- Investment Insight
- 5 minute read
As the COVID-19 pandemic has swept across the world, so too has the economic impact of the social distancing measures implemented to contain the spread of the virus. China, the first country to report cases of the virus and to impose shutdowns, was also the first economy where business surveys signalled that a sharp drop in economic activity was waiting around the corner. As expected, Europe, the UK and the US duly followed suit, with survey data pointing to economic contraction across these markets.
Will the economic reality reflect the gloomy picture painted by numerous surveys? Early data suggests that the decline in activity has indeed been sharp. In China, where the COVID-19 outbreak weighed on growth for most of the first quarter, GDP fell by 6.8% over those three months.
First-quarter GDP data suggests the picture may be worse in the US. Although the US economy shrank by little more than 1% in the first quarter, social distancing measures were not introduced in the States until the middle of March. This suggests that the economy declined by almost 2% in the month of March alone. Given that consumption spending is a very high share of the US economy – and that hospitality and retail represent significant segments of US employment – it is easy to see how the introduction of social distancing measures has translated to a significant hit to economic performance. In its World Economic Outlook , published in April, the International Monetary Fund forecast a -3% contraction of the global economy in 2020, due to the world entering a coordinated recession.
How long will the recession last?
The hit to global growth is clearly going to be severe, but will it be long? That is the key question being asked by policymakers and investors alike. To some degree, the answer depends on the evolution of the pandemic. Economic activity cannot fully recover until social distancing measures are relaxed.
Most of the world’s main economies now appear to be past the peak rate of infection, suggesting that the immediate health crisis is coming under control. Many countries, including the UK, have begun to roll back social restrictions in order to reopen their economies. Nevertheless, there is still a high degree of uncertainty around how long social distancing measures will need to be in place. Given that it will take time for governments to gain information on which measures have been most effective, it is possible that measures may potentially be rolled back, and then reinstated by a process of trial and error.
COVID-19 has spread widely throughout the world. So governments need to be able to access an effective vaccine if they are to feel confident about reducing social restrictions over the longer term. While research is progressing, it is likely to take some time before an effective vaccine becomes available. In fact, Prime Minister Boris Johnson has admitted that a vaccine might never be found.
Prospects for recovery
Once social restrictions are rolled back, how quickly is the economy likely to recover? Timely indicators suggest that, with social restrictions mostly lifted in China, economic activity is bouncing back, albeit slowly. As an economy, China has high exposure to manufacturing and it is affected by weak external demand from the rest of the world, which is only slowly emerging from lockdown. This weak demand is beginning to weigh on the country’s recovery.
Will the rest of the world exhibit China’s resilience in the wake of the pandemic? A key factor will be the duration of shutdowns. The aggressive response to the virus from China’s policymakers meant that mobility restrictions could be eased as early as February, with most shops and restaurants open by the end of March. Nevertheless, consumer activity remains somewhat subdued and localised shutdowns continue to be implemented in order to contain outbreaks. The virus has been contained less effectively in most other countries, and social distancing measures are likely to be in place for longer as a result. Hence it may be longer before these economies can recover.
Policy makers have been alert to the danger of prolonged economic stress due to the virus. Governments have therefore introduced schemes to keep workers in their jobs. These are designed to combat immediate hardship, support consumption and also limit the increase in unemployment. The higher the unemployment rate now, the lower the chance of workers re-entering the workforce once the worst of the pandemic has passed. Central bankers focused on providing businesses with ample liquidity to reduce the number of companies that go under during the crisis. Hospitality and retail are the sectors most vulnerable to the impact of social distancing, yet they were the key drivers of employment growth in the wake of the global financial crisis of 2008-9. Immunising these sectors from the health crisis gives the economy a better chance of recovery.
Implications for investments
What does the weak outlook for growth mean for investments? We see monetary policy remaining extremely accommodative for the foreseeable future, providing ongoing support to government and corporate bonds. The hit to demand, especially oil demand, is manifesting itself as a powerful disinflationary force, lending further support to nominal investments, although it is possible that changes to the structure of the global economy resulting from the pandemic will be inflationary in the future. A weak growth backdrop is likely to weigh on earnings growth over the next 12 months, a headwind for equities.
Companies have revised their headline earnings forecasts downwards, but we question whether these revisions fully reflect the scope of the hit to growth. Clearly the longevity of the period of suppressed activity is a key determinant in equity pricing. A one-time shock to earnings matters much less to valuations than if the crisis is likely to have a lasting effect on businesses and the economy.
COVID-19 has also proved to be a catalyst for a number of trends that were in train before the crisis. For example, the disruption to supply chains and demand patterns has underlined the importance of digital inventory monitoring and automation for businesses. Meanwhile, enforced teleworking has compelled companies worldwide to invest in technology and change working practices. Unfortunately, the pandemic has also stoked geopolitical tension, especially between the US and China. While relations have been strained in recent years, the two countries were making progress towards a trade truce at the end of 2019, a pact that now appears vulnerable. In Europe, disagreements over how to respond to the crisis have provided fresh material for melodrama, turning up the dial on north-south relations within the bloc.
Furthermore, COVID-19 is likely to result in other issues being de-prioritised. Progress towards climate change commitments may be put on hold, while governments tackle the immediate economic fall-out from the crisis. While the coronavirus has stopped many things, it has not put an end to Brexit. The June deadline for the UK to request an extension to the transition period is fast approaching and negotiations are ongoing. We anticipate that the path of Brexit may gain focus in the second half of 2020.
How are we positioning portfolios in current conditions? With significant risks to growth still present, fund managers have used recent strength to lighten positions. They are holding modestly higher levels of cash, as a result. It is important to remember, however, that equities are long-term assets and pricing is becoming more heterogeneous, reflecting the differing fundamentals of different companies. For now, we maintain our neutral equity allocation and remain focused on understanding the profile of COVID-19 across regions, as well as monitoring medical progress towards a treatment or vaccine.
Capital at risk.
The information contained in this document is believed to be correct but cannot be guaranteed. Past performance is not a reliable indicator of future results. The value of investments and the income from them may fall as well as rise and is not guaranteed. An investor may not get back the original amount invested. Opinions constitute our judgment as at the date shown and are subject to change without notice. This document is not intended as an offer or solicitation to buy or sell securities, nor does it constitute a personal recommendation. Where links to third party websites are provided, Close Brothers Asset Management accepts no responsibility for the content of such websites nor the services, products or items offered through such websites.