Are markets over-optimistic about a V-shaped recovery?

By: Graham Wainer, CEO and Head of Investments at Stonehage Fleming Investment Management (UK)

The three factors driving market confidence

Since the outbreak of Covid-19 in January, markets have gone through four distinct phases. Denial through January and February, disorder in March, recovery in April and then, what we have now – a semblance of stability. Although this is a fairly typical pattern for economic recovery, markets, it seems, are taking a particularly optimistic view of the future.

This confidence rests on three things: faith in the positive impact of fiscal and monetary policy, optimism about the positive effects of steps taken to combat the disease and, finally, a rather utilitarian view on ‘social triage’, whether voluntary or enforced.

The first of these drivers of market performance is policy action. The massive monetary stimulus we are witnessing is straight out of the 2008 playbook, only globally coordinated and turbo boosted. With interest rates to zero, repos in overdrive and swap lines opened up, it is really money for nothing and for a substantial period of time.  The South African Reserve bank has also come to the party with 2.25% in interest rate cuts with potentially more cuts to come.

Additionally, you have huge fiscal stimulus, ranging anywhere from 5-25% of GDP – considerably more than 2008. In South Africa, the announced fiscal stimulus amounts to around 10% of GDP.  The politics this time make a difference. Saving the economy, it seems, is viewed very differently from bailing out bankers as many perceived it to be during the Global Financial Crisis.

Today’s policy is attempting to put as much income back into the economy as the lockdown has taken out. This is being done through a series of loan guarantees, furloughs, social grants and so on so that when we finally emerge from the crisis, there is an economy to come back to.

These policies are building a ‘bridge’ over the ‘V’ or ‘U’ -shaped dip in the market and, for the time being, the market is prepared to walk on it in order to reach safer ground.

Source: Stonehage Fleming 2020

The second driver of market forces is a belief in the fight back. The market, it seems, is taking a bet that social distancing measures, testing and medicine will be effective in combatting Covid-19. This doesn’t seem unreasonable.

We know now that social distancing has a good effect on slowing transmission. Furthermore, medical science has come on leaps and bounds since 1987 when scientists developed an effective treatment for HIV/AIDS, six years after AIDS was first clinically reported in 1981. To bet against medical science’s chances of making effective progress against Covid-19 seems misguided when there is so much money and resources directed at it.

A utilitarian view of social triage is the third main factor driving market confidence. Until now, public policy’s noble mission has been to put lives ahead of livelihoods; the strong look after the weak. The market, in its cynicism, is taking another bet. Its current confidence is, in part, propped up by the notion that at some point society’s heart will harden when the costs get too high.

Mercifully, we are not there yet, but slight changes in narrative are discernible. We are beginning to see a lot more discussion in the press around how deaths caused by Covid-19 might be compared to those caused by other conditions or circumstances while resources are allocated elsewhere.

As the costs escalate, it is quite conceivable that society will segregate either voluntarily or by legal imposition into those mildly affected by Covid-19 and the vulnerable, including the elderly and those with underlying health conditions. It seems probable at some point that the huge majority of people likely to be unscathed by a brush with Covid-19 will demand that their lives return to normal?

Bloomberg reported recently that President Donald Trump is pushing to reopen the country very soon, saying Americans should begin returning to their everyday lives even if it leads to more sickness and death from the pandemic.

Having no emotion, the stock market, has sensed this inevitable tipping point and is already pricing it in.

Together, these three key drivers account for the market’s current optimism vis à vis Covid-19. Such is the market’s confidence, it seems fair to assume that it is expecting a V-shaped recovery: a short sharp dip which will bounce back to good health in a relatively short space of time.

This, though, feels a little too good to be true, a U-shaped recovery seeming more realistic, where markets see a considerable drop in economic activity followed by a slow recovery over a 2-3-year period.  The South African economy was in a poor position coming in to the crisis, already in a recession with large fiscal deficits and rapidly increasing debt levels. Arguably markets were already pricing in the poor economic outlook, however the question now is whether “even cheaper” South African assets are fully pricing the additional economic impact of the virus.

In the depth of the crisis, markets were disorderly and panicking. Sitting tight proved to be the right strategy. Since then, however, our investment strategy has evolved, mainly because the market signalling has improved and we can afford to be a bit more proactive. This will mean staying invested while we tilt and tune portfolios to reflect the strange economic environment we are living in.