April 22, 2020
Investor sentiment remains fragile this week as the threat of an oil price meltdown adds to concerns about the post COVID-19 global economic landscape. Global energy prices fell precipitously on Monday as a supply/demand imbalance bumped up against strained storage capacity. This capacity constraint also drove volatility in the U.S. energy market. The U.S. benchmark, West Texas Intermediate (WTI), faced intense pressure, particularly in the pricing of futures contracts, resulting in the contract for WTI to be delivered in May falling to a low of approximately -$37.
Economic data has also lived up to our fears, reflecting broad and deep weakness. For example, approximately 22 million workers, or 13% of the U.S. labor force, began seeking unemployment benefits in the four weeks ending April 11; we had the largest monthly drop in U.S. retail sales on record in March; and new home sales have plummeted. However, investors are trying to look past this economic valley toward eventual recovery, whatever shape it may take.
Below are answers to some of the most common questions we received from clients during the past week.
As evidenced again this week, investors are pivoting between fear and hope. Please note we did not use the word “greed,” because there is caution reflected in the kinds of stocks that have led the recent rebound: tried-and-true technology names, where investors see safety – not the deeply cyclical or smaller capitalization names, which would suggest economic optimism.
All said, U.S. equities have rebounded significantly from the March 23 low, and the real driving force has been the one-two punch of fiscal and monetary stimulus, which together, have taken the worst case scenario off the table. At the lows, investors feared a temporary, albeit deep, recession would turn into a depression as businesses faced bankruptcies and households defaulted on their debts. Policymakers have made it clear that they will do whatever it takes to avoid that outcome, and we expect a fourth fiscal stimulus package to be signed into law this week.
In addition, and also critically important, we have been successful in “stopping the spread,” and data bears that out, setting the stage for the next phase: reopening the economy. More confident advances in risk asset markets will rely on the success of this next phase, which in turn, will rely on medical advances, including:
- Progress on serology testing (blood tests for antibodies) and tracing technology that can identify those with potential immunity to COVID-19 and allow for the safe isolation of those potentially infected
- Development of effective treatment options (potentially including biopharmaceutical firm Gilead’s antiviral, remdesivir)
- Development of a viable vaccine, which has an estimated timeframe of 12-18 months
The speed and magnitude of the policy response to COVID-19 has been unprecedented – and necessary. Some components of government policy will work better than others, and more will be required in the most heavily impacted areas of the Eurozone. However, we do believe that the aggregate responses will be successful in preventing a more serious and prolonged downturn.
In U.S. fiscal policy, we have already seen three stimulus bills and a fourth appears imminent. The focus of this stimulus is on providing a bridge to recovery by offering temporary support to those impacted by measures taken to flatten the curve. We think that, ultimately, the aggregate level of support will be sufficient due to the following factors:
- The government is providing a massive amount of support to households; the $2.2 trillion CARES Act is historic and significantly surpasses the American Recovery and Reinvestment Act (ARRA) of 2009.
- Bodies supervising the financial sector, such as the Office of the Controller of the Currency and the Fed, are encouraging lenders to meet the financial needs of customers affected by the coronavirus by forgiving potentially delinquent borrowers.
- Temporary layoffs are driving labor market deterioration. The hope is that these furloughed employees should be able to return to their jobs when the economy re-starts, making negative impacts to consumption temporary.
In terms of monetary policy, it is still too early to fully assess its effectiveness. But Fed policies have significantly relieved the stress in the municipal and corporate credit markets, bringing in credit spreads and greatly improving liquidity. While conditions on both fronts remain far from pre-COVID-19 levels, the improvements are meaningful. We believe more will be required by the European Central Bank (ECB), including potentially allowing non-investment grade bonds to be held as collateral. This will be a critical lifeline, as Italy, in particular, continues to feel the full brunt of the lockdown and risks a sovereign downgrade to junk.
Risk of inflation
As the amount of stimulus in the global economy continues to break records, many investors are worried about the potential rise in inflation. We believe that near-term inflation will fall measurably amid demand destruction, as supported by the following:
- On April 6, the International Monetary Fund (IMF) updated its global growth forecasts, and the results are grim: Global GDP is expected to contract by 3% in 2020. This is much worse than the 0.1% recorded during the Great Financial Crisis.
- The IMF predicts that the growth shortfall will be so large that the global output gap will remain deeply negative until at least 2022, despite assumptions that the pandemic fades in the second half of 2020 and that the global economy rebounds sharply in 2021. The cumulative loss to global GDP over 2020 and 2021 is estimated to be around $9 trillion, which implies that inflation will stay muted in the near term.
- Inflation expectations already reflect deflation (as shown below).
While unprecedented levels of global fiscal stimulus could set the scene for inflation to surprise on the upside, we believe that this will not occur in the near term as the recession creates significant spare capacity. Longer-term inflation is more difficult to predict. We have had a longstanding “stuckflation” theme as a tenet of our longer-term investment thinking, under the premise that technological advances and demographic challenges create the perfect disinflation storm. But this theme bears a closer look this year and will be a key issue for debate in our upcoming annual Capital Market Assumption investment-forecasting meetings.
We consistently preach the global portfolio. We believe that the global portfolio – priced by the collective wisdom of investors around the world – is the optimal portfolio, as it provides investors exposure to all available investment opportunities and offers key diversification benefits.
For U.S. investors in emerging market assets, there are important considerations to keep in mind. First, emerging markets typically have more economic and political volatility, and valuations reflect this; emerging market benchmarks sell at a discount to their developed market counterparts. For example, the long-term median priced-to-forward earnings multiples for U.S., developed world and emerging markets are 15.5X, 13.8X and 11X, respectively. Valuations reflect increased risks as investors require a higher rate of return as compensation. Risk and return are related, and we believe that investors will be rewarded over time with higher returns.
Second, we invest in companies – not necessarily the countries themselves. As we consider the largest companies in the broad emerging market indices, we see strong growth dynamics in companies like Alibaba, and strong global competitors like Taiwan Semiconductor, Tencent and Samsung. Further, we see companies poised to benefit directly from the demographic and socioeconomic changes in emerging market countries as consumers increase spending and young populations form families. It can be difficult for a foreign company to usurp a strong local competitor in these highly attractive growth markets.
Third, your allocation to emerging markets should align with the size and timing of your financial goals. At Northern Trust, we use a Goals Driven Wealth Management framework to help clients determine their appropriate level of exposure, which is primarily driven by the long-term risk/return characteristics of the asset class. To invest in equities in general – and particularly in more risky emerging markets – investors need an appropriately long time horizon.
A Eurozone breakup would involve mutually assured destruction; hence, we do not think the European project will fail. It has become clear, however, that members will have to collectively live up to the spirit of the original agreement, despite currently conflicted views. Germany and the Netherlands, specifically, have continued to resist the joint and several liability manifest in “coronabonds,” designed to support ailing countries like Spain, France, and in particular, Italy, through the crisis. This exemplifies the lack of progress toward full integration.
The agreement to enable embattled countries to access loans through the European Stability Mechanism (ESM) is a step in a good direction, although the conditions, or “strings attached,” to these funds represent obstacles. This leaves the ECB as the only reliable game in town, and we expect it to enact more policy measures designed to support sovereign credit during this crisis, including a new provision that will allow it to take non-investment grade bonds as collateral. This is driven by an assumption that Italy could be downgraded to non-investment grade, perhaps imminently.
In terms of our return outlook for European equities, we believe that the global economic recession across developed markets will drive an earnings recession in 2020; however, investors will begin to look toward earnings recovery in 2021, which while not robust, will be enough to drive a high single-digit/low double-digit total return. Critical to this forecast is valuation expansion, which we think is possible given interest rate suppression in light of tremendous monetary stimulus.
Global public real estate has felt the full brunt of the COVID-19 crisis as investors worry about tenants’ ability to pay rents and the long-term consequences of COVID-19 on key sectors in the market.
We do expect rent and lease payment pressure, as well as pressure to renegotiate lease contracts, to be near-term characteristics of the real estate market. Currently, both property owners and tenants want to hoard liquidity as the crisis unfolds; however, our outlook for a “checkmark” shaped recovery suggests that the intensity of these pressures may lessen as we approach the second half of 2020.
Some of the fiscal bridges being built in this country to sustain businesses during the downturn will help. However, the office and multifamily sectors will certainly face some near-term stress, and our expert considers this period to be a “net operating income recession,” where lifelines may be necessary, but if applied quickly, effective. This is very different from an “asset recession,” when structural issues suggest a more permanent impairment. The COVID-19 crisis has accelerated the recognition of some of these structural issues, specifically in the retail sector, which will remain under stress even as economies recover.
About Your Questions Answered: With volatility at historic levels amid the COVID-19 outbreak, investors continue to be challenged by a daily barrage of news and unprecedented economic uncertainty. To help them navigate this difficult period, each week we are featuring answers to some of the top questions we have received.
Most importantly, please know that our thoughts are with each one of our readers – our clients, colleagues, business partners and everyone else within our community – as we strive to overcome this health crisis.