Risk assets have continued to recover the losses experienced during the market correction in March. However, as uncertainty in the outlook remains, investors may benefit from remaining patient in building a medium to long term investment strategy. Sentiment in markets has been positively impacted by early signs of activity as lock-downs are slowly being removed. This cyclical risk-on behaviour of the past two months has also been fuelled by record amounts of monetary and fiscal policy stimulus. Easy policy settings, positive momentum in the recovery, potential vaccine developments and opportunities provided by changing societal preferences, are some of the reasons to continue to be positive. The worst feels behind us for now.
Recent high-frequency economic data has been better than expected. Combined with the easing of economic restrictions, markets have reason to be optimistic on the outlook of the nearer term macro environment. Moreover, investors appear to have discounted this year in terms of economic growth, evident in the current divergence in negative economic and corporate earnings momentum relative to the positive financial market bias at present (investors are looking to the recovery in 2021).
Some broader activity levels are already higher than they were in mid-March, based on signals from big data sources such as Google’s community mobility reports1. The negative impacts of the global economic shut down had been widely expected, though the magnitude and duration of these impacts has yet to fully play out. Data across the US had been weak in most sectors particularly through April and the early parts of May. US unemployment rose above 15%, manufacturing survey data registered new lows and US GDP over the first quarter fell by 4.8%. Expectations are for more significant falls in trailing economic activity over the second quarter. Over the medium term, financial markets tend to be driven by where we are in the economic cycle. This is not a normal cycle and as such the macro outlook is complex. Cycles tend to end from the excesses of the prior expansion period driving unsustainable levels of debt, excessive growth, high inflation, interest rate shocks, productivity shifts or a combination of these factors.
Policy makers ended the last cycle with an abrupt and indiscriminate decision to rightly protect public health in response to a global health pandemic. They countered this with huge spending programs to bridge the income gap caused by the lock-down restrictions. These programs cannot carry on indefinitely and as they come to an end, the hope is that economies can pick-up where they left off. This poses the question, are markets too focused on the current policy outcomes and not enough on the medium term repercussions and growth outlook? Most forecasts are suggestive of some form of recovery and early indications from countries lifting lock-down restrictions are in line with these expectations. However with the disruptions to supply chains and employment, it should be considered there is a high potential for longer lasting economic damage to weigh on growth potential. Policy makers are right in their efforts to reassure markets that more can be done2 as economies face the worst economic situation for many decades.
Our longer-term views have been focused on the evolution of three key themes, which continued to drive our belief that a broadly diversified portfolio of assets and investment strategies remained the most prudent course of action towards the end of the last investment cycle. The current exogenous shock to markets and economies has been indiscriminate and brought about the end to one of the longest bull markets in history. It is important to recognise the uncertainty, fluidity and path dependence of the current situation. But as the current crisis evolves, recognising the future drivers of asset price performance will help investors position for the next investment cycle. We expect investors will face similar challenges of the past cycle.
The crisis has induced significant increases in the size and scale of government debt programmes. The current support to the domestic economy is near +10% of GDP while in the US for instance, the fiscal deficit will exceed $3.8trn3 (19% of GDP) for 2020. Compared to the 2008 financial crisis, the US deficit never exceeded 10% of GDP, while cumulative debt outstanding is now expected to exceed the record set post WWII. The increase in government debt is a global phenomenon with the deterioration in debt-to-GDP to be most severe in Europe (Italy is forecast to increase to 160% and around 120% for France and Spain). Research conducted by the IMF4 and ECB5 looking back over the past 40 years, suggests an inverse relationship between initial debt and subsequent growth is most significant once debt levels move above 90 - 100% of GDP. On average the IMF study quantified that a 10% increase in the initial debt-to-GDP ratio is associated with a slowdown in annual real per capita GDP growth of around 0.2% pa. Substantial debt burdens impede government policy flexibility to provide stimulus and support as sovereign revenues (taxes) become consumed by interest burdens. How economies will respond to the increased debt burdens will likely define the strength of growth into the next cycle.
Historical downturns have also led to weak demand and high unemployment which has resulted in lower inflation. It is difficult to quantify the full implications of the current crisis on inflation as we are likely to witness hits to both supply and demand. It’s likely in the short term that a deflationary impulse is evident, given the substantial disruptions to consumer-led industries such as services and leisure. On top of this, the collapse in energy prices will add to the short-term deflationary impacts. In the longer run, much will depend on any destruction of current capacity. Large output gaps and low productivity were outcomes of the last cycle post the GFC. The collapse in the cost of capital and expansion in credit markets allowed marginal businesses to remain afloat. The current crisis is likely to see a consolidation amongst the private sector; weak businesses are likely to collapse during the economic lockdown period and probably more coming out of the recession. Other factors in the long run will be linked to wage pressures and employment mobility trends and whether the short term precautionary savings trends by households and corporates extend beyond the immediate period. The Japanese experience was consistent with these dynamics following the late 1980s. Deleveraging of the corporate sector was offset by an increased fiscal deficit and subsequent extended periods of weak growth. ‘Japanification’ is one possible outcome particularly in areas where older state demographical trends are similar, such as in Europe. These trends were also evolving prior to the crisis.
Growth and income will remain scarce for investors
The future investment cycle may not be that dissimilar to the prior expansion following the GFC. The low growth and interest rate outlook will support ‘growth’ companies with strong balance sheets and dividend paying business models that have a low volatility in earnings. This future environment risks a continued underperformance of ‘value’ stocks as investors seek growth and yield in order to maintain adequate returns. This could mean the performance of mega cap technology companies in the US and the global conglomerates of Europe (i.e. L’Oreal, Glaxosmithkline and Nestle) is likely to continue to lead markets. With a stable outlook and low volatility in earnings, paying a dividend yield of just +2.5% (much higher than other asset classes) will remain very attractive for investors. The emphasis on ESG integration is also likely to favour companies which have the balance sheet leverage or technological flexibility to continue to focus on such outcomes in an environment of lower profit margins.
Focusing on the evolution of this pandemic can help provide insights into the confidence levels of governments as they move to re-open economies. The risks around the pandemic, economic activity and longer-term implications around the economic recovery make this current risk-on period in markets challenging but not unwarranted. The strong cyclical rally continues to be supported by higher activity levels, falling global interest rates and massive stimulus. As we look to position the portfolios into the oncoming cycle, many of the challenges investors faced since the GFC still remain and emphasise the need to continue to develop a well-diversified portfolio across asset classes and investment strategies.
2. Various speeches, Jerome Powell US Federal Reserve, Andrew Bailey Governor of the Bank of England, proposal of a European Recovery Fund for fiscal mutualisation of the EU.
3. According to The Centre for Budgetary Responsibility in the US
4. See Kumar, M. S, and Woo, J. (2010). Public Debt and Growth. IMF Working Paper 10/174
5. See Checherita, C. and Rother, P. (2010). The impact of high and growing government debt on economic growth. An empirical investigation for the Euro Area. ECB Working Paper Series, n. 1237
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Information current as at 15 June 2020. © Westpac Financial Services Limited 2020.