Difficult headlines, discounted markets
These are difficult times for communities as the COVID-19 pandemic passes through the global population. There is however light at the end of the tunnel as the growth rate of new cases has slowed markedly in a number of European nations. For the corporate sector and the global economy, lockdown periods appear to be closely tracking the ancient Venetian custom of 40 days. We believe it serves no purpose to hold back from investing on moral grounds.
The social purpose of free markets is to efficiently provide capital to the economy and the quicker prices return to normal, the quicker the recovery will be. We believe investors should consider a modestly overweight position on global equities as market valuations remain depressed.
The global COVID-19 policy response of a rolling quarantine has had a similar rolling effect on economic activity in each region. Survey data measured during lockdowns has been universally dire, indicating GDP contractions of a magnitude similar if not greater than the financial crisis of 2008. We believe however that these effects are temporary. As more nations transition to a position of having managed the initial COVID-19 impact through non-pharmaceutical interventions (NPIs), investor and corporate confidence is likely to return more quickly than the GDP reported in national accounts.
The largest economic burden of this pandemic has fallen on those less able to cope with its consequences, rather than the listed corporate sector. Those marginally attached to the employment market have been made redundant while small businesses have been shuttered with rent and other fixed costs to pay.
There will be less GDP in 2020 as haircuts, entertainment and vehicle mileage cannot be made up in later periods (even if in the latter case this may be a welcome environmental benefit). Governments might have offered to underwrite the damage of the mandatory lockdowns at the aggregate level through fiscal support, but there are likely to be unavoidable distributional inefficiencies falling hardest on self-employed individuals, gig economy workers and SMEs.
Exhibit 1: Coronavirus lockdowns converging on Venetian quarantine period of 40 days
Source: National governments. Days to provisional release are Edison estimates based on current government guidance
The duration of the interruption to economic activity is therefore the critical factor in terms of the damage to personal, corporate and government balance sheets and whether there can be a smooth resumption of normal economic activities as social restrictions are lifted.
The time-history of the Chinese epidemic and the rapid slowdown in the growth rate of new cases in Italy and Spain offers an increasing weight of data suggesting the duration of the most restrictive forms of lockdown is close to the ancient Venetian tradition of 40 days quarantine.
Based on the starting time of the various lockdowns in major economies, if this proves to be the case, most developed nations will be looking to encourage populations back to work by the end of April, with the US a week or so later.
People may be encouraged back to work but it is unlikely to be business as usual during the summer. We expect nations to implement significant health-related surveillance and implement intrusive but selective lockdowns for individuals who, based on their specific contact history, may be at risk of harbouring a COVID-19 infection.
It may be late in the day, but mobile apps are in development in the UK for this purpose for example. We also note that airport operators are already facing the fact that health screening will now need to accompany security screening to facilitate the return of air travel at the earliest possible opportunity. Civil liberty campaigners may object, but the public and government will be pushing to get back to normal life and it is in our view inevitable given alternative of keeping the economy in lockdown.
We suspect COVID-19 will be studied by economists as a near-perfect example of a sudden exogenous shock for years to come. Qualitatively, we are in real-time observing the impulse response of the global economy, with its time-lags and autoregressive components on full display. The key question for investors in our view is whether this shock will reveal previously hidden instability in the system or whether it will rebalance close to its prior trajectory once the pressure from COVID-19 has eased.
We believe the answer to this question in most cases will depend on the duration of the lockdown. A short lockdown/release cycle measured in weeks is much less likely to create economic, social, corporate or bank sector instability compared to a lockdown lasting several months. Nevertheless, we cannot rule out that some individual nations previously in a fragile state may yet require additional support post-crisis.
We note that governments are underwriting the hardest-hit sectors of the economy. There will be a strong motivation given the exponentially escalating costs of a long shutdown to get the economy moving again at the earliest possible opportunity. Nevertheless, with developed nations still struggling to ensure an effective public lockdown as springtime approaches, we understand if public messaging will remain severe until restrictions are ready to be lifted.
We believe investors are making a transition from panic to acceptance in respect of the impact of C0OVID-19. Provided economies re-open and infections can remain at a tolerable level as a result of continued but selective NPIs, there is likely to be a progressive recovery in activity starting during Q3 which is likely to be complete only by H1 2021, as a vaccine becomes available.
Exhibit 2: Median price/book for UK large-caps remains close to 10y lows even after recent rebound
Source: Refinitiv, Edison calculations, data to 3/4/20
The decline to date in global equity markets remains severe, and especially so in continental Europe and the UK even after a 10% bounce from the lows of mid-March. This means forward price/book multiples remain at levels not seen since the 2008 crisis. We would however note that some of the more extreme liquidity-driven anomalies in European markets at least now appear to have been corrected as investors with liquidity on hand have absorbed excess supply.
Exhibit 3: Median price/book for Europe ex-UK large cap equities at levels not seen since 2012
Source: Refinitiv, Edison calculations, data to 3/4/20
Despite the bounce in markets, if we are correct in our view that economic life will soon move much closer to normal as lockdowns are eased and later make a nearly-full return to a pre-COVID-19 trajectory, global equities remain better value than at almost any other point in the past 12 years.
We believe that provided investors are suitably circumspect in accepting balance sheet risk and focus on quality companies which are likely to progress through this crisis without recourse to shareholders, expected returns are likely to be higher than average over the long-term. This is the time in our view to seek to build positions in quality business franchises which are rather more often trading at very high valuations. In our view, investors should now be carefully looking through markets with a view to raising equity allocations to a modestly overweight from neutral position at this time.
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