Watching financial markets, it is tempting to think the worst of the COVID-19 crisis is over. Equity values have bounced and credit spreads have narrowed, even as the oil market continues to suffer alarming strains. With the number of dead rising relentlessly every day and unemployment rates surging to Depression levels, market optimism sits uncomfortably with the deeply negative news flow. But remember, the ‘delta’ is everything for financial markets. As Jeremy Grantham remarked ‘the market does not turn when it sees light at the end of the tunnel. It turns when all looks black, but a subtle shade less black than the day before’. On this basis, perhaps it is easier to rationalize the market’s recent optimism. Sure, COVID-19 continues to spread, but the rate of infection in most countries is slowing. Yes, global health services remain stretched, but they have not hit ‘breaking point’ - contrary to what the authorities had warned. And, while most economies remain in ‘lock down’, governments have started to outline their exit strategies. There are also hopes for more effective COVID-19 testing, drug therapies and even a vaccine, which has further bolstered sentiment. Yet, when you talk to investors about what is driving asset prices higher, nobody mentions the ‘delta’ – instead, it’s all about the policy response.
To misquote Blackadder, this is a large crisis...and a large crisis called for a large policy response. Governments and central banks have unleashed a policy stimulus of unrivalled speed and scale. Many investors believe this has effectively ‘underwritten’ global financial markets, removing the tail risk of a major economic and financial crisis. A less flattering interpretation is that this is just the standard ‘bear-market rally’, driven by classic overconfidence in the policy response combined with the traditional ‘fear of missing out’. Investors know equity returns are highest at the start of a recovery. The reality is that the macro situation is no ‘less dark’ than it was a few weeks ago, with massive uncertainty about the timing and speed of the global recovery. The most bullish scenario assumes the current downturn is closer to a natural disaster than a recession, which means activity can bounce back quickly after the lockdown (the ‘V’). This is the outlook equity analysts seem to be assuming in their earnings forecasts for the next 18 months. But it is increasingly hard to find any economist who still believes in the V-shaped recovery. Even the IMF has published an unusually bleak set of global economic projections, showing a hesitant post-lockdown recovery, permanent income losses and dangerous financial vulnerabilities.
Global policymakers have done well to prevent a global health and economic emergency becoming an immediate financial crisis. Yet the fundamental aspects of this pandemic remain as troubling as they were before the rally in asset prices. First, there is still a lot we don’t know about COVID-19. Severe lockdowns have slowed the spread of the virus but with no herd immunity and no vaccine (which may not be deployable until 2021), it's unlikely the global economy can reopen without further waves of infections. Disruption is not a policy choice – evidence from past pandemics shows the absence of non-pharmaceutical interventions (e.g. lockdowns) is linked to even worse macro outcomes. The second reason for cautiousness is that COVID-19 has unleashed powerful recessionary forces that will persist even after the virus is contained. Unemployment will stay high (though not as high as the headlines, which include temporary layoffs), consumers will be reluctant to spend, and over-indebted businesses will struggle to survive (even with monetary support). There is also an international dimension to this crisis – especially the vulnerabilities in emerging economies – which will create additional spillovers. Policymakers can alleviate these pressures, but they are not as powerful as many investors like to assume. And they will always be behind the curve. Current asset valuations do not reflect this macroeconomic reality, which means the bear market is likely to return – probably soon.