Investment Clock insights

Economic recovery: rapid, then flat?


Trevor Greetham

19 June 2020

First published in Money Marketing on 18 June 2020

This will surely go down as the most extreme recession ever for its depth, speed of onset, global reach and the degree to which policy makers have been willing to rack up debt to cushion its impact. Technically it could also be the shortest. The rebound is already breaking records. Economists had expected to see US companies cut 7.5 million jobs in May. Instead 2.5 million workers were added back to the payroll. Forecast errors don’t come bigger than that. We wouldn’t be surprised to see stocks continue their recent melt-up as economic activity comes back to life, but with equity markets recouping most of their losses, attention will soon move to the future and what seems to us a very uncertain path back to normality.
The global economic cycle is an important driver of financial markets. A full business cycle can take years to play out but with the corona crisis things are moving at warp speed. The Investment Clock that guides our asset allocation moved from mild late cycle overheat in January 2020 straight into a disinflationary slump by April. We expect a sharp rebound in activity to move us back into disinflationary recovery by late summer as businesses re-open (figure 1). 

This will surely go down as the most extreme recession ever for its depth, speed of onset, global reach and the degree to which policy makers have been willing to rack up debt to cushion its impact. Technically it could also be the shortest. The rebound is already breaking records. Economists had expected to see US companies cut 7.5 million jobs in May. Instead 2.5 million workers were added back to the payroll. Forecast errors don’t come bigger than that. We wouldn’t be surprised to see stocks continue their recent melt-up as economic activity comes back to life, but with equity markets recouping most of their losses, attention will soon move to the future and what seems to us a very uncertain path back to normality.

The global economic cycle is an important driver of financial markets. A full business cycle can take years to play out but with the corona crisis things are moving at warp speed. The Investment Clock that guides our asset allocation moved from mild late cycle overheat in January 2020 straight into a disinflationary slump by April. We expect a sharp rebound in activity to move us back into disinflationary recovery by late summer as businesses re-open (figure 1). 

Figure 1: Investment Clock with RLAM base case for the future trail

The sudden switching back on of the world economy should be very familiar as it happens every Monday morning when most people head back to work after a weekend off. What’s different is the length of the shutdown and its impact on cash flow. To comprehend why policy makers have been willing to step in with such incredible force, in terms of both monetary policy (figure 2) and fiscal policy, we need to understand that this was not only an economic collapse of their own making. It was also a perfect storm from the point of view of a heavily-indebted world economy.

Figure 2: G20 policy response to the coronavirus pandemic

Source: International Monetary Fund as at 8 April 2020 (left chart) and Bloomberg as at 5 June 2020 (right chart)

Setting policy is a bit like playing whack-a-mole. While some of us called for fiscal ease at the time, the solution to the 2008 Financial Crisis leaned very heavily on monetary policy. With banks withdrawing credit and governments cutting spending, central banks were forced to cut interest rates to zero and use quantitative easing to push bond yields lower. It worked. Asset prices rose and banks were able to deleverage their balance sheets while corporates tapped the financial markets directly. The downside was it meant the credit markets ballooned in size like never before, as documented in the International Monetary Fund’s financial stability reports. 

Seen in this context the Covid crisis was the stuff of nightmares: a sudden stop in cashflow for almost every company in the world and all at exactly the same time. A surge of corporate defaults would have set off wave after wave of forced selling into markets that can be pretty illiquid at the best of times. But just as the banks were too big to fail in 2008/9, the credit markets were too big to fail in 2020. The US Federal Reserve stepped in, earmarking trillions of dollars to preserve liquidity in the US commercial paper, investment grade and even junk bond markets. 

Figure 3: A square-root shaped recovery?

The big question for investors is whether this support will be enough to prevent a liquidity problem from turning into a solvency problem. Our assumption is that the profile of this recovery will look something like a square root symbol (figure 3). A rapid pick up as economies re-open followed by a long flatter period with activity well below January 2020 levels as businesses fold, sectors like air travel and hospitality struggle and fears of a renewed surge in virus infections prevent consumer spending from snapping back. Concerns will creep back into markets as this plays out.

Longer term, the withdrawal of policy support will itself create significant two-way risk for the world economy and markets. Cut it too soon and you risk turning temporary layoffs into long-term unemployment. Leave it in the system too long and you create a surge in inflation a year or two from now. This will be almost impossible to get exactly right. 

While the most intense period of financial market stress may be behind us, the fight against the coronavirus is a marathon not a sprint and investors need to keep an open mind. Diversficiation and flexibility are the watch words.

Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the author’s own and do not constitute investment advice. Portfolio holdings are subject to change, for information only and are not investment recommendations.