Get to the chopper
Australian Market Strategist
Summary: US equity markets recorded a seven-sigma move last week. Under a normal distribution, the expected occurrence of this event is equal to one day in 3,105,395,365 years
By the time this goes to print, a lot could have changed already — that is how quickly information is moving while financial markets, policymakers and communities grapple with the global pandemic.
At this stage, sentiment is stretched and we are probably nearing peak panic, but that does not necessarily coincide with the market bottoming. With limited quantitative data related to the virus outbreak, precise forecasts are scarce.
We are in unchartered waters with respect to both the global public health crisis and financial market conditions: hence the heightened cross-asset volatility. To have real confidence in a relief rally, volatility must reset meaningfully lower.
For now, the AUD remains under pressure as recession looms, but being a risk proxy there will be moments of optimism. The Reserve Bank of Australia (RBA) has lowered the cash rate to the effective lower bound of 0.25% and adopted QE policy in Australia, aiming to maintain the 3-year bond yield at 0.25% and support liquidity in fixed income markets.
Heightened volatility and risk aversion; a domestic economy that’s already in the midst of a pre-existing slowdown; stretched consumers saddled with high household debt levels and a shift to unconventional monetary policy are all weighing on the local unit. The palpable rush to the USD certainly isn’t helping. The US dollar remains a safe haven in the midst of the global equity market and liquidity rout, cementing the path for recession as the strong dollar compounds the virus damage.
The virus outbreak has sent tremors through highly leveraged financial markets, revealing multiple fault lines that we previously caught glimpses of in Q4 2018 and September 2019. These fault lines were patched over, fuelling the ever-extending complacency and yield reaching which have lulled markets and volatility alike throughout the past decade of central bank intervention. In the wake of the global pandemic, the fault lines are now fissures.
Moreover, the record lows in volatility that drove a generation to chase excess yield, momentum and passive mania have been replaced with soaring volatility, stressed liquidity and deleveraging across all corners of financial markets. Even the havens are not safe while many dash for cash.
US equity markets recorded a seven-sigma move last week. Under a normal distribution, the expected occurrence of this event is equal to one day in 3,105,395,365 years, a period almost five times longer than complex lifeforms have existed on planet. Clearly, we are not assessing these probabilities correctly. Not only has risk been misgauged due to the prior decade of financial repression surpassing volatility and spurring complacency, but the assumptions upon which we build our asset allocations are wrong and vastly understate true risk.
As Steen highlights in the introduction to this outlook, the popular idea that the spectrum of asset allocation only stretches from some mix of bonds and equities has always been flawed. This most recent rout could truly shake the long-term allocation model away from a 60/40 bond/equity allocation.
Markets are dealing with a health crisis that cannot be appeased by central banks. As the baton is passed to governments, who will be stepping up to provide cash directly to businesses and households, we enter a new regime. Whether the shockwaves of this event are truly enough to shift traditional industry thinking remains to be seen, but we should at least see a more broad-based approach to diversification over the long term — thus increasing exposure to the potential higher volatility regime shift.
Although the virus is a shorter-term issue, some of its ramifications will be long lasting. It has not only laid bare the fault lines in financial markets, but also the systemic risks embedded in our heavily interconnected and globalised supply chains. The US/China trade war was a warning shot for the global flow of goods and a reminder that tectonic shifts are underway for global geopolitical architectures and international cooperation.
Vulnerabilities throughout global supply chains, ‘just in time’ manufacturing models and the pursuit of cost minimisation above all else have been exposed by the virus outbreak. The crisis of confidence among communities has been perpetuated by political fragmentation, populism and pro-nationalist sentiment. This means the tailwind for the ongoing de-globalisation shift has only grown — and with it, nationalism, protectionism and localisation.
If low inflation has been perpetuated by globalisation and a 30-year spate of deregulation, the opposite should be true down the line. But only once the global economy emerges from the deflationary demand shock the virus crisis and oil price war brings. The assumptions that have underpinned asset prices for many decades are shifting, which favours increased portfolio diversification to counter trend assets to achieve superior risk-adjusted returns. For example, by building long-term allocations to real assets that benefit from eventual higher growth and inflation — such as commodities and precious metals.
What is currently a liquidity crisis could fast become a solvency crisis as the simultaneous shocks to demand and supply weigh on the balance sheets of otherwise solvent SMEs. This crisis is about too many to fail, as opposed to too big to fail. Distressed entities (businesses and households) desperately need a lifeline to maintain wages, rents and other such payments that do not stop as economic activity grinds to a halt. That cash flow support will be vital in providing goodwill payments to casual workers who lose shifts, extended sick pay for those unable to work and preventing layoffs for those businesses facing a material impact from the COVID-19 outbreak.
Given the level of household debt, another key area of concern for Australia is the labour market. With household leverage ratios at almost 2x incomes, a spike in unemployment could prompt a far more serious economic fallout. That is why it is paramount for the government and the RBA to consider maintaining job security as a focal point in their response measures.
The fiscal package to date is just the first line of defence that’s needed for the Australian economy. More will be necessary. The measures so far pale in comparison to the New Zealand government’s package, which is approximately 4% of GDP relative to the Morrison government’s 1.2%.
The Australian economy comes from a position of weakness and desperately needed a fiscal contribution even before the virus hit. The economy has lost momentum since the second half of 2018: unemployment has risen, the private sector is in recession and both business and consumer confidence has been in the mire. In addition, more recently the combination of bushfires and drought have served a one-two punch to Australia’s economy and battered the agriculture, tourism and recreation industries even before any travel bans came into place.
Things are moving quickly — far quicker than they did in the GFC — markets and shutdowns included. For each stimulus package announced, a corresponding travel ban is enacted or city is locked down. Shutdowns, border closures and disruptions are moving at such a pace that economists and markets alike cannot mark down growth expectations quickly enough. As the number of infections continues to rise globally, the likelihood of these measures becoming more aggressive will further impact economic activity.
With so many unknowns at large, forecasts seem little more than vague verbiage that are consistently marked to market. However, what is certain is that an exceptional policy response is necessary. TINA (there is no alternative) can be applied in a different sense as monetary policy pushes on a string and unemployment rises. Policymakers must underwrite the demand shock and helicopter drop payments directly to households along with support for cash-strapped businesses.
We have little doubt of this, given multiple conjectures toward wartime action to buy time in the virus fight while we await a vaccine or immunity. Although even this is no perfect solution, as the hit to sentiment and therefore demand cannot easily be reversed by monetary or fiscal policy. While consumers are fearful of the threat of a global pandemic, confidence will be hard to restore. Hence why containment efforts and public health policy are equally important in supporting confidence.
Although stimulus packages may ease downside risks to the economy, for markets to really recover the onus will be on reduced COVID-19 transmission rates, increased immunity and a clear containment of the outbreak. As yet, relative to previous crises, valuations have not become outright cheap. Nevertheless, hope springs eternal both in financial markets and humanity, so there will come a time for bargain hunting. However, as the rulebooks go out the window in terms of crisis rescue packages, we may eventually enter a different investment paradigm. The extraordinary fiscal stimulus, a de-globalisation tailwind and eventual recovery in economic activity will bring at the very least higher inflation expectations, and long-term bond yields may eventually rise. Perhaps we’ll see an opportunity to rethink diversification beyond the traditional 60/40 and a comeback for value, cyclicals and commodities.