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Extra Market Commentary: A ray of light amid the continued gloom

The COVID-19 pandemic and reactions to it among decision makers and market players seem to be entering a new phase. Everyone realises the magnitude of short-term problems, but the focus of attention is gradually shifting to the question of when a recovery will come and how it will look. Despite very serious developments around us, with tragic consequences for many, we are cautiously optimistic about the prospects for economic recovery late in 2020 − with financial markets reacting positively before then, as the outlook becomes clearer.

We are approaching a second phase

The novel coronavirus pandemic is tightening its grip. The coming weeks will doubtless be extremely stressful in much of the world, especially the United States but also Sweden and elsewhere in Europe – above all from a human perspective, as we empathise with all victims, but also from the perspective we have a responsibility to try to interpret: economic and market developments.

It is now quite clear that the world’s economies and markets are entering a kind of second phase. We know more about how the virus spreads, what countermeasures to take and their impact – but not everything. It is increasingly possible to see the big picture and make forecasts, causing markets to calm down somewhat. Yet because of continued great uncertainty, we will have to live with market turbulence for a long time.

Prospects that the virus’ spread will culminate

There are now signs that the spread of COVID-19 may soon culminate. This is relatively clear in parts of Europe (Italy, to some extent Spain etc.). Optimists are hoping for a similar trend in New York. Many observers now say it may be possible to start lifting the paralysing lockdowns at some time between mid-May and late June, depending on country and events. We share that view. But not everything will revert to normal; the process is likely to be fairly protracted. Naturally no one knows the exact course of events, which will depend on the spread of the virus.

Fewer restrictions as summer approaches

In our assessment, the world economy can withstand this extreme stress without excessive, lasting losses of value. All the extremely powerful steps that have been taken by governments and central banks to offset the impact of the pandemic have the potential to soften the decline and hasten the recovery once it starts, especially if the forecasts that we can begin easing restrictions before summer prove correct.

However, it is over-optimistic to believe everything will soon revert to normal. We will see effects on the supply of goods and services, since lost production resources due to businesses that went bankrupt or sharply reduced their capacity will take time to replace or restore. We will also see effects on demand, since purchasing power falls as people lose their jobs, while some consumption patterns will probably be affected for a long time; for example, perhaps we will travel less and save more.

The economic recovery

Our main scenario is still a U-shaped economic trend. We now have the initial steep decline behind us and are moving along the bottom of the U, hoping that the trend will start climbing again relatively soon. But unlike the letter U, we must expect the ride back up to the old level to take far longer than the downward slide. Still, in our main forecast we expect the world economy to accelerate late in 2020 and grow at a relatively healthy rate in 2021. We are starting at a lower level, with higher unemployment and various new structural imbalances to deal with, yet the trend will be positive.

Impact on financial markets

What does all this mean for financial markets in general and stock markets in particular?

If we begin with the fixed income market, government bond yields have plunged, especially in the US where there was room for a decline. Yields there were higher than elsewhere, and the US Federal Reserve has now also slashed its key interest rate. But yields on corporate bonds have meanwhile moved in the opposite direction, rising sharply. In other words, corporate bond prices have fallen. This has meant tough times for everyone who invested in corporate bonds, especially those with higher risk, known as high yield (HY) bonds. It is not unusual for this to happen. The risk that companies will encounter payment problems increases in times like these; investors want compensation for this in the form of higher yields and thus lower bond prices. This effect has been amplified because market liquidity has occasionally been strained.

We now foresee that today’s HY bond yields will provide good compensation even for fairly negative events ahead. We thus foresee good potential returns for long-term investors. In the near term, though, prices may fluctuate strongly, so those wanting to buy HY bonds should do so in batches, not all at once.
In stock markets, we foresee a similar but less clear picture. Now that share prices are 20-25 per cent below their February peaks, the market has already priced in much of the weakness ahead. We also expect it will be necessary to make sharp downward revisions in corporate earnings forecasts for 2020 and perhaps 2021, so the downturn is partly justified. But once our picture of events more clearly suggests that the world will move towards normalisation within a reasonable period, share prices will probably also have shifted to a more positive trend. There will then probably be room to predict rising corporate earnings going forward.

A bumpy road ahead

But the road ahead is lined with extreme uncertainties. Historical experience shows that once we enter a “bear market” (downturns of more than 20 per cent), it often falls further. In such cases, the average downturn has totalled around 35 per cent. This is consistent with the lows we saw in late March, but today share prices are substantially higher than this. More bad news might thus trigger new downturns.

Another common historical pattern is that after a rapid initial downturn, we see one or more “false starts” followed by new lows, before the market rebounds in a more lasting way. Obviously it is hard to predict whether it will happen this time around; perhaps investors will choose to “see through” bad news and focus on the recovery that all the powerful government and central bank actions have led them to hope for.

At present, however, we see clear risks that the weak economic statistics likely to be published over the next few weeks, and continued reports about the spread of the virus, may lead to new share prices downturns. We are of course monitoring developments carefully, with a special eye on risks. Remember that some of the most successful long-term investments have often been made when uncertainty was at its greatest: something that is likely to be true this time as well.

Johan Hagbarth
Investment Strategy

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