The last month and a half has been an exceptional period for stock markets around the world. The speed of the sell-off that started towards the end of February is almost unprecedented.
Most global markets have, however, now delivered double-digit returns from their lowest point so far this year. As the table below from S&P Dow Jones Indices shows, some regions have already experienced recoveries of greater than 20%.
What this table also shows, however, is that there is still a long way to go for markets to fully recoup their losses. Even after a 15.5% recovery, the S&P South Africa Composite Index is still 40% off its 2020 high.
Given the uncertainty around how long and to what extent Covid-19 will continue to impact on economies, this is an extremely challenging environment. The scale of the market movements is unsettling even for experienced investors.
“We are really talking about a crash resulting from three shocks that combined,” notes Philip Saunders, co-head of multi-asset growth at Ninety One (previously Investec Asset Management). “The first shock was the realisation that Covid-19 was not just a Chinese problem and that it was rapidly acquiring the international characteristics of a pandemic. On top of that, we had the grotesquely mistimed oil price war instigated by Saudi Arabia in the face of Russian intransigence. And, finally, that combination of the two triggered what is really best described as an international dollar margin call.”
In effect, there was a rush for dollar cash. This led to massive drops in market prices because so many investors were trying to liquidate securities that there weren’t enough buyers.
“There was nobody on the other side, and that led to the extent of the undershoot,” Saunders explains. “Prices got driven to levels that are a function of illiquidity, and there were questions whether monetary authorities were able to respond appropriately. The US Fed [Federal Reserve] briefly lost control of the treasury market, which is probably without precedent.
“But since then they have expanded their balance sheet, aggressively provided dollar liquidity internationally, and some semblance of order has been restored to markets,” he adds.
This is reflected in both the recovery in stock markets and that bid-offer spreads on bond markets have come back to normal levels after reaching extremes at the height of the crisis.
Scale of the response
Saunders believes this shouldn’t be underestimated.
“Since 2008 we knew that markets have this tendency to become chronically illiquid,” he says. “If you have a series of events, the market can rapidly become dysfunctional. And part of this move was not associated with the pandemic itself, but with market functionality.”
The Fed and other major central banks around the world have, however, responded by showing a willingness to do whatever it takes to prevent this developing into a credit crisis. That has alleviated an immediate danger.
As the graph below shows, the Fed’s intervention has been both much quicker and far more substantial than it was during the global financial crisis of 2008.
In a recent note, BlackRock noted that central bank balance sheets globally have now reached $20 trillion “and are poised to increase a lot further”. This is reflected in the graph below.
On top of this, governments, led by the US, have very quickly approved huge fiscal stimulus packages to mitigate the longer-term economic consequences.
“The reaction by monetary authorities and governments has been truly extraordinary in the sense that the lessons of 2008, where there was a lot of faffing around that made a bad situation worse, has not occurred this time,” says Saunders. “Once the magnitude of the problem had been recognised and the implications of wide-scale lockdowns understood, governments had no choice but to really pull the trigger in terms of fiscal stimulus.”
The chart below gives an indication of the size of these fiscal interventions.
As London-based fund manager CrossBorder Capital calculates, collectively governments are adding stimulus of around $6 trillion. This is 6.5% of global GDP.
“The reaction in Europe and the US has been significant,” Saunders says. “It won’t completely offset the hit to GDP that is in the process of occurring, but provided the lockdown period is not extended, there is a reasonable chance that it will sustain productive capacity and it will sustain demand.”
He points to the fact that China is already ramping up production again, having lifted its lockdown. This shows that a quick rebound in industrial production is possible once the virus is contained. Given that markets tend to be highly correlated to industrial output, this suggests there is potential for a similarly sharp recovery in markets as well.
“The concern among many is that the typical profile is that you have a crash, you have a strong relief rally, which we’ve had, and then you have a retest of the lows,” says Saunders. “That is a standard market pattern that is concerning investors at the moment.
“I think it’s not going to be as bad as that because of the degree of the distortion and how it was associated with the liquidity shock that seems to be improving,” he adds.
Ninety One’s most likely scenario, to which it attaches a 50-55% probability, is therefore for markets to deliver a V-shaped recovery within the coming months.
What could go wrong?
In Saunders’s view there is however still a 30-35% chance of a negative scenario playing out. For this to be the case, a number of adverse things would have to happen on top of the poor economic data that markets are already discounting.
“If the liquidity shock becomes a credit shock, if the attempt to open economies happens prematurely, and if you have a residual effect on demand that impacts manufacturing, that would result in a protracted bear market with lower lows than we have had,” Saunders believes.
The most significant question that needs to be answered in this regard is whether the policy response from governments and central banks has been sufficient to mitigate the worst effects of shutting down large parts of the global economy.
“Under our central case we suspect that the quantum is sufficient to help deal with the transitional period and allow a more rapid recovery than would have been the case if you’d seen more severe demand destruction and curtailment of industrial capacity,” says Saunders. “But this is unprecedented.”
It is therefore difficult to judge.
A positive shock?
There is also, in Ninety One’s view, a 10-15% chance that the recovery is even more swift and substantial than anticipated.
“This would see a number of things happening more quickly,” says Saunders. “In this case, the sheer level of liquidity injected into markets turns things around and causes credit spreads to compress aggressively again as investors reach for yield and drive equity markets higher again.”
CrossBorder Capital also notes that the possibility of an upward surge exists, given not just the swiftness of a potential change in investor sentiment, but also its scale.
Currently, its calculations of investor risk appetite, based on the skew between current allocations to safe assets like cash and government bonds, and allocations to risk assets like equities, is at extreme levels.
“From past experience, whenever the risk-appetite index is below the minus 40 index threshold, subsequent two-year-ahead returns average 33%,” CrossBorder Capital notes. “Latest readings show a swing into extreme pessimism with an index reading of minus 79.9. Such a reading has never occurred in the long data period since 1978.”
From this point, it argues, there is therefore potential for equities to deliver “jaw-dropping returns”.