This is the first global consumer shock (especially for U.S. and Chinese consumers) since the Great Financial Recession (GFR) of 2008-2009, so the fear gripping capital markets is completely justified because the consumer has propped up the post-GFR global economic recovery. In addition, post-GFR, business investment has been quite weak (outside of the energy sector and maybe big data investments) with a lot of debt issuance used to buy back stock, a non-productive use of capital. Now, with the Saudi-Russia oil price war, the energy sector is hard hit and capital expenditure has already been slashed significantly, despite the fact that the spat is only a few weeks old.
No amount of monetary policy will change investor sentiment or get consumers (who are effectively quarantined at home) to consume and businesses certainly won’t be investing at this time. Even in cities/provinces/states/countries without mandated lockdowns, businesses are voluntarily closing shops, so consumers aren’t able to consume; this implies economic demand (as well as GDP) will fall off a cliff. The effectiveness of policy responses will determine whether an expected rise in unemployment rates - and likely technical economic recessions (defined as two quarters of negative gross domestic product – GDP – growth) - will be of short or long duration.
Monetary policy – “By trying to do too much, you risk not doing enough.”
Global central banks have more than done their bit, and in seemingly coordinated fashion. They have taken measures to try to ease credit conditions and make it cheaper for consumers, businesses, and governments to borrow. They have also leaned on other tools at their disposal to improve market liquidity such as announcing monthly purchases of Treasuries, Treasury Inflation Protected Securities (TIPS) and mortgage-backed securities (MBS) and reactivating a commercial paper funding facility to ensure corporations could continue to meet their short-term funding needs (such as wages payable and other working capital items). For some context, the U.S. Federal Reserve and the European Central Bank (ECB) have taken measures totaling more than $1 trillion (USD) each. These actions will take time to result in a noticeable improvement in liquidity – and in some cases, additional central bank actions will likely be required. The fiscal response has taken longer to materialize – this is also why central bank easing (which began several weeks ago) has been seemingly ignored by risk assets. Investors know that monetary policy alone cannot support consumers and economies through a global health pandemic. Monetary policy can predominantly assist in the funding side of the equation and the well-functioning of capital markets.
Fiscal policy – follow the (political) leader
In addition to sound health policy responses and strong political leadership, investors are looking for fiscal policy easing (government spending and other measures to assist households and business – especially small and mid-size enterprises – through this shock) and slowly but surely, they’re getting it. On average, if we look at responses from Australia, Japan, South Korea, Germany, France, U.K., Spain, Italy, and more recently, Canada, governments are pledging short-term (and potentially longer-term) spending that is on average the equivalent of anywhere from 2 to 3% of GDP.
¹Anticipated. Full size of fiscal stimulus not yet announced. ²Includes stimulus from France, Spain, Austria, Italy, Netherlands, Portugal and Ireland
Source: www.usnews.com, Bloomberg Finance L.P., Signature Global Asset Management. As of March 19, 2020. Full URL in disclaimer
Germany, for its part, with the lowest debt-to-GDP across the G10 economies, has pledged unlimited financial support for its businesses as they grapple with the economic hit from the pandemic. In Canada, the $82 billion (CAD) package is roughly 3%-4% of GDP and covers support for individual incomes as well as businesses, in addition to tax deferral, which takes immediate effect (more details will be forthcoming in the budget). These are good developments that may help economies get through the economic shock. Now, we wait to see what the U.S. will do, but so far numbers that have circulated out of the Trump administration – upwards of $1 trillion (USD) or more – suggest that U.S. spending will be equally significant. Trump’s re-election (and U.S. unemployment) will depend on the size and effectiveness of the fiscal package. Trump’s goal will be to minimize the rise and duration in unemployment in order to get a bounce back in the U.S. economy by the third quarter and avoid a technical recession before the November election.
The future of fixed income – “To improve is to change.”
Global real rates are responding to these fiscal measures by rising, although risk assets and inflation expectations are still falling. That said, there is a lag that should be taken into account here. After all, government bonds were first movers on the recession narrative (similar to prior recessions), well before risk assets started selling off. Perhaps they are also first movers on the economic recovery story. However, if inflation expectations don’t move higher and if risk assets don’t find a floor, the Fed will not be able to stand by and watch real rates rise indefinitely (as this makes funding costly for consumers, businesses, and governments).
Source: Bloomberg Finance L.P. using daily yields. October 1, 2019 - March 19, 2020.
So, if risk assets don’t stabilize, it is very possible that the Fed will implement yield curve control and peg interest rates for medium-term government bonds at some low (close to 0%), but positive level. If this happens, we must learn from the experience of the Europeans and Japanese: that is, there will be no benefit to holding short to medium-term government bonds (those with maturities of 0 to 7 or 10 years). Those bonds will see very little movement (up or down); only long-term government bonds will see price movements. However, holding very low yielding 30-year bonds indefinitely will not be an attractive proposition either. Those bonds will not generate cashflows, will not protect against any potential future inflation and, given the long duration risk, suggests that investors’ allocation to these bonds (for potential mark-to-market gains) will be smaller. This means investors will need to complement their small allocations to long-term government bonds with other instruments like options, currencies, cash or commodities (gold), in order to create a “defensive” or “safe haven” position in their portfolios.
Fiscal response to Covid-19 graph: https://www.usnews.com/news/best-countries/articles/2020-03-19/increasing-number-of-countries-push-coronavirus-rescue-packages
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