A prolonged recession would challenge the management of markets by central banks.
15.05.2020 | 13:07 Uhr
A key issue for market is its lack of breadth. Only 17% of stocks in the S&P are trading above their 200 day moving average despite a 25 % rally in 8 weeks, which is highly unusual. The outperformance of the Nasdaq, which is roughly flat year-to-date, is of course responsible for this. The question is: how dangerous is it? And can it last?
A large divergence makes sense, and this is how we have built our portfolios. In this world of radical uncertainty, to use the words of Keynes, with low interest rates as far as the eye can see, companies with high earnings visibility and long term growth potential are bound to be scarcer than ever and hence deserve a high premium. Conversely, everything that is fragile, that is to say indebted as it is the best way to lose flexibility in a downturn, and sensitive to the macroeconomy, gets hit very hard. We are confident that our stock selection is putting us on the best names, but it remains that it creates a lot of fragility for markets when they rest on so few winners. And in addition, quality can define gravity only as long as the market believes that the economy is not entering a deep long recession. Let’s not forget that in 2007, there was a discrepancy of the same sort, and the 2008 collapse brought everything down.
What is different today? First, clearly today large tech stocks are highly profitable, and valuations are much more reasonable than 10 years ago, for this very reason. And secondly, of course this time central banks have been very quick to respond in order to avoid a lasting crisis. Nobody was ready for the pandemic, but surely Central bankers were ready to defend markets. Because that is what they have been doing repeatedly for 10 years.
Indeed, policy makers have managed to push back any serious recession for over a decade by stepping in every time there was a real threat. Defending markets is a by-product of the imperative to avoid recessions. The latest example is of course 2019. They have to do that every time because they fully understand that a large recession on highly leveraged economies and companies would be disproportionately painful. And since they have more control over markets than over the real economy, there best bet each time has been to push up the prices of financial assets, thereby relaxing financial conditions, defending overall wealth and keeping consumption humming. Keeping markets on a solid footing has been for 10 years the most effective policy tools of central banks.
So this time again, policy makers have used their favorite policy tool, massively, and investors have been well protected. Even corporate bonds ETFs will now be bought, and surely equities will be next if necessary. These have been and are more than ever “managed markets”. “Don’t fight the Fed” has been a reliable recipe for success for years.
So the question is: will it be enough this time given that 1) policy makers have pushed the can down the road for many years already, and 2) this economic shock is of extraordinary magnitude? This is where there is radical uncertainty, because making a call on the economy is partly making a call on the virus. No-one knows.
In the short term, there possibly is pent-up demand that will produce an economic recovery in the next few months. But this is not even sure, because consumer spending is more driven by confidence, about health or about the job market than by Government decisions. Look at Taiwan or Sweden, where there were few deaths and the economy was never locked down: consumer spending still fell considerably. So deconfinement does not necessarily mean a vigorous resumption of consumer spending, without even mentioning the risk of a second wave of contamination.
In the US, unemployment is obviously an additional concern. We expect the unemployment rate to soon reach 25%, which was the level reached in the Great depression. Of course, this will be a peak and will quickly go down, as job flexibility works both ways, but it does not mean that the evolution will be symmetrical: it will probably take a long time before unemployment goes back to previous levels, so that consumer confidence is likely to fall and savings rate to stay elevated. This matters for consumption but probably also for home prices with the risk of a feedback loop on the wealth effect. In Europe social stabilizers are more powerful, but the same psychological issue applies, and unemployment of course starts from a much higher level than in the US.
As for capital expenditures and exports, remember the trends that were prevailing before the crisis: company margins were declining on average, and global trade in 2019 was down 0.5%, whereas it normally grows at 2-3X the pace of GDP growth. In other words, economic momentum was already weak, therefore the idea of a so-called V-shape recovery any time soon seems to us very unrealistic, and the risk of a prolonged recession is not 0.
So, in conclusion there is certainly a path in the western world for more of the same, taking the “Japanese path”: low growth, low interest rates forever, ample liquidity supply, in which case equity indices may trade sideways, but high quality growth stocks keep outperforming. This is the base case, and this justifies our sector allocation in our global funds. But the macro risk in our opinion is to the downside, as economists might overestimate the economic recovery beyond the initial short term relief, and we could be heading for a prolonged recession. In such case, the capacity of central banks to keep managing markets would be challenged, and markets could be destabilized seriously again. It is this risk asymmetry which explains that we maintain our cautious stance overall despite the market rally.
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