The Federal Reserve’s emergency dose of monetary drugs this week is a clear warning to equity and credit investors. While some mocked the sharp drop in borrowing costs by the US central bank on Tuesday, a rate cut does not inject wallets into the threat of a deeper economic and stock market crisis.
The Fed rolled out a similar game book in 2008 and 2001 – years that were characterized by frantic bouts of market volatility. And there were a lot of false dawns during these periods before asset prices stabilized and started to recover.
Due to the coronavirus epidemic, investors are facing decidedly opaque prospects for economic activity and corporate profits in the coming months. The severity of the epidemic could decrease in the spring – or an increasingly uncomfortable environment could emerge, such as in late 2007 and early 2008, when the scale of the financial crisis slowly became apparent.
These scenarios are illustrated to some extent by the contrast between government bond yields and the broad equity benchmarks. Amid all the market noise, stocks have been relatively resilient, wiping out only the gains of the past few months, which is little more than a short-term blow to corporate profits. If the coronavirus dissipates relatively quickly, the combination of a weaker US dollar and lower bond yields – causing budget spending around the world – could fuel a recovery in economic activity and asset prices.
This explains the correction of the FTSE All-World index, which, from peak to trough in recent weeks, is around 14%. Declines of around 20% to 30% for the major stock markets are signs of a deeper economic contraction in the future. This type of decline has already been observed in the stocks of American and European banks in recent weeks.
But the really grim signals come from the bond market, where the 10-year Treasury bill yields well below 1% – and far away from the average overnight rate of 1.125% set by the Fed. Also look at real returns, which guide forecasts of future growth. The 10-year real yield collapsed, approaching minus 0.5% on Thursday. This suggests a deflationary shock, which is hardly good news for the economy or for corporate profits.
In this perspective, it seems to wait too long for the disruption of coronaviruses to be limited. More and more economists expect weak activity beyond the current quarter, as quarantines and restrictions reduce activity. Estimates of global growth this year fall to 2.5%, a level that leaves little room for maneuver for a prolonged economic shock. The Institute of International Finance notes that in its worst scenario, global growth could approach 1%, compared to 2.6% last year and the weakest since the global financial crisis.
The Fed’s action this week, along with the easing of central banks in Canada and Australia, reflects efforts to anticipate tighter financial conditions. The latest Fed’s Beige Book survey released on Wednesday revealed supply chain disruptions and said travel and tourism were already suffering at the end of last month. It therefore becomes increasingly difficult to minimize the prospect of a more bumpy outcome.
“The Fed is trying to prevent this process long enough, so when the real data finally catches up with the current gloomy sentiment of risky assets, investors will be ready to trade the stimulating and reflationary implications,” said Ian Lyngen of BMO Capital Markets.
A particular problem could be a tightening of liquidity, as small and medium-sized enterprises find it difficult to obtain new financing. The sharp increase in debt over the past decade has focused on non-financial corporations, which are now facing disruptions that threaten their ability to repay and refinance these loans.
Jefferies analysts believe that the risks of turnover “will ultimately determine whether global stocks will escape Covid-19 with a slight slowdown in earnings growth”.
Long-term investors should do as usual: look beyond periods of market volatility and wait for opportunities to buy high-quality companies at a great price.
But given the high starting point for equity and credit market valuations, there is clearly room for further lows before any clarity arrives. Dhaval Joshi of BCA Research believes that the recent decline in stocks means they are valued for a three-month economic slowdown.
Investors with a longer deadline of six to 12 months have not yet capitulated, it seems, which is logical, given the efforts to contain the virus which could limit its economic damage. But it is worrying to note that during the financial crisis, when some investors had capitulated at the beginning of September 2008, the bottom of the stocks occurred about six months later.
Joshi said investors should keep this in mind. “The financial markets have fully assessed the downturn when the time horizon of the investors who have fully surrendered equals the length of the downturn,” he said.
The Federal Reserve’s emergency dose of monetary drugs this week is a clear warning to equity and credit investors. While some mocked the sharp drop in borrowing costs by the US central bank on Tuesday, a rate cut does not inject wallets into the threat of a deeper economic and stock market crisis.
The Fed rolled out a similar game book in 2008 and 2001 – years that were characterized by frantic bouts of market volatility. And there were a lot of false dawns during these periods before asset prices stabilized and started to recover.
Due to the coronavirus epidemic, investors are facing decidedly opaque prospects for economic activity and corporate profits in the coming months. The severity of the epidemic could decrease in the spring – or an increasingly uncomfortable environment could emerge, such as in late 2007 and early 2008, when the scale of the financial crisis slowly became apparent.
These scenarios are illustrated to some extent by the contrast between government bond yields and the broad equity benchmarks. Amid all the market noise, stocks have been relatively resilient, wiping out only the gains of the past few months, which is little more than a short-term blow to corporate profits. If the coronavirus dissipates relatively quickly, the combination of a weaker US dollar and lower bond yields – causing budget spending around the world – could fuel a recovery in economic activity and asset prices.
This explains the correction of the FTSE All-World index, which, from peak to trough in recent weeks, is around 14%. Declines of around 20% to 30% for the major stock markets are signs of a deeper economic contraction in the future. This type of decline has already been observed in the stocks of American and European banks in recent weeks.
But the really grim signals come from the bond market, where the 10-year Treasury bill yields well below 1% – and far away from the average overnight rate of 1.125% set by the Fed. Also look at real returns, which guide forecasts of future growth. The 10-year real yield collapsed, approaching minus 0.5% on Thursday. This suggests a deflationary shock, which is hardly good news for the economy or for corporate profits.
In this perspective, it seems to wait too long for the disruption of coronaviruses to be limited. More and more economists expect weak activity beyond the current quarter, as quarantines and restrictions reduce activity. Estimates of global growth this year fall to 2.5%, a level that leaves little room for maneuver for a prolonged economic shock. The Institute of International Finance notes that in its worst scenario, global growth could approach 1%, compared to 2.6% last year and the weakest since the global financial crisis.
The Fed’s action this week, along with the easing of central banks in Canada and Australia, reflects efforts to anticipate tighter financial conditions. The latest Fed’s Beige Book survey released on Wednesday revealed supply chain disruptions and said travel and tourism were already suffering at the end of last month. It therefore becomes increasingly difficult to minimize the prospect of a more bumpy outcome.
“The Fed is trying to prevent this process long enough, so when the real data finally catches up with the current gloomy sentiment of risky assets, investors will be ready to trade the stimulating and reflationary implications,” said Ian Lyngen of BMO Capital Markets.
A particular problem could be a tightening of liquidity, as small and medium-sized enterprises find it difficult to obtain new financing. The sharp increase in debt over the past decade has focused on non-financial corporations, which are now facing disruptions that threaten their ability to repay and refinance these loans.
Jefferies analysts believe that the risks of turnover “will ultimately determine whether global stocks will escape Covid-19 with a slight slowdown in earnings growth”.
Long-term investors should do as usual: look beyond periods of market volatility and wait for opportunities to buy high-quality companies at a great price.
But given the high starting point for equity and credit market valuations, there is clearly room for further lows before any clarity arrives. Dhaval Joshi of BCA Research believes that the recent decline in stocks means they are valued for a three-month economic slowdown.
Investors with a longer deadline of six to 12 months have not yet capitulated, it seems, which is logical, given the efforts to contain the virus which could limit its economic damage. But it is worrying to note that during the financial crisis, when some investors had capitulated at the beginning of September 2008, the bottom of the stocks occurred about six months later.
Joshi said investors should keep this in mind. “The financial markets have fully assessed the downturn when the time horizon of the investors who have fully surrendered equals the length of the downturn,” he said.