The uncertain path and implications of the COVID-19 virus and the yet unknown impact of unprecedented global monetary and fiscal policy responses to the pandemic have resulted in an extremely wide range of economic expectations. Our outlook lies between the best- and worst-case scenarios:
- We expect a Q2 plunge in economic activity with a rebound in late 2020, followed by roughly trend-line global growth in 2021.
- Our expectations rest on an extrapolation of the general contours of Asia’s COVID-19 epidemic and its related economic experience to-date, along with the belief that global monetary and fiscal policy have been and will continue to be robust as well as supportive.
- We believe the most globally exposed equity markets, including those in the U.S., are unlikely to fall significantly below levels seen in March. For a number of asset classes, we would view any further material weaknesses as buying opportunities.
- We see technology, health care, financials, extended credit, China and Asia equity as some of the potential beneficiaries of the environment ahead and will continue to position portfolios to take advantage of positive trends buoying these sectors, adding to and/or changing the composition of portfolio exposures as opportunities develop.
Pandemic and policy impact uncertainty allows for a wide range of outcomes
Visibility on the future of the global economy is cloudy at best: U.S. and European COVID-19 infection rates have not yet peaked and the full economic impact of the virus remains unclear. On the positive side, it is impossible to quantify the extent to which unprecedented monetary and fiscal policy responses can bend the economic trajectory. The result is a range of available forecasts that extends from a deep recession to full recovery within the next 12 months.
We view both economic extremes as unlikely. Instead, we anticipate a late-2020 rebound—strong in the U.S. and Asia and more muted in Europe—followed by roughly trend-line global growth in 2021. The massive stimulus being injected into the global economy may provide a positive growth kicker in 2021 and beyond, based on what we have seen from the prolonged impact of stimulus programs put in place as a response to the great financial crisis.
All things considered, we expect continued extreme volatility in economies and asset markets in the near term. The absolute magnitude of the projected economic and employment dislocations will likely be jaw-dropping to investors and may catalyze a round of profit taking in the weeks ahead. We will continue to take volatility as an opportunity to reposition and prepare for the post-COVID-19 environment, one we believe will have some of the same characteristics as the pre-COVID period. Economic disruption and the “new economy” sectors will continue to encroach on the brick and mortar economy, while we expect there to be a new emphasis on investments that supply yield and diversification beyond a traditional 60/40 stock bond allocation.
Key considerations influencing our outlook
We are encouraged by the Chinese experience in dealing with COVID-19. Depending on how you define its start date, the crisis in China has progressed from quarantine to negligible infection rates in roughly two months (Exhibit 1). This approximate experience is shared across other Asian countries, most notably South Korea, Taiwan and Japan. With a later start date for COVID-19 in the West and, at least initially, a slower-to-act and less-effective command and control approach to quarantines, we see a virus peak in the U.S. and Europe within weeks, not months, as a viable working projection.
Exhibit 1: COVID-19 CONFIRMED AND NEW CASES (THOUSANDS)
Without going into the details of stimulus plans globally, we expect those monetary and fiscal responses to be, at a minimum, enough to prevent more than a one-quarter plunge in economic output. Importantly, we believe that equity prices at the lower end of March’s trading range (which we view as having been near a bottom) reflected market expectations of a Q2 fall-off in real GDP on the order of -15% to -25% in the U.S. and Europe.
The debate as to whether the economic turnaround following the viral peak will have a “V”, “U” or “L” shape hinges on whether the stimulus programs accomplish their purpose or lose potency in their execution—a source of real concern. But policy makers appear to have a clear grasp of the magnitude of the problem and we believe the “whatever it takes” attitude should prevail (Exhibits 2-4). To put the enormity of these programs in perspective, in the U.S., the estimated near-term fiscal impact of the CARES Act ranges from 10% to 12% of GDP, making it likely the largest single-year piece of legislation since FDR’s New Deal.1 Further adjustments through additional stimulus packages, liquidity provisions and lending facilities should be forthcoming, as needed. Once the last program is passed, whenever that occurs, the aggregate stimulus, combined with the animal spirits likely to take hold once the virus appears contained, should leave some room for event and execution slippage if not over-stimulus. A reasonable guestimate would be for a strong late Q3 or early Q4 economic revival mimicking the very strong snap-back in China where, as recently reported, both service and manufacturing PMIs are in expansionary territory after their collapse in February.
EXHIBIT 2: GLOBAL MONETARY AND FISCAL STIMULUS TO FIGHT THE IMPACT OF COVID-19 (FEBRUARY THROUGH MARCH 2020)
EXHIBIT 3: FEDERAL FUND RATE EXPECTATIONS
EXHIBIT 4: FEDERAL BUDGET DEFICIT AS % OF GDP, 1990-2020
How will risk markets perform over the next few months?
We expect that the lows have probably been reached for the most globally exposed equity markets, including those in the U.S. We also think that there is marginally more upside left in the countertrend rally, within the context of extreme volatility. Hence, we added modestly to our U.S. technology/growth stock position toward the end of March. History has shown, however, that major bottoms are not events but rather processes (Exhibit 5). As such, we believe a retesting of mid-March market lows may take place. The magnitude of the economic decline expected in Q2 and uncertainty around growth in the second half of the year—together with a wide range of expectations around earnings—may shake investor confidence and catalyze a round of profit taking in the weeks ahead. We would be enthusiastic buyers of several asset classes, should they break below their old lows.
EXHIBIT 5: A HISTORY OF S&P 500 INDEX BOTTOMS
The Endowments & Foundations CIO team believes the COVID experience and the responses of policymakers will likely serve to accelerate changes already afoot in the global markets, particularly around new economy spending, rethinking the role of core fixed income and the value that real assets may play in a diversified portfolio. Central bank activism and fiscal policy responses are likely to be semi-permanent fixtures furthering the ultra-low interest rate environment and perceptions around economic stability and growth. Against that backdrop, we anticipate greater investor attention to and improved valuation for certain segments of the economy going forward. We consider technology, health care and financial stocks, extended credit and China and Asia equity as some of the potential beneficiaries of the environment ahead. As opportunities develop, we will be adding additional allocations and/or changing the composition of our existing exposures. We will provide more details on our key positions as we migrate portfolios:
- Health care: Health care stocks offer an attractive combination of strong fundamentals, defensive earnings and cheap valuations. They remain significantly undervalued, trading near a 10% discount to the market, despite superior fundamentals that remain driven by innovation, increased adoption and global penetration.
- Technology: Technology stocks are increasing their fundamental advantage relative to the market. The sector provides the vision and solutions that businesses and individuals need to overcome physical immobility. While other industries are shackled to the contour of a recovery, technology will likely continue compounding its impressive financial gains and accelerate toward a new digital economic frontier.
- Financials: After serving as the epicenter of the 2008 global financial crisis, banks are now positioned to be part of the solution rather than the problem. Fortress balance sheets, excess capital and much improved management teams are not reflected in current valuations that indicate a 40%-50% discount to the market. In 2008 banks were weighed down by regulatory pressures and fragile capitalization structures; today their exceptional balance sheets combined with unprecedented monetary and fiscal policy should allow them to significantly outperform implied expectations.
- China/Asia: The effectiveness of the COVID-19 response and the noticeable rebound in the economy, albeit from a low base, should make China and most of Asia attractive investment destinations in the year ahead.
- High yield: Credit stands out as an interesting opportunity, considering how wide spreads have risen above Treasuries. In the high yield market, spreads (approximately 900 basis points as of this writing) have narrowed but still discount recessionary conditions and look attractive on the margin. Considering that we expect some backpedaling in markets in the weeks ahead on any further spread widening, we should have better entry points, especially considering the relative illiquidity of these markets during risk-off periods.
As we consider the wide range of potential outcomes for the economy and markets over the course of 2020 and beyond, our experience tells us that this time is not likely to differ from previous crises. After the largest single-day plunge in U.S. market history on October 19, 1987, economists and strategists suggested that a depression was not likely but had to be considered. More than $1 trillion was lost over a two-month period, raising concerns for the course of future equity returns. Yet, nothing close to that worst case scenario materialized. No doubt there is an existential dimension to the current crisis on top of the economic and financial issues. Structural changes already underway in the global economy will likely continue to accelerate as a result of the virus and its aftermath. But in an age of policy activism, health care innovation and acute attention to the concerns of the average consumer, we fully expect solutions will be found and animal spirits revived, bringing the economy and markets back to some semblance of normal if not accelerated growth.
We intend as an investment team to look forward and find the best opportunities that volatility creates. As always, we are happy to address any questions you may have regarding our portfolio strategy and positioning.