BlueBay AM: The irresistible force and the immovable object

May 15, 2020

A slow path out of economic lockdown has seen ongoing downward revisions to growth forecasts as it becomes increasingly apparent that measures pertaining to social distancing will continue to be disruptive for the foreseeable future.

In the absence of positive ‘new news’ with respect to a vaccine for Covid-19, it seems that worries related to a second wave of infections are inevitably going to mean that risk-averse policymakers are inclined to tread a cautious path unless, or until, the economic pain being inflicted becomes too much to bear.

Meanwhile, in a world of falling inflation and ultra-low bond yields, the temptation may be to balloon fiscal deficits and permit central banks to engage in printing money in order to limit the recessionary impact.

However, it would appear dangerous to assume that the recent rally in asset prices resulting from such policy easing means that economic risks have been contained. Moreover, the consequence of current policies is a world increasingly awash with debt, with new issuance spiralling ever higher. This won’t endure forever.

Ultimately, economic pain can be deferred but not avoided altogether. In some respects, it may be that policymakers can do little more than paper over the cracks in a broken economy.

In this sense, it is possibly beginning to become apparent that the scars of the ‘Covid Depression’ could be every bit as deep as those from the Global Financial Crisis, thus casting a shadow across the global economy throughout the decade which has only just begun.

Challenging measures for testing times

Using the UK as an example, it is striking to observe that approximately 50% of all workers in the country are now having their wages paid by the state. Meanwhile, some projections see as many as one business in three failing to survive the current turmoil, meaning that unemployment will surely rise. This being the case, it is clear that we have now crossed the point where permanent economic damage is taking place.

Practically speaking, if there is a requirement for social distancing to be observed, it is hard to see how many working environments or modes of transport can be made ‘safe’ and how life in large cities can return to any semblance of normality for perhaps another 12 months, or possibly longer. Yet, with data showing that those succumbing to Covid-19 are, on average, over 80 years of age – one wonders when attitudes may start to change on this front.

In many quarters, the UK government has been lambasted for delivering a seemingly confusing and muddled answer as it takes steps to ease the lockdown. However, it seems odd that those in some parts of the media expect the government to have an exact answer for every situation that any individual may find themselves in.

Perhaps it is time for Boris Johnson to tell the country to grow up, take personal responsibility, use some common sense and figure out what practical steps it can take to resume everyday life, whilst minimising risks where possible.

Handout balancing act

Indeed, the idea that the state should be there to tell you what to think and what to do seems at odds with Conservative principals. But with the majority of society being paid wages and handouts from the government, it seems that attitudes are shifting. For example, in rightly seeking to shield the economy and its citizens from the impact of the economic crisis we now find ourselves in, it will also be important to watch that the prospect of collecting wages for doing nothing doesn’t come across as a viable or desirable long-term alternative.

Nonetheless, what is clear is that with each passing week, the risk of economic hysteresis grows. This, in turn, will serve to limit the economy’s ability to get back on its feet if skills are lost and if labour drops out of the work force.

Turning to financial markets

Core government bond yields have remained largely rangebound over the past week. Corporate bond spreads have tended to drift somewhat wider over the past fortnight, notwithstanding the commencement of the Federal Reserve programme to start purchasing corporate bond ETFs. Supply has shown little sign of slowing down, with issuers happy to secure long-dated borrowing at all-in yields, which remain very low by historic standards, even if spreads are relatively wide.

In Europe, spreads in the periphery have been contained, partly in thanks to a sharp acceleration in ECB bond purchases under the PEPP programme in the wake of the German Constitutional Court decision. Elsewhere, there has been some divergent performance across assets in emerging markets.

In Brazil, rising infection rates have seen assets under pressure with the real sliding to a new record low versus the US dollar. In other countries, performance in credit and local rates has improved, with central banks easing rates as inflation falls.

Real interest rates have tended to be materially higher in emerging countries and have been a beneficiary of policy easing up to this point, though if currency weakness leads to a renewed rise in inflation, then this trend could go into reverse.

Paradoxical forces

In assessing the current investment landscape, one could summarise that, if an economic downturn of epic proportions would appear to represent something of an ‘irresistible force’, so the counter-acting policy initiatives we have seen can be viewed as the proverbial ‘immovable object’.

Massive liquidity provision has meant that the S&P 500 index is trading at a near identical level to where it was 12 months ago, just as profits collapse. In the past few weeks, as we follow price action in markets, we have tended to observe that it has been policy announcements which have been the catalyst for a rebound rally in late March and early April, but over the past several weeks we have witnessed something of a stalemate in markets, with central bankers adopting more of a wait-and-see approach.

It would appear that we are waiting to see if the virus can be contained and lockdown restrictions eased, enabling a more cheerful economic prognosis as we head into 2021, or whether a renewed deterioration in the backdrop could see a further loss of confidence in markets, requiring yet more policy intervention.

In this way, we see something of an arm-wrestle underway and although volatility has recently been trending lower, it would not be too surprising to see markets lurch suddenly in one direction or the other.

Looking ahead

We believe that it pays to keep an open mind. We are inclined to believe that there may be some over-optimism in terms of how quickly economic activity can recover in the second half of the year. At the same time, the level of policy support we have witnessed in the past several months is unprecedented.

Ostensibly it will always be very difficult for policymakers to calibrate the size of their policy response to a shock, the nature of which we simply have not seen before. Given the perils we currently face, it is understandable that policymakers continue to see risks skewed to the downside – noting that there is still some complacency that Covid-19 will only prove to be very temporary in nature.

This being the case – one could imagine that, in the same way a golfer who needs to play a short shot over a scary-looking hazard may be inclined be to over-club the pin, similarly in the current situation, policymakers will judge that there is far more danger should their efforts come up too short.

In this case, we do not think that we have seen an end to policy easing measures and we would certainly expect the ECB to expand on its PEPP in June.

As mentioned before, we don’t expect the path ahead to be a straight line and so vigilance is required as we adopt a mindset of wanting to sell on strength and add on weakness.