Investors need to consider four key themes when thinking about Covid-19:
- Judging fiscal and monetary policy responses based on their effectiveness as stimulus during a recession rather than as part of economic hibernation.
- Underestimating how quickly government policy could change again as our understanding of the virus improves.
- Focusing on how developing markets themselves are coping with the virus rather than whether they will be able to sustain a withdrawal of external demand as developed markets hibernate.
- Moving to a risk-off stance and underestimating the potential speed of recovery.
Theme One: Prepare for hibernation, not stimulus: Investors should not simply compare the sizes of different governments’ stimulus packages; rather they should assess which governments are best enabling their economies to safely hibernate, ready to wake and grow once the virus has been addressed.
Many policymakers and market participants appear to be focused on traditional debates about how to stimulate the economy in recession: Monetary vs fiscal? In what size? How should fiscal be targeting? But this is missing the point. We aren’t in a normal recession where growth is stalling. The real economy was strong prior to Covid-19 – with the IMF forecasting acceleration in 2020 and 2021 – but in order to supress the disease, leaders globally have chosen to place most of the real economy into hibernation, judging that the health benefits will outweigh the economic harms.
However while most of the real economy is frozen, people still need money to pay for housing, tax and other essentials and service their debts. Companies similarly need to service their debts and continue to pay their leases, employees, suppliers and taxes. As such, policy in the developed world needs to focus on supporting businesses and households to meet these financial obligations while the real economy sleeps, not on stimulating economic activity. The more effective this is, the less balance sheet damage households and firms will experience during hibernation. And the stronger household balance sheets are when we emerge, the stronger the recovery will be (see Mistake Four).
What makes a successful hibernation? In short, hibernation will be similar to, but not the same as, stimulus in a recession. In a recession, policy seeks to cushion the blow of losing one’s job and simultaneously encourage productive firms to hire, thereby shifting labour into more productive sectors of the economy. In hibernation, however, the goal should be to keep layoffs to a minimum so that workers are ready to resume work when hibernation ends. Similarly, while in recession it makes sense to stimulate aggregate demand, in hibernation the goal should be to support the immediate cashflow needs of households and firms, by deferring payment terms, extending credit, and providing needs-based, ongoing direct cash support. As such, hibernation will likely require more targeted easing of credit conditions than stimulus does. Successful hibernation policy will need to be designed to avoid hysteresis effects by encouraging business to be ready to reopen quickly, and workers to be ready to return quickly to their jobs. And, just as with stimulus following a recession, economies with greater fiscal and monetary space will be more able to manage hibernation. Unfortunately, with the notable exceptions of China and wealthier parts of the GCC, most developing countries are limited in their ability to successfully enter hibernation.
Theme Two: Underestimating how much we don’t know, and therefore how quickly lockdowns could end as countries shift back to a herd immunity strategy: Investors need to closely follow developments around surveillance testing to determine who has previously had the disease and be ready for the possibility that the current lockdowns end much more rapidly than expected once policymakers better understand the virus and their options for addressing it.
The duration of the global hibernation is fundamentally uncertain because we don’t know enough about the virus. I would suggest that there are two scenarios – the Imperial scenario and the Oxford scenario – named for the papers presenting the two models for the spread of the disease. The Imperial paper argues that attempts to mitigate the spread of the disease, as opposed to supress it through strict lockdowns, will lead to much higher levels of deaths given the highly fatal nature of the disease. The Oxford paper argues that the percentage of people who have been infected without showing symptoms is potentially quite high. It presents a series of scenarios, all of which are consistent with the reported data on deaths from both the UK and Italy, ranging from the pessimistic view similar to that of the Imperial paper to an optimistic view that >40% of the UK population has already been exposed. If it is case that the disease is much less lethal than was previously thought, then the additional health benefits of suppression do not warrant the economic costs. While the Oxford paper does not argue for a particular scenario, I use “the Oxford scenario” to refer to a world in which large numbers have already had the disease in many countries, and the majority of those infected with Covid-19 are asymptomatic.
The Oxford paper has seen some academic criticism, especially focusing on its most extreme scenario that half the UK population has already had the virus, but it is also supported by new research, like this paper in The Lancet showing that the viral carriage period is longer than was originally thought. Meanwhile initial data from Iceland, the first country to undertake large-scale, general population testing, appear to support the Imperial scenario. But market participants would be mistaken to dismiss the Oxford scenario at this stage. Indeed, the whole point of the Oxford paper was to show the wide range of outcomes that are possible once testing of previous exposure begins. The reality is that we simply do not know which of these scenarios is correct until widespread testing is able to determine what percentage of the population not only currently has Covid-19, but what percentage has had asymptomatic previous exposure and recovered.
Such tests are likely to begin to become available in mid-April, and it may be several weeks thereafter before enough data is available to assess the actual percentage of the population that has been infected and, by extension, the actual lethality of the virus. On this basis, it is reasonable to expect that even if the Oxford scenario is correct, lockdowns will continue for at least two months until data is available to indicate the need for a change of tack, but once that data is available, things could change rapidly. The change could come sooner if testing ramps up more quickly, and investors need to be prepared for the wildcard that testing finds that most people have already had the disease, but lockdowns are still required because having the disease doesn’t confer reliable immunity. The Oxford scenario and the Imperial scenario imply very different medical responses, very different paths for the global economy and very different outcomes for markets, and at this point either possibility could be correct.
Even if the Imperial scenario is correct, policy could change rapidly were governments to move, as Paul Romer argues they should, from blanket isolation to massive, regular testing and test-based isolation, which would likely only require 10% of the population to isolate at any given time. While this would require a massive testing effort that would be costly and might only be practically possible in societies that can effectively compel regular testing or have sufficiently high social cohesion for the public to voluntarily undertake such testing, Romer’s model shows that even if the Imperial scenario is correct, a change in public policy could rapidly take the economy out of hibernation.
Lastly, it is also worth noting that developing markets, many of which lack the infrastructure and fiscal resources to effectively hibernate, should benefit disproportionately if the Oxford scenario proves to be correct. With high population densities, high levels of informal work, large numbers of households without savings and shared sanitation facilities (if any exist at all), lockdown will be extremely difficult to effectively implement in many developing markets. Indeed, only a few days into the lockdown in South Africa, it has already led to clashes between the army and township residents. The less lockdown is required, the better for emerging markets, both domestically and externally (see Mistake Three).
Theme Three: Focusing on what is happening medically in developing markets rather than on how hibernation in developed markets will impact developing markets: Investors need to assess which developing markets are best able to weather a withdrawal in external demand as developed markets hibernate.
The discussion among developing market investors has focused predominantly on how bad it will be medically in various EMs. But there is also a wide range of views on what Covid-19 means more broadly for the developing world. While I would rather be back in Africa, Tellimer’s Equity Strategist, Hasnain Malik, is concerned that India may be the archetype of Covid-19 in the developing world. Authoritarian regimes may use the virus as an opportunity to strengthen their tools of control, as Hungary has done by giving Prime Minister Viktor Orban the right to rule by decree indefinitely. Across Africa, opposition politicians, including most musically opposition Presidential candidate and musician Bobi Wine in Uganda, are urging their supporters to take Covid-19 seriously, rather than oppose government measures to contain the virus. And one has to hope that Ugandans heed his message to “sensitise to sanitise” because Uganda’s health system, which has fewer ICUs beds than the Ugandan government ministers, will be rapidly overwhelmed by the virus.
Despite the animated debate about what will happen in developing markets themselves due to Covid-19, what happens in developed markets may matter more. Apart from China and the wealthier parts of the GCC, EMs cannot sustain a temporary withdrawal of external demand during hibernation without massive damage to household and government balance sheets that will negatively impact future growth. The oil price collapse may help oil importers, but it has already placed a strain on the fiscal resources of major exporters. Which developing markets can sustain themselves while developed markets are in lockdown will be as important as which developing markets lockdown themselves.
Theme Four: The recovery when we come out of hibernation, at least in developed markets, may give us whiplash: Investors need to focus on how much damage the global economy sustains during this hastily arranged hibernation, be ready for a sharp recovery where the hibernation has been successful, be cautious about taking risk off, and be ready to rapidly move risk back on.
Fiscal and monetary stimulus that is not focused on enabling hibernation (see Mistake One) is like pouring jet fuel into the fuel tank when the car is switched off: it doesn’t do much to make the car go faster now, but it certainly leaves the car ready to rocket when the engine is switched back on. If the global economy can survive the hibernation process, then when it comes out, the recovery will be rocket powered, and we may all get whiplash. If the Imperial scenario proves to be correct (see Mistake Two), then various predictions that the S&P 500 will bottom out at 2000 seem reasonable, but investors may not appreciate how quickly it could move the other way and underestimate the risk of missing the ultimate recovery. Consider that the global economy hibernates for all of Q2, implying something like -20% annualised global growth, and then wakes up in Q3 and returns to 2% growth: the real economy recovery would be massively sharp, and markets would move in anticipation. The reality will not be as extreme, both because countries will leave hibernation at different times and because meaningful damage will have been done in economies that do not hibernate successfully, but this thought experiment gives a sense of the sort of moves for which markets need to prepare.
There is a vigorous debate about whether fiscal and monetary stimulus will lead to inflation, and whether that inflation will be a good thing for the global economy, by restoring the effectiveness of pre-financial crisis fiscal policy tools, or not. While this is an interesting debate for the future of economic policymaking, either inflation outcome is consistent with sharp appreciation in asset prices post-hibernation. For those constrained in their asset class choices, this should hopefully give some reassurance about the default choice to be fully invested. Indeed, Hasnain argues that EM and FM equity investors need “the courage to do nothing.”
Special thanks to the following for the conversations that helped shaped my thinking: Hasnain Malik (Tellimer), Stuart Culverhouse (Tellimer), Manos Papatheofanous (CPPIB), Will Marshall (RefinedSearch), Nick Dove (JH&Co), and Andy Hartwill (Simmons and Simmons). My thinking in this direction was prompted by Greg Mankiw’s “Thoughts on the Pandemic”, although I would argue that he is mistaken to endorse a one-off grant to all households as opposed to ongoing, targeted support for households without income.