Don’t fight the Fed and go long equity
COVID-19 has been wreaking havoc on global markets. Investors dumped risky assets en masse in fear of the expected economic fallout of the pandemic leading to the fastest bear market of all time. However, as markets have already rallied from their mid-March lows, the most pressing question for investors is now: when should you re-commit to the market? The answer is simple: Once the virus has been contained and Keynesian animal spirits revive and start driving price action. This is likely before this year's end and depends almost exclusively on government policies.
The first quarter of 2020 has been the worst quarter of equity market performance since 1987, and the world seems to have reached the gloomy consensus that there will be a recession in the first half of this year. Obviously, everyone wants to know when this is going to be over and how bad it is going to get. For a crisis to end, two conditions need to be met: The cause of the crisis must be credibly under control and investors' animal spirits must reawaken.
While the comparison with the financial crisis of 2008 might easily come to mind, its characteristics are diametrically opposed to the ones of the crisis we are currently witnessing. In 2008, subprime mortgages in the US and the complex financial instruments derived from them precipitated the demise of Lehman Brothers, which shook the global financial system to its core. The cause of the disaster might have been brought to light fairly quickly, yet the path towards improvement by means of stabilizing ailing banks was opaque and disorderly, fostering feelings of distrust and fear among investors and the general population for a prolonged period of time. Only decisive central-bank action and the implementation of comprehensive stress tests assessing the financial health of systemically relevant financial institutions were able to gradually convince market participants that the cause of the crisis was finally under firm control. These tests were implemented in the first half of 2009, almost two years after the crisis had struck.
Transparency is the key word that differentiates the current situation from 2008. This time a threat to global health has hit us, which makes the cause and trajectory of the crisis abundantly clear. While ugly in its consequences, the advantage of COVID-19 is that the metrics around the virus offer us a straightforward outlook on future development, which enables us to make confident assumptions on when the cause of the crisis will be under control. If China is any indication, the crisis will be over by June 2020 in Europe. The US is likely to follow with a few weeks' delay. Therefore, the first condition for a crisis recovery, getting a handle on the cause, should be easy to assess and can be considered met when the number of new infections comes down.
Eliminating the cause of the crisis might be more straightforward than in 2008 but the second condition for a crisis to end, reviving investors' animal spirits, could prove more challenging and deserves dedicated attention. Keynesian animal spirits are best described as spontaneous optimism urging investors to act. They arise from the premise that investors tend to make decisions based on gut feeling rather than rational reasoning. The stronger investors' confidence in the economic development, the more willing they are to take risks. At the same time, confidence levels are inversely related to rationality. The more confidence investors possess, the more emotional their decision-making process. Confidence, or lack thereof, spreads by way of narratives that are “contagious” in their messaging so that they easily and quickly pervade vast numbers of market participants, who then start acting in concert shaping market phenomena.
COVID-19 has put a damper on investors' animal spirits, requiring a careful mix of fiscal and monetary measures, as well as psychological incentives to come back to life. This is because we are dealing with a crisis that sits at the crossroads of irrational fears around human life and rational economic necessities, which lays bare the tensions and contradictions arising from the quest of balancing public health and economic policies. Social distancing reins in the virus but hurts the economy. This is unprecedented and, unsurprisingly, investors are scrambling for analytical frameworks that are able to assess the impact of the current crisis. However, traditional economic analysis models tend to be built on the assumption of rational investor behavior, whereas the COVID-19 crisis is largely driven by sentiment with strong emotional undercurrents bordering on irrationality.
The danger that the global economy could become stuck in a quagmire of uncertainty and pessimism even after the virus has been contained hinges on investors' ability to find confidence again. As central banks have already largely done their job, this is essentially in the hands of our governments.
So far, central banks and government officials have been flooding the markets with liquidity and credit, albeit to moderate effect on equity markets. For a full rebound, technocratic regulators should give way to pragmatic economists able to provide the right guidance going forward.
First, a prolonged and crippling lockdown needs to be prevented by a shift to case-dependent quarantine measures that essentially allows the healthy and cured to go back to work. Only vast and rigorous testing orchestrated by the government can make this possible.
Second, fiscal policy needs to credibly address the main economic issues at the core of the crisis. These are high unemployment, lower profits, and higher leverage. With respect to that, some countries, including the US and China, seem to be on the right track, whereas Europe still seems to be debating. It is imperative that policy makers around the globe follow through on their credit promises so that that the bridge money can take hold in the system on a broad basis to the degree that widespread concerns around short- to medium-term solvency and profitability are alleviated.
The good news is that investors’ animal spirits are light sleepers and, if stimulated with the right cocktail, could reawaken with surprising fervor, thus driving a strong equity market recovery in the second half of this year. Once the majority are comfortable to resume free movement without any deadly health threat, and once jobs come back, especially in less rigid job markets such as the US, we could see equity markets pick up worldwide and we should not be surprised to see substantial gains by the end of 2020.