Two weeks is a long time in markets. Two weeks ago we were still not certain whether this was a bear market or a 1987 type valuation correction in a bull market. It is now clear that the global economy is going to suffer a self-induced recession which will be worse than anything since the Second World War. You cannot shut down whole swathes of society and avoid the economic consequences. The second shoe to drop in markets is likely to be a shortage of liquidity. That is why the US Federal reserve has expanded its balance sheet by more in two weeks than it did over the whole Global Financial Crisis. Regular readers of this blog will not be surprised: we have highlighted over the last 18 months the problems in the repo and corporate debt markets. The core issue here is whether companies are able to refinance their short-term debt. If they cannot, they will fail. In the US it has spilled over, as in the GFC, to the mortgage markets too. Markets have probably largely discounted both these risks. They know the economy is going to nose-dive and that there is going to be trouble in corporate debt. Equally they can see the fiscal and monetary responses by central banks and governments to try and alleviate them. At Linchpin we are now focusing more on the second-order effects which markets have not yet got their heads round. We’d divide these into two broad areas: one is human behaviour, whether economic or market-related, and the other is more financial as investors begin to think about the long-term future of the new environment. We’d stress that there are as many positives here as negatives. With a third of the world’s population in lockdown, consumption is going to be weak in the short-term. However, fiscal policy will put money into the hands of those who may not previously have had it. Will they spend or will the coronavirus experience make them more risk-averse? Will enterprise be stifled as the government plays a much larger part in the economy? On the one hand, these events are a gift to right wing governments because they can steal the left’s clothes without alienating their traditional supporters. On the other, if populations get used to living on government hand-outs, will entrepreneurial spirit be reduced? One likely consequence is a retreat in globalisation. This will happen in a myriad of ways: supply-chains may shorten, humans may decide travel is less desirable, the political rift between China and the US may widen. Conversely, there may be a huge move to on-line interactions now that people are having to become used to working and shopping from home. That could have a major impact for a whole range of businesses, from high street retail to airports and commercial property. In the second category, the over-arching question is that of inflation. While a recession and the fall in the oil prices are disinflationary in the short-term, we are not alone in suggesting that the world is in the process of turning over a page in history and that the future will be much more inflationary. We don’t see this as necessarily bad for risk assets. We said two weeks ago that a valuation correction was healthy and, if the result of government and central bank policies is a huge boost in spending, then that is an acceptable background for investors. Moderate inflation and low interest rates are probably also helpful. The problem today is to assess what represents fair valuations in a world where the future is so unclear. Profit margins will be lower, risk appetite may be reduced and there are going to be dividend cuts. Ultimately the market direction will be set by how long-term investors weigh up these issues but we would be cautious about being overly negative.
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