By Tom Wickers, Hottinger Investment Management
“The inability to predict outliers implies the inability to predict the course of history” ― Nassim Nicholas Taleb
Over the last month, we watched from our windows as the world went quiet. Wuhan’s reality became ours, and social and economic systems have tumbled as a result. Very few economists had a global pandemic on their list of key economic risks, but the consensus has been out for some time now; the vast majority believe that we are already in a global recession[i]. The hotly-debated topic has become how long the downturn will last. Analysts’ forecasts of the recessionary damage and length are understandably wide-ranging as there are a plethora of unknowns still surrounding Covid-19 and we have limited economic data on the effects of the shutdown. While historic precedent should always be taken with a pinch of salt, it should help add some colour to these forecasts as well as our understanding of the current economic situation.
The current economic crisis is unique, like all that have come before it. However, what makes this downturn particularly extraordinary is that, purely from an economic perspective, it will be a recession that world powers entered entirely voluntarily. Governments have been attempting to press pause on the economy while supporting balance sheets and family wealth. Should the coronavirus pandemic pass as is currently forecast, the ability of the economy to return to the status quo will therefore depend on how well governments are able to execute this pause, to avoid structural losses, and how much damage is done to fiscal debt as a result. Regardless, a “pause” rather than a slip into recession means that economists are predicting a v-shaped bounce-back in earnings and GDP next year, similar to the 1974 Oil Crisis and other recessions caused by temporary shocks.
The most prominent economic forecast was released by the International Monetary Fund (IMF) this month, expecting US GDP to drop by 5.9% this year and recover by 4.7% in 2021. The Global Financial Crisis of 2008, the Oil Crisis Shock of 1974 and the Great Depression of 1930 are three recessions that put this new GDP forecast into perspective. Figure 1 demonstrates that while this US downturn is not expected to resonate on the same level as the infamous Great Depression, it is shaping up to be the sharpest we have seen in modern times. Furthermore, despite the IMF forecast being released only this month, Kristalina Georgieva, the managing director, has already clarified that it may be overly optimistic[ii]. Forecasts on unemployment paint a darker picture, with the Federal Reserve Bank of St. Louis estimating that it could reach 32.1%[iii] in Q2. This rate would likely be short-lived and requires certain levels of social distancing to be maintained, but it would represent the highest figure since records began.
Translating the economic data into what we would expect from markets from history, Figure 2 provides a clear depiction of one of the reasons why a lot of investment houses are predicting another leg down in stock prices after the recent rally we have experienced this month[v]. It would be unprecedented if the S&P 500 were to make sustained gains this early on in an economic crisis, before the extent of the initial damage has even been fully realised. The need to de-risk and preserve capital has meant that the previous recessions referenced below have required at least 10 months before the stock market has made gains relative to the industrial production index; an indicator of economic health. Therefore, even with the fact that this crisis is expected to be relatively brief, it is difficult to believe that the current rally will continue upwards after just two months, particularly as the economic data are looking dismal for at least the next year. Valuations are also currently poised on the optimistic side of Covid-19 forecasts; prices are reflecting a strong v-shaped recovery[vi] with no severe reoccurrences of the virus, no particular difficulties in vaccine creation and little in terms of economic structural shifts out the backend of the crisis. The counterargument in support of further upside is that once you ‘give investors confidence that the worst is behind them, history suggests they can put up with quite a bit of bad news’[vii]. If we truly have already turned a corner as some investors believe, with global self-isolation restrictions gradually easing, then markets may continue to tick up from here.
Given the freshness of the current economic crisis and the level of uncertainty that remains encompassing both its depth and longevity, to say we are out of the woods feels premature. Covid-19 has proved to be both pervasive and stubborn. As lockdowns have eased across Asia, cases have once again been on the rise[x], proving we do not yet have a clear route back to a functioning society. Equity investors tend to be intrinsically optimistic, which introduces substantial downside potential should news disappoint. However, optimism and foresight also mean that equity markets bounce well before economies recover, and the potential for substantial positive news in the form of a cure or excessive stimulus should not be discounted. Nevertheless, to chase a bear market rally is treacherous and currently caution mixed with occasional opportunism appears to be the sensible approach.
[v] According to positioning in Business Insider’s Global Fund Manager Survey
[vi] Absolute Strategy Research, ‘Equities Not at Trough Valuations’, 9th April 2020
[vii] Morgan Stanley Sunday Start, ‘Short-Term Pain for Long-Term Gain’, 16th April 2020
[viii] The start of the crisis is determined as the month when the Industrial Production Index started deteriorating.
Our investment strategy committee, which consists of seasoned strategists and investment managers, meets regularly to review asset allocation, geographical spread, sector preferences and key global market drivers and our economist produces research and views on global economies which complement this process.
Our quarterly report presents our views on the world economic outlook and equity, fixed income and foreign exchange markets. Please click the link to download.