Quarterly Investment Outlook Q3 2020: Covid Recovery and Anxiety

Mon 13 Jul 2020

A quarterly report is not normally a difficult document to put together. Usually it consists of an account of the trending state of affairs, the more possible outcomes and risks to those outcomes. In the past few years, these reports were actually made easier. The US Federal Reserve was underwriting risk at such an unprecedented scale, nearly unwavering for more than a decade, in a manner which suppressed all major hazards to the economy and financial markets. Ever since 2010 the question, repeatedly, had been: “With opportunity costs driven down so much for so long, whatever can bring markets down?”
This report sees all previous economic trends broken but, persistently, financial risk assets back up to trend.

The first exogenous shock to the economic and financial system, a global pandemic which led to extensive lockdowns, especially in key economies, has produced a range of negative outcomes to the economy. While similar pandemics occurred in 1958 and 1968, the “Great Lockdown”, i.e. successive and strict lockdowns of all major economies, was indeed a first in recent recorded history. All of the world’s 11 major economies, representing more than two thirds of aggregate output, have virtually stopped most non-essential economic activity at varying degrees from March until early June in an effort to stop transmission of the virus.

As a result, a record 11-year anaemic economic expansion came to an abrupt end. Global demand for goods and services has retreated to its lowest levels since the Great Financial Crisis, supply chains have been broken, capital investment virtually stopped, while unemployment – and even worse the threat of it – is soaring. It is worth mentioning that we are entering this environment from a position of weakness. A 10 year period of “secular stagnation”, deteriorating global trade conditions and de-globalisation. Massive monetary and fiscal stimulus have been pledged to fight the effects of COVID-19, yet, according to the IMF, global aggregate output is set to contract 4.9% for the year, the worst since WWII. British output is set to contract close to 10%, the worst year since 1921 and before that 1709-1710, years where Britain suffered from the worst winter in half a millennia. Meanwhile, emerging markets are haemorrhaging investment money at yet another record pace. The situation is momentously accentuated by the lack of central coordination between the G7, but also within the EU and, incredibly, the United States of America.
It is frustrating certainly that the final depth of the recession, and the subsequent shape of the recovery, are at the mercy of an invisible enemy who does not comprehend economic and financial cycles, doesn’t sleep, may shift its composition, moves in stealthy and unpredictable ways and may re-appear anywhere in the world. No defence can be mounted against it, except for isolation and good hygiene. At the time of writing, the virus was in full upswing in populous countries like Brazil and India, while the US was either seeing a second wave or a significant extension of its first wave. In search of a modicum of certainty, the global economy remains in suspended animation, like particles in the air waiting for the next gust of wind to blow them in any direction.

So it probably confounds logic for many an investor that the opposite holds true for financial markets. At the time of writing many US stocks were up for the year, while Europe and the UK were suffering a only a mildly bad year, not nearly reflecting economic realities and dangers to potential earnings. Additionally, despite a record projected amount of borrowing and global debt to GDP levels rising to levels previously ascribed to Greece and Italy, bond yields remain at their lowest levels in history, and thus prices at their highest.

The answer to this conundrum is, surprisingly, easy. The purchase of something, anything, be it a debenture, a fork or a forklift, depends on the need for the asset weighed against the opportunity cost for it. If the opportunity cost is – virtually – zero then the decision to purchase said asset becomes that much easier, especially if they come with the promise of further returns. Quantitative Easing, from which the global economy has seen nearly $5tn of new money since last September, is a process specifically designed to boost prices for intangible financial assets, stocks and bonds. At the same time, it supresses market risk, a practice which could prove especially helpful at a time of unprecedented pressures for the real economy. Put simply, when faced with a once-in-every-four-generations global pandemic, which could take an even worse turn at any time, the last thing policy makers would want is to have lines forming in front of ATMs too. Thus markets act as a supporting mechanism to the economy, rather than a reflection of it.
Having said that, risk suppression does not mean the absence of risk altogether. When we buy equity, shares of a company, we share in the profits. Further viral waves could hurt companies and supply chains more permanently. If there are no long term profits and prices go up on the single virtue of an institutional investor creating demand, then investing turns into an opportunistic asset inflation game, and yes, there is a point at which the disconnect with the real economy might end. Similarly, when buying government or corporate debt, we do so with the faith that this debt will be repaid to us. Zero interest rates and institutional buying help refinance all debts, especially national ones, as Modern Monetary Theory allows for countries to print as much money as they need to pay off their debts.

Nevertheless to this practice there are breaking points as well. If operational earnings are very low for a long period, and debt and equity financing becomes the only way to keep an enterprise going, reasonable investors will eventually decide to opt for investments with real organic growth or tangible real assets. And the limit of monetary expansion for the state is the inflationary threshold, beyond which all money printed comes with a direct price tag for consumers. Money printing is a mechanism that is supposed to buy time for the real economy to recover, not substitute it in its entirety.