World leaders have made unprecedented decisions around the costs and benefits of temporarily restricting economic activity to limit the spread of an infectious disease. The social distancing measures now in place across much of the world—ranging from the closure of entertainment venues, to travel bans, business closures, and restrictions on personal movement—will have a major economic impact. We estimate that the kind of restrictions now in place across many major economies could cut between 20% and 40% from private sector activity over the duration that they are enforced.
In response, the Federal Reserve has rolled out its entire Global Financial Crisis playbook in just three days. The European Central Bank has launched a Pandemic Emergency Purchase Program, backing its claim to do “whatever it takes.” Fiscal policy makers are ramping up their response too, with programs announced so far worth 16% of GDP for the UK, 15% of GDP for Germany, 15% of GDP for France, and 10% of GDP for the US. We believe these measures, and policymakers’ willingness to do more, will help us avoid a global financial crisis-style credit crunch. So far, however, the market impact of widespread restrictions on personal movement has overwhelmed this set of policy responses.
In this article, our goal is to examine how we see the interplay of health, monetary, and fiscal policy impacting markets, so investors can effectively evaluate risks and opportunities today. We have organized our thinking into three scenarios: upside, central, and downside, each determined by the answers to the key questions: a) how quickly economic activity can normalize, and b) how much policy responses can limit corporate bankruptcies and job losses.
In an upside scenario, some combination of high compliance with social distancing, viral seasonality, and/or pharmaceutical solutions means that virus infections in the major economies in Europe and the US follow the path of China and peak by early-April, allowing measures to be gradually relaxed from early-May onward. Government stimulus is sufficient to avoid lasting damage to the economy, and allow growth to begin a V-shaped recovery in the third and fourth quarters.
In our central scenario, new cases of the virus generally peak by mid-April, allowing the most severe restrictions to be lifted from mid-May, although the virus proves hard to eradicate, meaning restrictions need to be reimposed intermittently in some countries for the remainder of the year. A coordinated monetary and fiscal response eventually provides the necessary funding to backstop affected businesses and industries, but it arrives too late to protect all. A U-shaped economic recovery takes hold around the fourth quarter.
In a downside scenario, containment measures do not prove sufficient to halt the spread of the virus, and new cases continue to rise in Europe and the US into May/June. We also see the virus spread again in China, requiring renewed restrictions there. Most restrictions in Europe and the US remain in place into June or July, and are reimposed intermittently for the remainder of the year. In this scenario, government policy would not meaningfully offset the lengthy demand shock, leading to a sharp rise in bankruptcies and joblessness. Companies would forgo significant revenue, and losses would be borne by shareholders, creditors, and banks. Economic growth would have an L-shaped profile through 2020.
While it’s impossible to tell with any certainty which scenario will occur, we continue to believe that a disciplined, diversified, and far-sighted approach to investing will remain the best way to grow capital over the long term. The significant recent drops in markets mean that many portfolios will now hold a lower weight to equities than their long-term targets. We generally recommend rebalancing back to target allocations, although in volatile times addressing asset allocation gaps through averaging-in, or combining the sale of put options with the purchase of call options, may help investors reduce timing and overcome the human behaviors that drive underperformance.
In our tactical asset allocation, we hold overweight positions in hard currency emerging market sovereign bonds, US high yield credit, and select emerging market currencies. CIO is also overweight TIPS versus nominal Treasuries, as well as the British pound versus the US dollar.
Read the full monthly letter for our latest asset allocation recommendations and investment advice pertaining to the COVID-19 outbreak.