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Macro Overview - March 2020 17 APR 2020Global health crisis...

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    Macro Overview - March 2020 17 APR 2020

    Global health crisis takesunprecedented personal, economic and market toll
    The globaleconomic environment and financial markets were upended in the last few weeksof the quarter as the coronavirus (COVID-19) pandemic made its way across theglobe. The headlines clearly tell the story. As governments sought to containthe spread of the virus, there have been mass closures of businesses, resultingin unheard of jumps in unemployment. Stock markets collapsed in one of thefastest declines in history and debt markets are struggling under thepossibility that companies that only weeks ago looked in good financial shapeare now bankruptcy candidates.

    Governments the world over have responded with fiscal andmonetary stimulus of a scale never previously seen. The situation isunprecedented in economic and financial market history. Below is a broadoutline of our current thinking on how we see the economic situation unfoldingand the response of financial markets.

    The Economy

    In order to have a view on where economic activity may trackfrom here, we need to address the nature of this economic collapse. We are allused to the economy being defined by sets of numbers such as interest rates,inflation, employment, retail sales, government spending, trade deficitsand surpluses and the like. While these are all useful indicators of whathas happened, viewing the economy through the lens of such data tends to makeus think of the economy in an abstract manner.

    The goods and services produced using the factors of productionare our income and the sum total is referred to as gross domestic product (orGDP). These factors of production and the goods and services produced are the real economy.

    Governments around the world have reacted to COVID-19 with awide variety of containment measures to slow down the spread of the disease. Innearly every case, the result of these measures has been to limit the abilityof people to go to work and spend money (e.g. at bars, restaurants,travelling), thus removing the opportunity for work in these industries. Thiscollapse is nowhere better demonstrated than in the United States, whereinitial unemployment claims spiked to 3.3 million in a single week in March (upalmost 12-fold from the previous week). They then jumped a further 6.6 millionthe following week (see Fig. 1), which is almost 10 times the previous recordset during the global financial crisis (GFC).

    Fig. 1: Rise in Weekly US Jobless ClaimsDemonstrates Collapse in Economic Activity
    WeeklyInitial Claims For Unemployment Insurance, Seasonally Adjusted, - United States

    The key point to be taken from all of this, is simply that, economicactivity will stop falling and start to recover when people can return to work.Exactly when containment strategies can be wound back is unknown at thisstage. There is much attention on China as a roadmap and recently Wuhan (theepicentre of the outbreak) has started to re-open a little over two monthsafter the initial lockdown of the city. There is considerable uncertainty aboutwhether this timeframe will be representative for the rest of the world and indeed,what will happen in Wuhan as freedom of movement returns. However, at thispoint in time, the data from the rest of China suggests reasons to beoptimistic that we will be able to slowly get back to work once the spread ofthe virus has been controlled.

    Once we can all get back to work, the productive capacity of theeconomy, as represented by the factors of production, will be largelyundiminished and in theory, economic activity should quickly regain much ofwhat has been lost. In practical terms though, many businesses that have beenclosed may never return, simply because they were marginal in the firstinstance, or as a result of bankruptcy. While the closure of these businesseswill release resources that can be used in other activity, this takes time.

    How quickly will activity return to prior levels? Looking to history,probably the most appropriate period for comparison is the GFC. During the GFC,the breakdown in the financial system saw business activity stifled due to alack of funding, and similarly to today, resulted in a period of time where theproductive capacity of economies could not be put to use.

    There was also a dramatic fall in activity, though not as rapid as wehave experienced in recent weeks. After the major economies peaked in early2008, it took the US economy just over three years to return to this level,Japan took five years, and Europe took seven years. Of course, this crisis hasa different cause, and we still do not have a clear sense of the depth orlength of the economic decline. All that can be stated with any confidencereally, is that while the rebuilding will start the day we get back to work, itwill take some time before we can recover to the previous highs in economicactivity.

    There is also the issue of government responses to the crisis. Thesevary significantly across countries, but generally the various fiscal andmonetary policies that have been enacted can be grouped into two categories.Many countries have created lending facilities for companies that arestruggling to finance their ongoing operations. Typically, the central bank iseither directly offering funds to businesses, or indirectly via the bankingsystem, often at concessional interest rates.

    These policies are aimed at ensuring companies do not fail as a resultof not being able to access funds due to the short- term freeze in debt marketsand banks trying to protect their positions. The goal of governments is toensure people have jobs to go back to when we are through this period of containment.There has also been large-scale buying of financial instruments by centralbanks, which has played a similar role in ensuring that financial marketscontinue to remain open and able to provide funding to companies. The secondkey area of focus has been the provision of funding to individuals who havelost their jobs or have been temporarily laid off. The large percentage ofworkers who have lost employment are from relatively low-income roles in thetourism, retail, and other service industries, and typically have little roomwithin their finances to sustain themselves through a period of unemployment.Payments to those impacted will ensure they can afford their weekly grocerybill and await the chance to search for work at a later point in time.

    What is important to understand about these policies is that theyachieve very little in the way of new activity. Simply, going back to firstprinciples, if people can’t work for whatever reason, economic activity willremain suppressed. It helps that a newly unemployed individual can afford theweekly grocery bill, but in the scheme of the broader loss of activity, this ismarginal. The various policies ultimately aim to remove the worst-case outcomesfrom the economic collapse and they effectively do this by redistributing theburden of the crisis from those who are initially impacted (such as those wholose their jobs), across the broader community. While governments can spendmoney, they are not a source of economic activity. When they spend, they dothis either by raising funds through taxation, borrowing money from the privatesector (which then has to be paid for from future taxation receipts) or byprinting money. The burden of today’s spending measures by governments willeither be funded from taxation (today or in the future) or through a loss ofvalue in money or cash (i.e. inflation). It is not to say that these policiesare not necessary. It is just to state that these are the mechanisms by whichthe burden is spread more broadly across all in society.

    Once we do come out the other side of this crisis, it is likely thatconsumer and business confidence will recover slowly, especially in the lightof the damage to household and corporate balance sheets. Additional governmentspending is likely to remain a feature of the environment, as governmentsattempt to fill the spending gap left by the private sector. At this point,such spending will aid in creating economic activity as it helps createemployment. The future economy may potentially look quite different, as someindustries may simply not recover and the growth path of others, such ase-commerce, information technology, renewal energy and healthcare, will bereinforced by today’s events. Government spending on infrastructure, not juston the typical ‘roads and bridges’, but healthcare and efforts to decarboniseeconomies, seem likely. There will potentially be interesting challenges aroundthe future funding of government initiatives given the deterioration innational balance sheets resulting from current policy initiatives.

    In Summary:

    · The current economic shock is a result of large numbers of people beingunable to work as a result of the strategies to contain COVID-19. There can beno economic recovery until people can get back to work.

    · Current government initiatives around the world will prevent worst-caseeconomic outcomes and help share the costs of the downturn across society.Government policies will have little impact in creating activity until we startto move beyond containment strategies.

    · Ultimately, a recovery in the economy will take hold, though it willtake time to recover to 2019 levels and this may vary dramatically by country.Further, the make-up of our economies may be very different in the recoveryperiod, compared with that of 2019.

    The Markets

    The response of stock markets to the unfolding pandemic has been swift,recording some of the largest and fastest declines on record. From peak levelsin markets during the first weeks of 2020 to their lows in the second half of March,markets fell between 31% to 44% in local currency terms (see Fig. 2). Theexception was China, which had already been in a protracted bear market forsome time.

    Fig. 2: Market Declines from 2020 Highs to Lows

    These are very significant adjustments by any standards, otherthan against the most significant bear markets in history. For reference,during the GFC the S&P 500 Index fell 57% from its peak in 2007 to itstrough in early 2009, Germany fell 54%, Japan 61% and Australia 54%. Thecomparison with the GFC is interesting, as the decline in economic activity inthe current downturn has been far swifter. However, if the rest of the worldfollows the experience of Wuhan and is able to release the lockdowns after twoto three months, the base in economic activity is likely to be reachedrelatively quickly.

    As discussed above, the recovery in economic activity will beginwhen people can go back to work, though a full recovery will take time.However, markets will anticipate the full recovery well ahead of its actualoccurrence. Post the GFC, stock markets rallied strongly in subsequent years,well ahead of the full economic recovery. Ultimately, the market is likely toreach its low at the point of greatest uncertainty. Potentially, we havealready seen that occur as the major monetary and fiscal initiatives that wereannounced by governments at the end of March did reduce some of theworst-case scenarios as discussed earlier. On the other hand, there were ralliesin markets of the order of 20% on two occasions in the latter months of 2008,only for the market to falter and fall to new lows.

    There remain many unanswered questions at this point. Besidesthe length of the lockdowns occurring around the world, the quantum of theeconomic loss is far from clear. Additionally, the impact of the slowdown oncompany profits is not linear. Companies with high fixed overheads will incursignificant losses and will need to either take on debt or issue equity tosurvive. Others may find profits suppressed for a number of years if revenuesremain subdued. Probably of greatest concern is what appears to be a highlydisorganised response in the US, the world’s largest economy.

    Our view at the time of writing, is that markets will likelyreturn to their recent lows and possibly fall further. It is likely thatthis will occur relatively quickly as many of the uncertainties outlined abovewill start to be better understood with each passing day. Our position maychange quickly. Ultimately, what will guide our longer-term position is thevalue that we can see in current stock prices. We do this by taking a view onthe earnings power of companies three to five years in the future, based on ourassessment of their business prospects. We will adjust valuations for lossesthat we expect them to accrue during the worst of the downturn. We will assumea reasonable rebound in future economic activity in aggregate, but will notexpect this to play out evenly across all industries. On this front, we have amixed view. There are many extremely attractively priced companies,particularly in cyclical areas and those areas directly impacted, such astravel. On the other hand, many market darlings of recent years, whilehaving been sold off, have continued to perform better than the broad marketand remain expensive.
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