This article was originally written and published by Openly Investing.
“We’re still in a recession. We’re not going to be out of it for a while, but we will get out.” – Warren Buffet
What a striking statement that is or more accurately was. Mr Buffet said that during the last major setback that investment markets endured, namely the Global Financial Crisis or GFC. It was a simplistic enough statement and I include it here because it is relevant today.
Synchronised global recession
Without a doubt, the worlds economies are in a synchronised recession that will last for at least two quarters and potentially longer. The length of the recession is dependent on how quickly the current pandemic is brought under control, but my sense is that it will take quite some time for the 195 economies to dig themselves out of this particular hole. Some talk optimistically of a ‘V’ shapes recovery however I see this as highly unlikely given several factors that I outline below. Despite this, we will recover, it is simply a question of time.
The difference between this and prior recessions is the speed with which it has occurred. Usually there is a slowdown caused, for example, by a period of over-tight monetary policy (interest rates too high), consumer confidence declines, and stock market or house price collapses to name but three. These are standard triggers for a recession. What is not common, although it has happened before, is that the recession is caused by a viral outbreak. What is more unusual, in this instance, is COVID- 19 has caused a synchronised global recession in just a matter of days as opposed to a regional one in the area of outbreak over weeks or months.
How deep this recession will be, only time will tell, but it will not be shallow given the response. Closing borders and restricting movement has created both a supply and demand shock of extraordinary magnitude. To address this and the economic implications of these actions, both governments and central banks around the world have thrown the ‘kitchen sink’ at the evolving situation in an attempt to preserve jobs and keep businesses afloat. Will the current stimulus be enough? Personally, I doubt it and would not be in the least bit surprised to see further actions taken to shore up ailing economies around the world.
Whilst there was little choice, the speed and magnitude of the stimulus offered by both parties, their efforts should be applauded. However, these measures – whilst successful in the short term – can only be successful over any meaningful time frame if the underlying cause is addressed.
Restoration of confidence is crucial
Feeling safe is at the bedrock of our willingness to interact, to go about our daily lives and to spend money. Even when the ‘all clear’ is given, for normalcy to return we need to feel safe and this will take a little time and may be longer than many believe. This may be the result of an effective vaccine or it may simply be a function of time but in order to triumph, confidence needs to be restored.
For investment markets, confidence is a key component of returns – without it, prices will struggle to move higher. Investors go through several distinct phases pertaining to investment sentiment which I will distill to just five: fear, panic, capitulation, hope, euphoria. Recent investor action saw euphoria turn to panic almost instantly given liquidity concerns and we may even have capitulated given the need to raise cash at all costs. It is too early to say for sure and we should continue to expect significant volatility in day to day movements. Put differently, I believe we will see additional pressure on asset prices, but the severity of the moves may be more muted than we have witnessed over the last few weeks.
Regardless of behaviour and other factors driving the short-term, I believe we need to focus further out and the real implications of what has transpired.
Capital destruction only occurs when an investor realises a loss or an investment defaults and moves into insolvency, thereby rendering the investment either worthless or impaired. Reasons for selling investments differ greatly but ordinarily it should be to take profits and then reinvest those profits. However, on occasion, assets are sold to provide additional ‘income’ above and beyond the income that those assets are able to generate.
With this in mind, investment income from cash and fixed income securities has been trending lower for several years and remains an industry-wide issue. In New Zealand, corporate bond yields have moved (depending on the issue) from more than 8% toward 3% whilst interest rates have moved from 8.25% to today’s 0.25%. Post the GFC, interest rates peaked at only 3.5%, which is low when compared to historic levels. Australia has seen a similar decline in its interest rate moving from 7.25% to 0.25%. But this is not confined to the Southern Hemisphere, it has been the same the world over. Recently, the decline in yields for both cash and fixed income investments has been somewhat mitigated by rising dividends on equity investments, but for now this is will not continue as companies move to preserve cash. Companies are suspending their profit forecasts and either cutting their dividends heavily or entirely.
The duration of this phenomena will be linked closely to the path of COVID-19 and the outcome of actions taken by both governments and the confidence of the consumer to start spending. New Zealand has moved decisively to control viral spread, aiming to get the economy ticking along, albeit at a slower rate, as soon as possible. In my opinion, a return to normality will take some time and may not occur until the borders are reopened and tourism begins to flow.
Income under pressure
With increased risks surrounding the virus, investors will demand higher yields to compensate for the additional risk. Therefore, if a company wishes to refinance its debt or re-issue to replace a maturing bond, then it is highly likely they will need to pay a higher coupon (yield) than recent issuance would suggest. During the GFC, we saw a similar situation with corporate bond yields rising significantly. Of course, the amount of the increase depended greatly on the type of bond and the company issuing it, but it would not be a stretch to suggest they rose between 1% and 8%. Whilst a rise in fixed income yields would be positive, in the short-term it will not go far to offset any income lost from equity investments.
Whilst the income situation is less than ideal, it is important to keep one’s eye on the long-term. Investment income may have declined but so have other sources of income too. Term Deposit rates have fallen significantly and depending on the maturity date, offers yields of less than 2% before tax. This may seem attractive when compared to some assets today, but it should also be remembered that term deposits do not offer any capital appreciation either. In any positive economic scenario, term deposits will be left wanting compared to rising equity prices.
Of course, this unprecedented time and response gives rise to many other questions: How will we remove the policy response, what will happen to inflation, what will unemployment look like and the effect on housing and demand. These are big topics in their own right and reserved for another time.
Stay safe, be kind and look to the future.
Update #5 will follow shortly.
Chief Investment Officer
Openly Investing Limited. 6 April 2020
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