The world is enduring the deepest peacetime recession in the past 150 years. Many investors have been surprised at the continued strength in equity markets and in this context, it could help to consider the market framework over three different time frames.
In the short-term, news flow will drive market direction and volatility, as will the existence of vaccines/treatments, and economic data such as PMIs. Technical factors such as whether markets are overbought or oversold and the ratio of puts to calls are also important over shorter timeframes.
A return to trend growth
Over the medium term, 2021 and 2022 could remain a positive period for markets. Previous eras of financial repression (when governments hold real interest rates below zero) have often been profitable for equity investors, especially in the early stages. In other words, markets front run negative real rates with a lower discount rate, driving equity valuations higher. Next year, the global economy is likely to return to trend growth, especially with the prospect of vaccines and better treatments being widely available.
Drug treatments and stimulus
The UK has seen reduced mortality rates from use of the dexamethasone drug and Gilead have announced that their remdesivir treatment, currently administered intravenously and successful with less severe cases, is being trialled in an inhaler form. Gilead also claims that the drug is helping reduce mortality in more severe cases.
Next year, there will still be huge stimulus in the financial system, both monetary and fiscal, and this will coincide with improving corporate earnings. With a backdrop such as this, it is unlikely to be a time to be too bearish on the medium-term prospects for equity markets.
Longer term, from the mid-2020s, threats could emerge to valuation levels in the form of higher inflation, the withdrawal of stimulus, both monetary and fiscal, and less globalisation, but these are not an immediate concern to markets.
Pandemics and risk aversion
There is no doubt that Covid-19 has transformed the world in an uneven and unequal way. The global economy has seen only muted growth in the 10 years post the Financial Crisis and 'secular stagnation', as described by Lawrence Summers, the former US Treasury Secretary, in his address to the IMF in 2013. Since then, there have been stronger arguments for a Keynesian response to downturns.
He argued that a chronic excess of savings relative to capital investment was developing in the global economy, forcing down long-term interest rates and threatening a persistent shortage of demand. Interestingly, work by academics at the University of California Davis, looking at long term economic implications from pandemics, demonstrates that previous pandemics have resulted in an excess of savings at a time when a savings glut had not been a pre-existing condition in the world. Pandemics have also historically increased risk aversion in the private sector, resulting in higher savings rates, both by households and by businesses who invest less. In other words, both individuals and corporates will require higher levels of 'rainy day' money. Until an effective vaccine is found, consumer spending in sectors requiring high levels of personal service will remain under pressure and way below pre-pandemic levels. Covid-19 is only likely to increase the trend towards secular stagnation that manifested itself in the post GFC period.
Paying for debt down the road
In the short term, the rise of populism demonstrated by concerns over inequality, which resulted in the vote for Brexit, the election of Donald Trump, and the global spread of the Black Lives Matter movement, strongly suggests that austerity policies will not be adopted. How debt is paid for over the longer term will become more of an issue down the road, but it is likely to involve some form of higher taxes, together with debt monetisation. A consistent positive is that the annual cost of servicing debt is likely to remain negative in real terms and below the nominal growth rate of an economy and central banks seem set to keep rates at these levels, which is a form of financial repression.
With interest rates below the growth rate, the debt/gross domestic product ratio is likely to eventually stabilise and, as long as an economy is growing, the post Financial Crisis period has shown that markets will become less concerned about fiscal deficits, as long as governments run primary budget surpluses. In other words, a surplus pre-debt servicing costs.
Politics and the 3Ps
The US election is likely to be of increasing importance to the stock market. Trump is losing ground in opinion polls due to what some would describe as increasingly erratic actions, potentially over fears of an end to his term in office, which could result in prosecution.
Investors should focus on 3Ps in the campaign. The first P is for 'pandemic' which is the number of cases/deaths; this will be a judgement on how Trump has responded to the coronavirus. The second P is for 'production', in other words the state of the economy at the time of election. The third P is 'personality', how each candidate comes across. Compared to Biden, Trump has a strong presence on social media. There is no doubt that he will attack Biden as an 'establishment figure' and Biden has been known to struggle in events with live questioning. As the election moves closer, the difference in tax policies for corporates between Republicans and Democrats will also attract attention.
Markets are now once again entering a period of financial repression, where central banks deliberately hold interest rates below the level of both inflation and nominal economic growth, which will aid deficit reduction over the medium term. Post the Financial Crisis, periods of financial repression have provided positive returns for equity investors, although these returns have been front loaded with recovering markets benefitting from the lower discount rate applied to corporate earnings. Markets have once again proven this year that it is better to buy when the price is right and the news is bad than when the news is good but the price is high.