Growth Scenarios Ahead
With the world dealing with the impact of COVID-19, our Head of Global Market Strategy looks at three possible scenarios that could to unfold in the economy and markets.
- The Bull Case
While it is named bull, this is more like the utopic scenario, as just a short-term growth blip with the US resilient and China roaring back seems quite unlikely at this point. Yes, stimulus is coming – or has arrived – but given the drastic containment measures required to halt the coronavirus outbreak, a significant impact to growth with a gradual recovery is probably the best we can hope for at this point.
- Muddle Through
As mentioned, we know that economic growth is going to take a serious hit from the current containment measures. What will make the difference between our ‘muddle through’ base case and the more bearish case we will set out later is how long the spread lasts and therefore how long dramatic containment measures will be needed. That is, how long will the economy need to be at a standstill before it can start again? In any event, growth – and probably markets – are going to stay ugly for a while. We are still in the exponential expansion phase of contagion, suggesting at least a few more weeks before we see a peak in cases, which we believe will be key to determining the severity of the growth impact. We also believe markets will remain extremely volatile until the virus appears ‘under control’. As such, growth in Europe and the US will be impacted in March and April at the very least, and most likely into May, even June. The first quarter might hold up since January and February were relatively solid, but the second quarter is going to be abysmal. In China and other countries in Asia, Q1 will be in contraction, but Q2 could improve – though at a slower pace than expected given the ongoing situation in the West.
We must acknowledge that we do not know the extent of the impact, or how quickly activity can pick up again. As seen in China, the ramp up is gradual and slow, and a V-shaped recovery is no longer expected – there or anywhere. Nonetheless, enormous fiscal and monetary stimulus are on their way, which should help avoid mass bankruptcies and defaults. We expect short-term lending facilities, payroll tax cuts, unemployment and sick leave benefits, industry support and more. Indeed, while this situation cannot compare to 2008, we believe that the response will. Policymakers want to avoid a long, drawn-out recession and will be creative in tackling it, as we have already seen from the latest announcements. And as they learned in 2008, global interconnectedness means even local business collapses can have global implications. As such, we believe that a gradual recovery in the second half of the year is possible, as long as the outbreak is contained in the second quarter and we avoid credit events.
- Worst Case
While we believe that we will ‘muddle through’ this situation, with a lot of help from governments and central banks, it is easy to see a more negative scenario where a protracted global recession unfolds. Indeed, equity and credit markets are already pricing in a recession, though how long or deep remains the question. And for now, earnings expectations have only been mildly adjusted, suggesting more downside in the months ahead. We have also seen global funding tensions emerge as investors liquidate holdings and draw down credit lines. Indeed, amid unprecedented volatility, cash (and USD) is king again, and even Treasury markets have come under pressure.
The longer the containment measures last, the bigger the risk of a sharp global recession. Indeed, with activity coming to a sudden halt, many industries and businesses are suffering unprecedented declines in revenues and will struggle to meet short-term commitments such as payroll. The airline industry is a prime example, but it is not alone. And with the oil price war between Saudi and Russia, US shale producers are at risk as well. It is easy to see how this can spiral into bankruptcies and defaults, leading to a bigger systemic concern of credit events. Indeed, corporate debt levels have risen in recent years, and the quality of credit has deteriorated. And of course, the impact on the banking sector will be significant, especially in Europe. Indeed, we believe that Europe will see a recession, as its starting point was already fragile.
While global policymakers are (finally) addressing the situation with the necessary urgency, a lot of uncertainty persists around the outbreak and governments’ ability to contain it. The more pessimistic estimates are for up to 14 weeks, and many economies might not prove resilient.
A number of conditions likely need to be met to reassure markets and start to move on. The first, and most critical, is a peak in cases. This appears still 6-8 weeks out, though some forecasts push this out even further. With Italy ahead of other developed markets by a few weeks, seeing a peak in cases there could help estimate the timing elsewhere, even if demographics, containment strictness and healthcare systems can vary greatly.
Second, we need massive, 2008-like fiscal responses from governments. These are now come in, and while the scale was unimpressive at first, policymakers appear to grasp the urgency of the situation and are responding accordingly.
Finally, we need markets to price in a very negative scenario – yes, this is already mostly the case – and much more negative investor sentiment / positioning compared to the beginning of the year. Both of these have occurred already, though we probably have not seen the bottom yet. Until these conditions are all met, we expect high volatility and fragile markets.
How to position
Regardless of which scenario unfolds, we are looking at a number of different strategies to complement our portfolios. Of course, in the most dire scenario, cash will remain king, even with zero yield. The next line of defence are defensive bond strategies, focused on more core holdings. While sovereign yields have become very volatile as well, we still believe that some allocation is warranted. For those with a medium-term view and an agreement that we will muddle through, we look at lower volatility strategies to keep some exposure to the equity markets, but with lower beta. Also, we believe that flexible, absolute return fixed income strategies can adapt to changing yields and duration conditions, while looking for attractive opportunities given the current dislocations. Finally, some less liquid alternatives can provide interesting diversification options in the current environment.
And if you can weather the ongoing volatility, then equity markets are offering more and more attractive entry points for the ‘after coronavirus’. We like more defensive, longer-term focused strategies, but acknowledge they are still likely to suffer in the coming weeks.