Vues d’Iggo

Le chemin de la normalisation n’est pas un long fleuve tranquille

Equities sold off this week as it became clear that the path to normalisation is not an easy one. Infection rates are rising in many parts of the United States and emerging markets, even while they are falling across Europe. The risk is that, globally, we get a second wave. Meanwhile, politics and social matters aren’t helping sentiment. Investors should expect roller-coaster risk markets. There is a lot of money in cash. I suspect it stays there for some time.

If you could, would you?

Here’s a little mind experiment. According to the latest Google mobility data (see here) levels of activity in retail, transport and at workplaces remain significantly below the levels they were at before the coronavirus hit. In the US, the aggregate numbers show retail activity still 20% below the benchmark, transit stations 34% below and workplace activity 36% below. For France the numbers are -26%, -37% and -33%. In the UK activity is still very weak at -67% for retail, -56% for transit and -53% for workplace activity. Now imagine that you were the supreme leader of the world and you decreed that all lock-down restrictions were to be totally lifted from Monday. How quickly would those numbers converge back to where we were between early January and early February? I would bet that most of you would not be saying that we go back to normal quickly. For both supply and demand reasons, that comparison of current activity with the early part of 2020 will have a negative sign in front of it for a long-time to come.

Not normal

The realisation of this seems to be hitting markets at last. One of the key reasons why activity would not quickly revert to normal is because the virus threat is still with us. In the US, new cases are reported to be running at over 20,000 per day. Some states are still showing increased infection rates. In Texas, for example, the daily new case count appears to have jumped from averaging around 1,000 per day between mid-April and mid-May to something closer to 1,500 to 2,000 per day. The daily case count in California is also rising. In many emerging countries there is clearly an increasing daily occurrence of new infections. The risk here is that as the southern hemisphere winter draws in, the virus will be kept alive. It can then re-spread through northern hemisphere countries towards the end of 2020. In Europe there is not much evidence of infection rates picking up with activity but as it was the imposition of lock-downs that forced the R-zero number down so there has to be a risk of that reversing.

Prolonged depressed output  

Demand functions have been shifted to the left and will remain below their pre-crisis levels for many areas of consumption. Supply won’t come back to normal either with retailers and hospitality providers either forcing extended restrictions or having to operate with social distancing guidelines that will limit capacity. The interaction of supply and demand curves that have both shifted leftwards means lower output and – probably – lower prices. At the aggregate level that means significant and long-lasting output gaps. In turn, that means low inflation and the need for policy support for a long-time.

Economists are quite gloomy 

Because demand and supply will remain constrained by health considerations, many workers that are currently furloughed will unfortunately become unemployed. This either means more government and central bank support for the recovery to bring unemployment rates down, or the risk of a W-shaped recovery, with a second-leg to the recession late this year or in early 2021. This week we held our quarterly macro-strategy sessions. One of the common features of the outlook was that the level of GDP for most economies will not get back to what trend growth would have otherwise suggested for some time. Growth rates might look like a V-shape but the actual path of the level of GDP will not be so positive. That means long-term interest rates below 1% are appropriate but equity price-earnings ratios of close to 20x are not.

Credit challenged by ratings downgrades, but still attractive 

Regular readers will know that I had four pillars against which to judge where we were on the recovery and what that would mean for different market return paths. The policy support pillar is a given and continues to be a very supportive factor. Corporates have raised as much liquidity through bond issuance and drawing of credit lines as they earned in 2019 in both the US and Europe. Bond markets are open and demand for fixed income remains strong. This week the Fed re-iterated it will continue to purchase bonds at its current pace for the foreseeable future and in its interest rate forecasts it suggested that there would be no rate hikes until at least 2022. The policy outlook remains positive for bonds, both government and corporate. The one caveat is that high yield has less direct support and is seeing the bulk of the ratings downgrade activity. A leading ratings agency suggested that the global high yield default rate will rise to above 10% in this cycle (from about 4%). Since 1 March, 90% of all downgrades have been to high yield companies. The two most important factors in establishing credit profiles is the strength of the business model in the face of the demand crisis and the resilience of the company’s financials, including its access to liquidity. High yield tends to have a higher share of more cyclical companies. Moreover, access to the market will be more difficult in these circumstances. I like high yield - but it is important to be aware of the forces that will impact on spreads.

The easy bit of recovery is done 

The second pillar of the recovery is the mechanics of the bounce. Sentiment around that looked positive a couple of weeks ago, less so today for the reasons discussed above. No-one was really fooled by the May non-farm payroll number, especially as this week’s continuing jobless claims data remained above 20 million. The initial bounce of activity off a very deep floor will have created a positive illusion in May and getting back to within 20% of baseline activity might be reasonably easy. But that final 20% will be harder, will risk second waves and will impact on market sentiment. There is less sentiment and equity and credit markets are backing off as I write. Now is the time to have had that long-duration bond exposure in the portfolio. Since the market closed following the non-farm payroll release on the 5 June, the S&P is down 6%; the over 15-year US Treasury total return index is up over 5% over the same period.

Vaccine hope 

Another consensus theme in this week’s review of the macro-outlook was the lack of any expectation that a workable vaccine would be in place this year. Of course, progress on this forms part of the longer-term adaptation of our economies, allowing activity to return to something closer to normal than if a vaccine is delayed. The slope of the GDP recovery will depend on this. This is a consensus view. As such, if there was more rapid progress this would constitute a potential upside trigger to the outlook and to risk appetite. Without a vaccine and without evidence of the effective eradication of the virus, it will be difficult to totally remove social distancing restrictions across retail, hospitality, medical services and education. That has implications for jobs and economic expectations.

Risk-on and off  

I suspect that markets will roll through periods of risk-on and risk-off over the summer and beyond. Central banks have done a lot and this impacts on the markets on a daily basis. The extended implication of that is the increased level of cash in the banking system which, at the moment, appears to be being held for precautionary reasons. Households don’t know what will happen when income support policies come to an end. Companies have liquidity but there will be a cash-burn until revenue starts to recover. We should not expect too much of an increase in consumer spending or capital investment even though there is plenty of ammunition. The surge in cash balances will help fund government deficits however and I remain of the view that government bond yields will remain very low as a result. Again, you want to own government bonds because of their capital preservation and diversification properties, not because of yield.

Driven by sentiment 

Sentiment and valuation will remain intertwined in these markets. Sentiment drove risk asset prices to sometimes stretched valuations in the April-May period. Cheap valuations in parts of the equity and credit markets allowed value to lead equities in recent weeks and lower-rated high yield to lead credit. However, sentiment tends to override valuation in the short-term, particularly when the tone of the news flow changes. It has changed in the last week or so. In both the US and UK, opinion polls are suggesting a fall in support for the incumbent leadership due to the handling of economic, health and social issues. The political atmosphere has become more toxic and that has to impact on market sentiment. This is not going away, given the economic outlook, the virus threat and the need for more social cohesion. Positioning portfolios in this environment is difficult. Perhaps more emphasis should be put on capital preservation and low beta income plays like short duration high yield. We have seen in the last three months plenty of upside to equities but a vulnerability to rapid reverses in sentiment. Hedging equity risk remains key.

The young and the old 

I played the little mind experiment with some friends on a zoom call this week. They are parents of 20-somethings, just like I am. We agreed that if restrictions were lifted then the young would probably try and go back to normal life quickly. They are less psychologically constrained than us older folk. They also have less spending power. One of the economists we met with this week said that our lockdown spending patterns were those of retirement. We have become more frugal, savings are up, and leverage will probably come down. The permanent changes to behaviour and risk don’t bode well for longer-term economic growth but do bode well for the ability to manage debt.

Staying home for summer 

Talking of youth, my son, who is a student at the University of California in Los Angeles, has spent lockdown in Hawaii. At the time I thought this was either crazy or genius. Turns out it was genius as the islands had very few cases of the disease but did have good broadband, so online classes and exams have not been a problem. Next week his time in paradise is up and he heads back to the UK on what, I am sure, will be a fairly empty British Airways flight. That’s another two weeks of staying home for me then. Ah well, plus ça change!

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