banks agreed to put a pause on mortgage and credit card payment demands for federal employees. A similar approach is already being taken in Europe, along with far-reaching wage support assistance. But we also believe that there will likely be political limits to the extent of the economic shutdown. Surprisingly little utilitarian analysis has emerged which balances the human cost of shutdown with that of the virus itself, but it is surely coming. In northern Italy where European quarantines were first imposed this question of balance was hotly debated while the US administration has recently spoken of wishing to avoid a cure worse than the disease. As the global shutdown deepens, so its duration could well be limited.  

Armed with this context, investors can look more calmly at the market picture. Many equity markets are now in correction territory and bond yields are on the floor, if not below it. This makes the prospect for risk assets incredibly attractive. As at 23 March, the forward earnings yield on the S&P 500 was over 7% while the 10-year US Treasury yield was less than 0.9%, suggesting an equity risk premium (ERP) of nearly 6.4%, see chart 2. In other words, investors are paid over 6% for holding equities rather than bonds. This is a high level by historical standards and analysis of past data suggests that it nearly always leads to equities delivering a strong absolute return over the next couple of years. And that timeframe is key. Speculative investing into the market in expectation of the magic ‘V-shaped recovery’ is unlikely to be rewarded. The virus and the response to it will not suddenly end; I believe it will instead dissipate over time as the efforts of the authorities are brought to bear. Then the story should start to change. But a recognition that market narratives, like human ones, tend to overshoot leaves an opportunity for some careful additional investing on a medium to long-term horizon. At the very least, investors should take it as a call not to capitulate on existing equity allocations. And when it is all over, they will be able to take stock. Serious discussions will be had regarding portfolio suitability and how diversification is best achieved, informed by the experience of recent events. 

Chart 2: Higher premiums: equities attractive, if you have the time horizon:

 

Source: Bloomberg. Past performance is not an indicator of future performance and current or future trends.

Assessing on-going market shocks has always carried a psychological bias toward negativity. Investment managers who paint a gloomy picture tend to sound more informed and appear to have carefully weighed the odds. Meanwhile those who paint an optimistic picture often seem to have misunderstood the risks or worse, do not care. But investing by definition demands a constructive mindset. Setting money aside from its core function of buying food and shelter demands a certain optimism for the future and confidence in humanity’s ability to make economic progress. Despite all the wars and episodes of folly that have punctuated human history, progress does get made and crucially, is investable. Sometimes, the long term gets interrupted. But usually not for long.     

 

Important legal information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of the manager in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.