This quarter has not been an easy one for most investors. While it was already clear that we were in the later stages of the economic cycle, nobody could have predicted at the start of this year that large parts of the global economy would be brought to an abrupt halt by the COVID-19 pandemic.
Unfortunately, the debate has now moved on from whether or not there will be a recession this year, to how deep and long it will be. As markets have moved to reflect this new reality, equities have fallen sharply, with the worst returns coming in March. The S&P500 fell 20% over the quarter and the FTSE all share declined by 25%.
At least the defensive part of portfolios has performed as expected with government bonds rising in price, as central banks cut interest rates and restarted quantitative easing. Gold has also delivered positive returns year to date, up nearly 5%. However, concerns about the effect of the shutdowns on corporate profits have led to corporate bond prices declining, which will have detracted from the returns of some fixed income portfolios. As should be expected, riskier, junk-rated corporate bonds have fallen by more than investment grade rated companies, with high yield energy bonds the worst hit.
Commodity prices, other than gold, fell sharply over the quarter. As countries around the world halted activity to try to bring the spread of the virus under control, demand for most commodities declined, hitting prices. Oil was caught in a perfect storm with an agreement between OPEC and Russia to constrain supply breaking down just as the outlook for demand fell. This led the oil price to fall by more than 60%.
One doesn’t need to wait for the traditional economic data to be released to appreciate the scale of the hit to the economy, which is emanating from the virus containment measures currently in place across much of the world. A few select data points demonstrate the magnitude of the shock. For example, car sales in China fell about 80% in February. Data from the restaurant booking app Opentable show that bookings are down close to 100% in nearly every country that they operate in. In one week in March, over three million people signed up for jobless benefits, more than four times the previous record since 1967. Clearly, this is not just a normal recession, but a sudden shock to the economy that is unprecedented among developed economies in the post-war period.
An unprecedented shock requires an unprecedented policy response and that is what we have seen. Most encouraging has been the policy response from the likes of the UK and Germany where governments have committed to pay a significant proportion of workers’ wages during the shutdown to enable companies not to lay off staff despite the dramatic hit to sales. This is precisely the right kind of policy to deal with this type of shock, to give those economies the best chance of rebounding sharply once the health situation is under control.
Government-backed loans should also help many companies to avoid otherwise inevitable cash- flow induced bankruptcies. However, loans may not be enough for the hardest hit companies, some of which are likely to require grants or bailouts to survive a substantial loss of sales, at least part of which is likely to prove permanent.
In the US, a very substantial fiscal stimulus package has been agreed, worth about 10% of GDP, which will include some grants to small businesses. The package also provides government backing for credit to be provided by the Federal Reserve (the Fed) to investment grade companies. This should ensure that large investment grade companies don’t fail in the near term because of a lack of cash-flow. However, again, some large companies may require grants or bailouts rather than just credit to survive this shock in the longer term.
In addition, while the US fiscal package significantly increases jobless benefits for the next few months, the policy appears less effective than the UK or German policy of encouraging companies to hold on to staff. Overall, fiscal policy has already delivered a significant stimulus globally, but further measures are still likely to be needed to deal with the size of this shock.
Central bankers have thrown the kitchen sink at the problem, cutting rates to their lower bound and restarting and expanding asset purchase programmes. The Fed’s commitment to purchase as many government bonds as necessary is a substantial step, which should enable it to keep government borrowing costs low, despite the massive fiscal stimulus that is required to deal with the economic consequences of the virus. The Fed’s corporate credit programme should also prove a significant support for investment grade corporate bonds.
While the European Central Bank and the Bank of England have not been quite as explicit that their firepower is unlimited, we do not doubt their commitment to keep government borrowing costs low and provide liquidity for investment grade corporates. In short, the central banks are doing all that can reasonably be expected of them to fight this crisis.
The depth and duration of this recession will therefore depend on the extent to which governments fill in the gaps in their current fiscal responses, comforted by the support of the central banks, to ensure that unemployment is prevented from spiralling higher and bankruptcies of otherwise sound businesses are prevented.
Government bond yields are likely to remain low, despite significant government spending, supported by central bank purchases. However, there is less room for government bond prices to rise now interest rates are at such low levels.