Assessing the response to coronavirus

The Long Term Investment Strategy team, part of the Investment Office at M&G, sets the Strategic Asset Allocation for Prudential’s savings and investment products. As part of this, we regularly review portfolio sensitivity to political and economic developments.

This note looks at the market impact of the coronavirus outbreak to date and assesses the effectiveness of monetary and fiscal responses so far.

Assessing the response

Just over a month ago, global markets first confronted the reality that the novel coronavirus, Covid-2019, had not been contained within China. In the intervening period, new cases globally have escalated rapidly and global capital markets have experienced exceptional volatility. The month of March 2020 saw extremely sharp declines in the prices of risk assets across the globe – for instance, March was the third worst month for the MSCI US index since 1970, behind only October 1987 and October 2008.

In the second chapter of the assessment by the Long Term Investment Strategy Team, we remain of the view that the lion’s share of the disruption from the coronavirus pandemic will be felt in 2020. We continue to gain comfort from the policy responses, which have been relatively swift and similar to responses during the global financial crisis in terms of scale. As the year unfolds, we should get a better idea of the sectors of the economy that need the greatest support and the policy measures will likely evolve accordingly.

The important takeaway from the past few weeks is that global policymakers have demonstrated a coordinated will to do whatever is necessary to limit lasting impacts on the world economy from measures to halt the spread of coronavirus. This gives us confidence that extremely elevated levels of current risk premia will once again compress.

Whilst there is a degree of policy coordination, different countries and regions are taking different approaches targeted to their own needs and capacities, both in terms of the Covid-2019 containment policy, as well as the subsequent fiscal and monetary policies, highlighting that in seeking to gain exposure to the recovery from this crisis, maintaining diversification will still be crucial.

 

Covid-2019 – Recent Developments

Just over a month ago, global markets first confronted the reality that the novel coronavirus, SARS-CoV-2, had not been contained within Asia. New cases began to emerge in countries as far afield as Italy and Iran. Cases globally have escalated rapidly since, exceeding the number recorded in China. Many countries responded by entering into a lockdown in an attempt to flatten the curve and ease the burden on their healthcare systems.

Current data tentatively points to the curve flattening. We remain cautious not to draw to many conclusions from this. Lockdown measures implemented across Europe and in many other regions are helping but many countries, including the US, are at an earlier stage. We continue to watch the data intently, and note that the peak in daily global deaths would lag any peak in active cases.

Economic and Capital Market Impact

The economic impact from the measures will be severe but should be centred on 2020. This downturn is different from the global financial crisis or from traditional recessions. It has not been brought about by imbalances or cyclical fluctuation but is a deliberate interruption of economic activity. The severity of the shock will depend on how long the health countermeasures will have to be upheld. That relation is likely non-linear.

Global capital markets responded vehemently. The US equity market ended its longest bull market on record and most global equity markets have fallen by 20-30% in short order. Credit has sold off heavily though spread widening has been less pronounced than equity moves would imply and more localised in specific sectors.

Several financial market indicators have shown evidence of liquidity issues; stress in cash markets, some credit funding markets and rising core government bond yields, where credit risk should be less severe. There has been a sudden rush by corporates to access cash at a time when financial market participants are also trying to raise cash to meet margin calls and post additional collateral. The result has been a strain on short-term funding markets and banks’ balance sheets. Unlike in 2008, however, the banking system has not amplified stress as tighter regulation following the Great Financial Crisis (GFC) has improved solvency ratios coming into this crisis.

Money market and bond funds, meanwhile, have experienced significant outflows, which is putting pressure on the commercial paper market. Interestingly, equity funds have seen relatively strong inflows over the same period, suggesting some of the move has been a repositioning for recovery.

Figure: Funding markets showing some signs of dislocation

We have also seen signs of USD shortages, particularly in emerging markets, where a high portion of liabilities are dollar-denominated. The IMF estimates that $80bn of capital has been pulled from emerging markets this year – the largest outflow ever and spreads on emerging market debt have subsequently widened significantly.

Given the scale of economic disruption facing the global economy, such distortions are not wholly surprising. In fact, we take some comfort that despite the tremendous volatility, market infrastructure broadly appears to be weathering the storm. The worst of the liquidity squeezes we saw in mid-to-late March have been alleviated, at least for now, thanks to targeted central bank actions protecting the integrity of the transmission mechanism.

Monetary and Fiscal Policy responses to date

The unique nature of the economic shock has had ramifications for the design of the monetary and fiscal policy response. Given the throttling of activity is deliberate, policy cannot stimulate but needs to bridge and smoothen. Central banks have acted to smoothen market functioning, support bank lending and keep governments borrowing costs low. Fiscal authorities should ‘fiscalise’ (some of) the losses to avoid a more permanent loss in productive capacity. We have seen promising signs of that happening in the last few weeks.

Central bank action

Central bank are able to react more quickly than fiscal authorities and have thus been best placed to be the first line of defence. Their action has been significant in scope and speed. Since the start of the outbreak, more than 75 central banks have responded to economic disruptions and fears of funding stress and insolvency risks.

Figure: G4 central bank balance sheets set to increase further in a targeted manner (projections in coral)

The arsenal of measures include rate cuts to ease a sudden and sharp tightening in financial conditions, liquidity injections to alleviate market stress, targeted measures to provide bank lending support for small and medium companies, asset purchases to support corporate bond markets and prevent sovereign spreads from blowing out, and more measure to reinforce the transmission of monetary policy. Importantly, a range of central banks have also provided coordinated USD swap lines to prevent a squeezing of liquidity in the global reserve currency.

The Bank of Canada launched its first Quantitative Easing (QE) program. The Fed is buying ETFs (with exposure to Investment Grade credit) for the first time in history. The Reserve Bank of Australia is now employing yield curve control. Hong Kong’s monetary authority has set a new precedent for monetary policy by sending in the proverbial helicopters: Permanent residents over 18 will receive a cash hand out of ~USD 1200 funded by central bank reserves.

Figure: Actions taken from key central banks

  Rate cuts? QE purchases? Credit easing and other measures
US 150bps to 0-0.25% target range Potentially unlimited asset purchases; initially at least USD 700bn of Treasuries & MBS Liquidity injections, CPFF, PDCF, MMLF, PMCCF, SMCCF, TALF, FX swap lines
UK 65bps to 0.1% GBP 200bn new purchases of Gilts and non-financial CP CCFF, TFS, FX swap lines
Europe unchanged at -0.5% Total of EUR 870n asset purchases; short term flexibility LTROs, TLTRO terms relaxed, FX swap lines
Canada 150bps to 0.25% First ever QE of min. CAD 5bn/week of government debt CPPP, PMMP, STLF, expansion of Repo collateral, bond buybacks, FX swap lines
Austr 50bps to 0.25% Asset purchases to control yield curve, targeting 3yr yield at 0.25% Term funding facility, extended repos, FX swap lines
Japan unchanged at -0.1% Doubling of upper limit for ETF purchases to  JPY 12tn/year Higher limits on CP and corporate bond purchases, FX swap lines
China 40bps to 1.95% No QE RRR cuts of 50-100bps, MRB 800bn relending program; No FX swap lines
India 75bps to 4.40% NO QE TLTROs worth  INR 1tn, variable term repos; other open market operations; 100bps cut of CRR

Source: M&G, Central Banks, IMF, Goldman Sachs

1Projections for the BoE and ECB are based on all currently officially announced purchase targets. The Fed has committed to uncapped asset purchases. We, hence, do not show a projection.

Fiscal responses

To bridge the demand and supply shortfall a lasting negative impact beyond the deliberate shutdown, however, fiscal policy is needed in conjuncture with the monetary policy action. While fiscal policy is slower to react, many fiscal authorities as well as the G7, IMF and World Bank have made financing assistance available and announced support measures. Many of these packages are unprecedented in size and scope. Measures are tailored to the individual needs of the economies but typically include a form of support for employees, business loans on favourable terms, grants and guarantees and in some cases cash pay-outs to citizens.

The UK government, for instance, was quite swift to coordinate with its central bank and launched a well-designed support programme. The measures announced by the Chancellor may be worth north of 5% of GDP. Depending on the length of the crisis and further announcements, it may be significantly more than that. The US fiscal package including grants, cash pay outs, bank lending and wage support as well as corporate bailouts could add up to 10% of GDP. And in traditionally fiscally conservative Germany, fiscal measures including government guarantees for loans could sum to more than 20% of GDP when the dust settles.

 

Assessing the policy response

The scale of the initial response from global policymakers has been relatively swift and only really matched in scale by the response to the global financial crisis. It is unlikely to comprehensively meet all of the challenges ahead but, as the year unfolds, we should get a better idea of the sectors of the economy that need the greatest support and policy measures will likely evolve accordingly.

The economic impact of containment policies is likely to be severe in 2020; with a global recession looking likely. The pause of activity could be followed by a significant rebound and at least partial recapture of lost activity, however, for this to happen businesses and households require support to ease the cash flow burden caused by revenues either stopping or being substantially reduced, whilst fixed costs continue to mount.

In essence, the global economy requires a bridge loan and forbearance in order to mothball productive capacity during this period. Central banks are introducing targeted measures to address liquidity issues and providing extraordinary levels of policy accommodation to ease financial conditions, making it easier for financial institutions to lend on accommodative terms.

To some extent this may be pushing on a string if these institutions do not want to lend and households and businesses do not want to borrow. Where there is uncertainty as to whether lost activity will be recouped lending may only impair loan books and increase private sector debt burdens. Thus, whilst Central banks are best placed to be the first line of defence, the monetary policy transmission mechanism via the private sector may be less effective in this downturn.

It will therefore likely fall to governments to take additional debt onto the public balance sheet in order to limit the permanent damage caused by the current pause in activity. We have been encouraged by the scale of fiscal response enacted so far. Given the unprecedented nature of the circumstances, responses will likely be uneven and potentially slow in implementation, however, where governments have fiscal space, deficits are projected to rise significantly. Many could reach upwards of 10% of GDP.

The question of what constitutes fiscal space is a live and open debate. Coming into 2020, net government debt in advanced economies had risen in aggregate to 80% of GDP. By the time the global economy moves past the current disruptions, many of these economies will have a government debt stock exceeding 100% of GDP. This may be most problematic in the euro area, where debt sustainability fears have been most pressing in recent years, and may require further steps toward fiscal union in order to ensure stability of the currency union.

Sovereign debt sustainability calculations are a function of debt serviceability inputs (potential growth), structural budget deficits, cost of debt, and assumed inflation rates. The level of debt is also important as it amplifies imbalances in the other inputs. With current elevated debt levels, sustainability is very sensitive to changes in real interest rates. Historically elevated debt levels have gone hand in hand with financial repression, through capping of interest rates and erosion of nominal debt balances via inflation. We may also see taxes gradually rise.

Investment implications

Surveying the various moves across major and ancillary markets, LTIS have observed several signs of significant dislocation not seen since the global financial crisis. Given the scale of economic disruption that is facing the global economy in the months ahead, such distortions are not wholly surprising. In fact, we take some comfort that despite the tremendous volatility, market infrastructure appears to be broadly weathering the storm. Some of this resilience can be attributed to increased defences and crisis resolution mechanisms put in place by policymakers over the past decade.

There will be lasting impact from these policy measures, as central bank policies are likely to act to suppress any subsequent pressure for the cost of government funding to rise. This likely manifests itself in a further extension of the low interest rate environment into the foreseeable future, emphasising the need to look to alternative sources for yield within the portfolio.

From a multi asset portfolio point of view, the current environment whilst extremely challenging offers opportunities in an SAA context. As we alluded to in our previous update, we had taken off risk in our 2019 SAA iteration given the stage of the cycle and what we saw as advanced valuations across a range of asset classes. The significant and sudden repricing of risk assets, in many cases indiscriminate, has presented us with a range of opportunities where cautiously and selectively adding risk to our portfolios becomes a more attractive prospect again.

The vulnerability of markets to the abrupt external shock has also accentuated the crucial benefit to diversification across all levels of the Strategic Asset Allocation. As we outlined above, while the pandemic and the market shock have been global in nature, differences in the acuteness of the virus spread across different regions and countries, some divergences in economic setup and in policy responses, and varying degrees of dislocation in different asset classes and sub asset classes in the current situation have us seek further opportunities away from ‘western developed markets’ and towards a diversified basket of Asian and other global allocations on a long term, structural basis.

When assessing these opportunities as LTIS, we try to remain vigilant about the robustness of our asset allocation under different scenarios and focus on areas where the present situation exacerbates structural trends or changes the underlying economic assessment of the economic structure. The important takeaway from the past few weeks is that there is an underlying global, coordinated willingness from policymakers to put in a huge amount of monetary and fiscal policy measures to limit any lasting impacts on the world economy from national policies to halt the spread of coronavirus. This gives us confidence that currently very elevated risk premia will once again compress, and whilst the economic impact is likely severe we remain of the view that the lion’s share of the disruption from the coronavirus pandemic will be felt in 2020.

There may well be other lasting implications and just like with other major crises, we it is likely that this pandemic will lead to structural changes and shifts including:

  • Shift toward deglobalization. Following on from the US-China trade dispute of recent years, the current tumult poses further incentive for companies and economies to become more self-sufficient via local supply chains. Such trends would likely lead us to greater differentiation in economic cycles relative to recent decades.
  • Accelerate the shift from West to East. In a previous note, the Long Term Investment Strategy Team provided a thesis of how the global economy was shifting from west to east at an unprecedented pace. For a number of reasons including differential policy responses to Covid-2019 and speed of subsequent recoveries, we feel that this shift would be even further accelerated in the short term.
  • Push towards greater domestic consumption within Asia. For crises in years and decades gone past, the standard formula has often been for the consumption in the western ‘developed world’ to pull the eastern and emerging export led economies out of a recession with increased consumption from the west. Going into the crisis, Asia was already much less dependent on exports to the west, and given the aggregate Covid-2019 policies and timeline, greater reliance on domestic consumption may prove to be a necessary condition to emerge from the downturn ahead of the curve.
  • Automation, Digitalisation and new ways of working. A much bigger push for automation and digitalisation of public services, education (distance learning) and healthcare (online doctor and prescription services). This could ultimately lead to an increase in the productive capacity of economies in aggregate, and at the very least new ways of working and changing attitudes to flexible working and demand for office space.
  • Ecological dimension to ESG principles: Last but not the least, as the dust settles from the impact of the Covid-2019 crises and we revert to business as usual, we feel that the ecological change will play a much more important role in the ‘E’ of ESG, either as a standalone pillar, or via redefining climate change to include a broader spectrum of ecosystem disruption.

Long Term Investment Strategy is part of Investment Office of M&G. It is responsible for generating economic and capital markets assumptions, setting investment strategies and Strategic Asset Allocation for Prudential’s with-profits, annuities and unit linked products.

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