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COVID-19 versus the Policymakers

Jun 22, 2020

• COVID-19 hits new peaks as markets maintain high valuations
• Engagement of policymakers leaves markets sanguine about the risks
• Equites driven by liquidity and momentum not valuation
• The working-off of the government debt mountain is a challenge for the future not for now

COVID-19 is turning out to be just another test for the policymakers in their determination to sustain the high valuation of asset prices. Asset allocators who try to key off weak economic data in a conventional way, by selling down risk assets keep getting left behind by rallying markets. Nothing has seemingly changed in a decade. Some investors are understandably worried at the lack of abeyance of COVID-19. However, we suspect that policymakers are primed to provide further waves of support. It’s expensive for asset managers to bet against them.

COVID-19 is still as big a problem as it has been since the early days of March. While much analysis keeps talking about the fear of a second wave what is as worrying is that the first waves in major populous countries such as Brazil, India and dare we say it, the United States are still not seemingly under control. Brazil’s ‘laissez faire’ political leadership has done little to stymie the pace at which COVID-19 has taken grip in the community. India remains under a first wave lockdown. In the United States, the President holds a political rally in a county that has yet to see cases peak. In many senses, the first round of the virus is still running amok.

Looking at the numbers and the growing warnings from the scientific community, we may know quite soon whether or not the easing of lockdowns was too early. Current evidence suggests it was.

It is debatable whether this challenging reality of a potential resurgence of COVID-19 will have a meaningful impact on markets. The U.S. Federal Reserve has already signalled that it stands ready to do more than it already has, and Congress is firing up its printing press to be prepared for more spending when required. Any debate about the shape of the recovery (V, U, swoosh, any other) is secondary to the sheer size of the Fed Chairman Powell’s Put, limiting the downside. “Whatever it takes” has come to mean precisely that: the authorities will not tolerate a bear market in the primary asset markets.

Putting all these factors together, we conclude that the link between the global growth and asset prices remains as loose as it has been for the past ten years. The global economy is struggling, but policymakers are providing relentless support for asset prices. Government bond yields are still declining relentlessly: German and Japanese yields remain negative, U.S. 10Y yields are now at 0.7%, and corporate debt spreads have narrowed back to levels seen in 2018 and 2019. At the same time, equity market valuations are very stretched and continue to look unsustainable by historical standards. To square off the analysis, policymakers are hell-bent on providing liquidity and remaining on an easing stance indefinitely. Such easing has been the rule, not the exception, ever since the GFC, with the notable exception of the ‘Taper Tantrum’.

The equity market prices that all will be fine, irrespective of how adversely the COVID-19 wave one two or three hits the outlook for corporate earnings. Retail investor buying has seen a renaissance. The epitome of this thinking and the ridiculous consequences of it reared its head last week with the cynical attempt by Hertz management to issue stock in support of their bankrupt car rental firm. We commented at length on it last week, suffice to mention now that the SEC has snuffed out this audacious act. Just as well.

The risk-on equity rally has been driven mainly by two factors: momentum and liquidity. Valuation has taken a back seat. Of course, this is not new. For some time, equity markets have continued to rally through PE multiple expansion; there has been an absence of true earnings growth unless manufactured by share buybacks (higher corporate debt) and corporate tax cuts (higher government debt). Equity investors are systematically willing to accept ever greater risk, partly because the discount rate (government bond yields) is low and is likely to remain low. Investors surmise that any drawdown will be met with a policy reaction to save the day.

To fund the entire exercise of saving asset markets has involved the most significant inter-temporal wealth transfer in the history of financial markets. Those funding this project are the next generation of income earners. They will have to foot the bill for the massive government debt that is being built across the planet to bail out the system right here and now. Already, the first rumblings are beginning to be heard about the exit strategy. An exit strategy is simple in concept, but as alluded to above, the ‘Taper Tantrum’ was an illustration of the damaging effect on markets when central bankers threaten to reduce the extra liquidity.

There are several ways governments may seek to reduce debt. The most morally acceptable is the conventional method of just paying it back. However, such a strategy will constrain future economic growth. Tax increases or spending cuts will need to fund government debt reduction. Companies will seek cost reductions (aka fewer employees, or cuts in capex) to repay the debt.

The second method is stealthy but time-tested: inflate it away. It involves allowing the liquidity injected today to push up prices, thereby reducing the real (inflation-adjusted) burden of debt repayment. Inflation redistributes wealth away from creditors, to debtors. The reason central banks are unwilling to allow inflation to rise is to prevent this process, where governments will be able to bite the hand that feeds it: inflation will cheapen the real cost of borrowing. Time will tell whether the policy can remain in control of inflation. Indeed, the typical 2% inflation targets of the U.S. and European central banks are not exactly inflating the debt away. And Japan is a salutary lesson in how inflating away debt can remain a pipe dream.

The final method is as time-tested as inflation, but not nearly as stealthy. It is brutal: just default. It is a much faster and effective way to redistribute wealth from creditors to debtors. It can also lead to the redistribution of cash flow stress from the debtor to creditor.

Some countries have perfected this method on their sovereign debt. Argentina is the latest example, but it is not the only one. Often enough, the strategy mix of debt reduction includes inflation and default, but seldom repayment. Today, many emerging market debtors face a rising tide of future commitments stemming from their laudable efforts in the here-and-now to prevent calamity due to the economic effect of the virus. Corporates face a similar issue, and already defaults are surging. Rating agencies are struggling to keep up with downgrade actions to reflect the reality of the virus’s impact on corporate credit quality.

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