Economic recovery from COVID-19 unlikely near term

Thomas Poullaouec June 01, 2020 06:00

COVID-19-induced turmoil have sent markets on a rollercoaster ride since February. The initial pace of the downturn in the current bear market was much more rapid than in all other bear markets since 1960, and the subsequent recovery since March 23rd has been one of the fastest on record.

Needless to say, we are not out of the woods. Major indices are still down 10-20% from pre-COVID-19 levels, with economic and earnings data reflecting the impact of the crisis only starting to trickle in – which could surprise on the downside compared to current expectations. Forward analysis is extremely difficult at this point, but a decrease in Q2 2020 that is several multiples worse than even the worse decline of the Global Financial Crisis in Q4 2008 is not out of the question, with a sharp decrease in economic activity expected through Q3 2020 and possibly longer. For its part, the International Monetary Fund predicts the recession could be as deep as -3% of global GDP this year.

In response to the crisis, central banks and governments globally have injected a huge amount of monetary and fiscal stimulus into the global economy in the past two months – amounting to US$15.86 trillion or 8.8% of global GDP. The key question on everyone’s lips therefore is what kind of recovery this will conjure and what impact will that have on markets.

A lot will hinge on the points at which different countries reach the peak of new COVID-19 cases. Slow and steady progress is being made around the world, with the number of new cases no longer accelerating; but we think the situation could rapidly change and force further disruption if and when a second wave manifests.

Thus, at this point, the data on the spread of the virus globally is not sufficient to confidently predict how long it will take for economic activity to return to normal. However, the length of the expected recession will be a key determinant of the ultimate impact to corporate fundamentals and earnings.

What is clear from the research though is that life as we knew it before the crisis will not be coming back any time soon and not in the same way. Instead of looking at a return to normality in a few months, it is more likely to be in one year, and what life will look like on the other side will be more akin to a ‘new normal’.

The continuing divergence in equity markets is an indicator that market participants do not anticipate a great rebound in economic activity on the horizon. Thus far, areas of the market that performed the best leading into the sell-off also outperformed during the sell-off. Growth led value and large caps have led small caps on the back of concerns about businesses with higher leverage and higher sensitivity to economic growth. Coupled with very accommodative monetary policy, it is clear that expectations are for a prolonged period of low economic growth and a low yield environment.

Positioning for This Environment

Despite this uncertain environment, equity markets may be preferable over fixed income in our view for medium to long term investors. The role of the latter as a protection against subsequent crisis has been challenged. Amid drawdowns in equity markets, fixed income, particularly sovereign bonds, usually perform well. Unfortunately, this time, it did not provide much protection outside long term US treasuries, with countries like Germany and Japan already showing low yields before the crisis. Looking at current valuation, sovereign bonds across different countries are currently the most expensive they have ever been in the last 15 years. Since all sovereign yields are close to zero or negative, a modest underweight to bonds makes sense to avoid duration risk. If anything, cash or short-term bonds instead of sovereign bonds might be a better alternative to park the money and waiting for clearer outlook.

We expect that massive fiscal and monetary support could set the stage for compelling valuations and attractive risk/reward over the medium to long term in stocks once the virus is contained and the economy rebounds. Among those that could benefit are small caps, which will benefit when the cyclical outlook improves – but by the same token could be vulnerable the longer the economy remains shutters. In credit, yields rose dramatically after the sell-off, with high yield bonds and bank loans yielding more than 10% at the peak of the crisis. Maintaining a prudent allocation to these sectors makes sense for patient, long term investors.

With an active approach and long-term investment horizon, investors will be able to pick the winners from the losers and add discriminately to riskier assets such as equities and high yield in this potential period of prolonged uncertainty.

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Thomas Poullaouec

Head of Multi-Asset Solutions APAC at T. Rowe Price