The last stand?

“There are decades when nothing happens; and there are weeks when decades happen” (Vladimir Ilyich Lenin)

Markets remain skittish to say the least. Investors continue to grapple with what the worst case outcome really looks like as large parts of the world economy power down. What are the main stress points? What can we expect from policy makers in the coming weeks and will it be enough? Is it time to sell everything and take succour in the safety of simple cash?

The Future

As always the danger here is that we exaggerate our ability to see what comes next. Nobody can. At times like these the hard numbers of economic forecasting are even less use than usual to an investor. The reality is that there are myriad paths ahead, some more likely than others admittedly. However, for all of us, it is probably more helpful to think about this full range and how incoming information changes that distribution of potential viable outcomes. It is worth noting that the below are the extremes of potential scenarios and not a prediction of the reality that the market will face.

A guess at the best…

In the best cases, you can put developments such as a benign mutation of the virus, or indeed a successful test of Remdesivir or one of the other potential antiviral treatment candidates (news is due here imminently). Further help might come the virus exhibiting the same degree of seasonality we have become used to in its coronavirus siblings. As a combination of treatment and seasonality combine to reduce both the case fatality and transmission of COVID-19, we see the economy bouncing back strongly in the second half of the year. The extra fuel being loaded on the global economy by policy makers supercharges that rebound, with economically sensitive assets, such as stocks and credit, soaring as a result.

And the worst…

The gloomier scenarios are characterised by persistent flare ups in the coronavirus as soon as quarantines are relaxed. As an aside, we are not so far seeing evidence of this in China’s tentative return to work, but there is time. Nonetheless in this scenario, where strict social distancing remains in place for longer than currently planned, you could plausibly imagine societal and political dysfunction, major default cycles and even a depression. A shorter leap of imagination is required for worries about the large quantity of US corporate debt perched somewhat precariously on the ratings line separating junk credit from investment grade to become a problem. The plunge in oil prices has understandably given such fears a little more impetus.

Memories of the past

All this unsurprisingly has investors muscle memories twitching. Whilst a global banking crisis is not that hard to imagine when we have such a recent and vivid example to call upon, the situation is different this time around. Here we can make a couple of points. In a sense, the last recession is potentially helpful here. The first point is that over the last decade the banks have built up significantly greater defences against just such eventualities. Balance sheets have a much greater capacity to absorb surges in non-performing loans than pre 2007. The annual stress tests conducted by the Bank of England war game all of the UK’s banks to see how they stand up to such shocks on an annual basis[1]. The latest results should provide some reassurance.

The second point is that policy makers themselves now have a much more complete and up to date playbook on how to handle crises that affect this crucial transmission mechanism for the economy. You are already seeing the Federal Reserve and other major central banks pull hard on levers that it took months to get round to using in the crisis between 2007 and 2009. Some of the understandable policy missteps of inaction from the last crisis are certainly not being repeated on the evidence of the last week.

What about governments?

We are already seeing a significant step in fiscal policy in the last few days in particular. So far these measures, both enacted and planned, already exceed that approved during the last recession. We expect more in the coming days and months as the reality of the situation starts to be sketched out in incoming economic data. Many governments are also stepping up to guarantee large chunks of credit for banks, deferring tax intra year and redirecting already appropriated budget funds. The fiscal package currently making its way through Congress is potentially worth over 5% of GDP.

When will markets settle down?

The most plausible paths ahead for us sit somewhere in between the extremes sketched out in our scenario analysis above. A degree of seasonality in COVID-19 is not proven, but neither is it unreasonable to assume. Treatments are likely forthcoming too. Policymakers are already acting forcefully and more will come in our expectation. Very low government borrowing costs are likely helping overcome previous qualms about sovereign debt loads. However, there are vulnerabilities in certain parts of the world, some of which may only become obvious after they have hit and a degree of humility is of course always appropriate.

Nonetheless markets seem to be overweighting the potential for the worst case outcomes in their scenario analysis. This suggestion is corroborated by the extreme lows in measured investor sentiment. On some estimations, this is already way below levels that investors plumbed in the crisis of over a decade ago. A more balanced assessment of the likely paths ahead would see stocks and core government bond yields quite a bit higher from here. We are gently positioned for this re-assessment in our multi-asset class funds and portfolios at the moment.

It is also worth pointing out that even in the worst case scenario, there is the potential for policy makers to surprise positively and negatively. Now is not the time to overweight your singular vision of the future, whether good or bad. The full range of potential outcomes needs to be taken account of.

[1] Financial Stability Report 2019 – Bank of England (Dec 2019)

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