The Outlook: March 2020 economic commentary
A Q&A on the coronavirus, the economy and markets
What’s happening? Why are equity markets falling?
Global equity markets have fallen sharply as investors react to the fallout from the spread of COVID-19 around the globe as well as an oil price war prompted by Saudi Arabia. The disruption caused by measures to contain the spread of the virus (city lockdowns, ‘social distancing’, travel bans, cancelled events etc.) is causing investors to reassess the outlook for profits growth, and in some cases whether companies will survive at all given the impact on corporate cashflow.
Airlines and oil companies are among the sectors that have been hit particularly hard, but few markets have been spared as investors move to price in a sharp economic downturn. The MSCI all-country world index – a gauge of global equities – has fallen around 22% since hitting a record high on 12 February.
What is the outlook for the global economy?
You don’t need to be an economist to predict that the dramatic increase in containment measures across the world will result in a sharp fall in GDP. To give some idea of the scale we are talking about, the draconian quarantine measures enacted in China resulted in a 13.5% year on year fall in industrial output during the first two months of the year, while retail sales plummeted 20.5% year on year.
However, encouragingly, with the policy apparently proving successful in containing the outbreak in China and the number of new cases slowing to a trickle, there have been signs in recent weeks that activity is slowly returning to normal. With indicators such as coal consumption and passenger flows picking up from their early February lows, there is a good chance that Chinese GDP in the second quarter will bounce back following a steep drop in Q1.
However, the prospects for a sharp recovery in the global economy following a period of disruption are highly uncertain and remain dependent on how the coronavirus develops going forward. It remains to be seen if measures to contain the virus in Europe and the US will be as successful as in China. Even under a best-case scenario, disruption seems set to extend into the second quarter, raising the likelihood of a technical recession.
There is a clear risk that Chinese infection rates could pick up again as businesses re-open, and with the epicentre of the coronavirus now in Europe, weak external demand will hamper the Chinese recovery.
While there is still hope that any downturn will be deep but short, this will depend on policymakers mitigating the negative economic impact of ‘social distancing’ policies and limiting potentially damaging ‘second round’ effects (e.g. loss of income, bankruptcies, tightening financial conditions etc.) which could lead to a more sustained contraction and more permanent damage to the economy.
How have policymakers responded to the outbreak?
Central bankers and finance ministers cannot prevent the steep, near-term downturn in economic activity that is resulting from containment measures. However, we have seen a host of measures (such as tax holidays, loan guarantees, deferred tax payments and support with sick pay) introduced to support struggling businesses and individuals through the crisis. French President Emanuel Macron has gone so far as to pledge not to allow any French business to fail.
Central banks around the world have cut interest rates, introduced measures to encourage commercial banks to extend credit and pumped liquidity into financial markets to ensure that they continue to function smoothly. The US Federal Reserve, the world’s most important central bank, has cut interest rates by 150bps to close to zero in recent weeks and restarted quantitative easing (QE or buying bonds). However, with interest rates now negative or close to zero in most of the developed world, and central banks typically cutting interest rates by around half a percentage point during recessions, there is understandable scepticism that monetary policy has sufficient firepower to fuel the recovery.
As a result, markets are looking to fiscal stimulus (i.e. tax cuts and increased government spending) to support the recovery. The UK has set an example in this regard, with the recent budget setting out plans for increased infrastructure investment and policy stimulus equivalent to around 1% of GDP. However, the sharp deterioration in the economic landscape in recent days suggest more is required. There are obvious political hurdles to be overcome in the US and the eurozone before we see more meaningful stimulus. However, signs of increased cross-party co-operation in the US, and indications of a more flexible interpretation of budget deficit rules from the European Commission are reasons for optimism.
What could stabilise markets?
We noted in our February commentary that the experience of previous epidemics suggests that markets are likely to recover once the number of new cases starts to slow. The scale of the current disruption clearly dwarfs that of previous outbreaks. However, the performance of Chinese equity markets offers some hope that markets will bounce back once the coronavirus comes under control.
The MSCI China A shares index (large and mid-cap companies listed on the Shanghai and Shenzhen exchanges) fell sharply after lunar new year, but staged a comeback in February as the pace of infections fell and investors started to price in a stronger economy. Chinese equities have fallen back somewhat in March, but are still one of the best performing regional markets this year.
Is now a good time to invest in equity markets?
As long-term investors, we subscribe to the view that a diversified portfolio and ‘time in markets’ rather than ‘timing markets’ are key to returns. There is little doubt that markets will remain volatile during the coming weeks and months and it is impossible to rule out further falls. However, there are good reasons to stay invested.
The stimulus being put in place by central banks and governments is likely to outlast the temporary drag on activity from coronavirus, suggesting equity markets could bounce back quickly once infection rates start to fall. Moreover, the sharp declines in markets have made valuations on some metrics more attractive.
With interest rates set to stay lower for longer and UK 10-year Gilts yielding just 0.6%, equities are one of the few asset classes that have the potential for inflation-beating returns. Although there is a risk that dividends will be cut, the dividend yield on the MSCI UK equity index is currently an attractive 6.5%. Recent volatility has been painful, but the risk-reward from equities is now looking more attractive.
17 March 2020
This article is for generic information only and is not suggesting a suitable investment strategy for you. You should seek independent financial advice that takes your individual circumstances into account prior to proceeding with any course of action.