08 Sep Drinking From the Firehose (Q2-20)

Monetary and fiscal policy coordination has been the most prominent driver of risk-asset performance in the second quarter of this year. This highly supportive backstop to markets will likely continue to push prices up even higher. Investor sentiment has stunningly moved from apocalyptic to euphoric in just three months as epic amounts of liquidity have been poured into an economy with rising unemployment, low inflation and zero-bound interest rates. This liquidity has lifted nearly every asset class, especially equities, which have risen even with sharp declines in per-share earnings reported by many publicly-traded companies. It may be true that stock markets are always anticipatory but current valuations seem to assume a revival in economic activity to pre-pandemic levels by Q2-2021. A rapid discovery of a vaccine, effective treatment options, or even herd-immunity[1] would certainly restore and sustain confidence but scars from consumer bankruptcies, company failures, and credit tightening could be lasting. Households and business are very likely to turn more cautious in a post-COVID world.

Consumers will save more, in our opinion, and firms will invest less. Lost jobs, many of them potentially permanent (in parts of the real estate and travel industries, for example), will increase slack in the labour market and exert downward pressure on wages. We believe the pre-pandemic status quo around certain issues, like teleworking, office space, supply chains, inventory management, online shopping, education, healthcare, and public policy, will be shaken.

The economic outlook is highly uncertain and the number of dead branches on the decision tree for investors is growing. Worries of an economic reopening curtailed by a second wave of COVID-19 infections, and a China-U.S. cold war, will keep volatility high. Risk assets are priced for steady economic progress and reopenings so any disturbance to these expectations could lead to lower valuations. Many investors, policymakers and medical experts believe that a second and more dangerous wave of infections will occur in the fall or winter months (when other coronaviruses tend to spread more readily) after the economy reopens and people become less vigilant about social distancing. A study of the Spanish Flu showed that second peaks frequently followed the sequential start, stop, and restart of nonpharmaceutical interventions.[2] The second influenza wave in 1918 caused much greater mortality world-wide than the wave that preceded it. The independent scientific committee advising the U.K. government, for example, warned in March 2020 that countries with heavy suppression would experience a second peak once such measures were relaxed[3]. There are contrasting views and different political motivations and no one really knows the ultimate truth because COVID-19 is a novel virus. However, at least for now, governments are inclined to reopen sooner than desired by medical experts because the cost of lockdown is too expensive for the economy relative to the risk.

Policymakers will continue their aggressive fiscal and monetary support. With real interest rates unable to decline in any meaningful manner to stimulate private consumption and investment, the onus falls on fiscal policy to fill the hole in demand. Canadian federal aid in response to the pandemic has already been enormous totalling about $330 Billion, or 14% of GDP, most of it to keep workers employed or supplemented in case of layoff.  As the recovery in the labor market slows, households will need further income support. Otherwise, personal spending will collapse and have a ripple effect throughout the economy. The Bank of Canada’s key role will be to ensure that Canada’s large fiscal deficits are funded smoothly and cheaply. The federal government is projecting a record deficit of $343.2 Billion for the current fiscal year ending in March 2021; nearly ten times what the government had predicted in December 2019. Tiff Macklem, the new Governor of the Bank of Canada, has reiterated his predecessor’s commitment to continue large-scale asset purchases until the economic recovery is advanced. The central bank’s balance sheet has more than tripled in size since the onset of the pandemic, reaching approximately 22% of 2019 GDP. The new mantra from the Fed and Bank of Canada may have to change from “lower for longer” to “lower forever”. For investors, the thirst for yield remains unquenchable.

[1] To achieve herd immunity, many people would necessarily die and the pressure on the health care system could be overwhelming. See our commentary in the Q1-2020 Investor Report.
[2] See our commentary in the Q1-2020 Investor Report for a discussion of the Spanish Flu study.
[3] https://www.gov.uk/government/collections/sage-meetings-march-2020