Listen to our latest “Talking Markets” podcast to hear from Ed and Stephen. A transcript follows.
Katie Klingensmith: I am going to start with Ed. You, in your role, look across asset classes and regions, can you just sum up what we have seen over these past three or four weeks and what the broad ramifications have been in different markets?
Ed Perks: A truly historic moment in financial markets and really for the global economy and we are seeing it unfold at a very, very rapid pace with a tremendous amount of uncertainty. I think when you see markets gripped by what we are facing today, the outcome is, I guess at some level, to be expected. What I mean by that is seeing the performance of different types of assets. We have seen in the US at least a material decline in yields for US Treasuries, a substantial rally. It’s been erratic. There have been days where it hasn’t acted necessarily as would have been expected, but over this more recent four-to six-week period, we have generally seen that kind of “haven-trade” play itself out.
I think what has been really striking and caught many market participants by surprise is just the extreme and dramatic declines in riskier assets. I guess even more to the point, the very, very high correlations that we are seeing across those assets, so very few geographies, very few sectors, being spared in the current market downdraft. And I think what investors are reacting to is that uncertainty. The likelihood that we are now entering into a recession in the US, likely in the eurozone, likely for the global economy. And that is something that is certainly disconcerting and causing a lot of concern and selling of assets. I think the question ultimately becomes what is the depth of the contraction that we are inevitably going to see in economic activity? And what is the duration of the contraction in economic activity? Those are more challenging questions, and those are questions that we will only be able to answer as we do proceed through the next couple of weeks.
Stephen Dover: To amplify what Ed says, we are seeing unparalleled correlation between all of the different sectors, even sectors that you would expect not to go down. Higher-yielding sectors like utilities have gone down as much as other sectors. The correlations are amongst the highest they have ever been, and I think there are probably two reasons for that. One is just that people are selling across the board, and two, we are in an environment in which we have more passive index type of investing. Of course, passive vehicles sell across the board when there is a sale. I think we are entering a period where we are both trying to estimate the future course of the pandemic, but we in the financial markets are also trying to predict the course of the fear of the epidemic. That’s really impossible to do at this point, but it seems that we are going through a point in which we underestimated, certainly in the developed world, the possibility of it being a pandemic. Now we are seeing countries closed down. And so, we are seeing the reality and then really the next step is as we face this, is that we get into a period of time where the virus starts to slow down. How will we react to that?
I think the good news is that there does seem to be some improvement in China. So we have some outlook at how long the pandemic might last in other parts of the world, and we are trying to balance whether it’ll be as bad as it has been in parts of Europe, particularly Italy, or whether it will be more like someplace like [South] Korea or Taiwan.
Ed Perks: I think you hit on some really important points, Stephen, particularly as it relates to fear and sentiment, which I had not mentioned. And I think that is just an incredibly important aspect of determining, you know, when markets really start to show some stabilization. I think we have seen other economies, those that have dealt with this on a little bit earlier stage really hit the brakes a bit to get ahead of the curve, to stop the spread and ultimately then to plan the kind of plan to leverage the stimulus, to leverage the policy moves that have been made and that will be a key element of getting the economy going again.
Stephen Dover: Yes, so I mean, I think the question isn’t whether we are going to have a recession or not. I mean, we are in a recession certainly, everything’s slowed down and will slow down at least for the next quarter or two. In terms of equities specifically, we will have a drop in earnings. I think the real question is how quickly will that come back and how will we respond to that. We are in a phase of unprecedented stimulus in some sense, more stimulus than we even had in 2008, which was stimulus for a broken system. We don’t have a broken system. We have a lack of demand at this point and we have interest rates at zero within almost all countries, fiscal stimulus coming within the next few weeks, and oil prices that are very low. Low oil prices are good and bad, but overall for the world as a whole, they are positive. We are in a situation and we have massive stimulus. So, while we have clearly a downturn and will be in a downturn, there is a possibility that at the end of the year there’s a recovery, a massive upturn, as well.
Katie Klingensmith: So let’s focus on that stimulus for a bit because as you mentioned, it’s been massive and there’s a real question about if it addresses the actual drop in demand. Do you want to outline for us what we have heard so far is proposed in actual fiscal and monetary stimulus?
Stephen Dover: I will just say, you know, in quick terms, in virtually all countries around the world rates have dropped. In the US, rates have dropped to zero. I think in addition to that, there are great concerns about liquidity, particularly in the fixed income markets. The Fed and all of the monetary authorities are concerned about liquidity and are working towards improving liquidity. On the fiscal side, we are just starting to get that stimulus, but remember, this is a demand shock in the sense that we have consumers that are forced to stay at home and aren’t able to consume as they would normally do. This means that lowering interest rates in and of itself won’t support consumption in the short term. It will in the long term when people refinance their mortgages and everything else, but it won’t stimulate. So we need to have some sort of immediate physical stimulus to offset that.
Ed Perks: You know, that’s what makes this period so unique is that demand shock is required. The demand shock is self-inflicted in many respects as a response to the pandemic and the desire to get ahead of the curve and to ensure that the spread is controlled and is contained and ultimately reversed as we have seen with some of the success in other regions that have dealt with it. I think the immediate measures certainly need to be there to support the industries that are most challenged, whether that be hospitality, restaurants, airlines, that’s a global event that needs to be addressed. Especially in the US, after a period of really difficult divisive kind of partisan nature of politics, I think we are seeing some really improved signs of some coming together given the importance for the overall nation.
I also think there’s a bit of a lesson for us here in the responses to the global financial crisis. And while that was targeted, very, very specifically to the financial system, this time around, you know, I think it’s going to be much more broad and much more targeted to the segments of the economy clearly being most impacted, certainly all of the individuals employed in those sectors. And, that’s where I would hope the immediate aspects are directed most importantly.
Stephen Dover: That’s a really good point in that the harm here is to the consumer. It’s very different than 2008 where we were concerned about the health of the banks. We are not concerned about that at this point. We are not even really concerned about big industry. So most likely, there’ll be a stimulus to the consumer, and to those consumption industries. So I would say we shouldn’t look to 2008 and the same sectors that were helped in that sense. This will be different. That’s true in Europe and as we have seen that in Asia as well. China has a lot of stimulus. Other Asian countries do as well and we see that rolling out in Germany, France, throughout Europe as well.
Katie Klingensmith: If the manufacturing supply chain has been broken, to what extent would these different stimulus measures be able to address that?
Stephen Dover: That’s a little different than what Ed and I were talking before. We were talking about a demand shock, meaning that consumers are at home, they’re not buying anything, so there’s less demand. I think we both think that’s probably the biggest issue, but there could possibly be supply-side issues too and that is the supply chain. We have lived in a just-in-time global economy where we’ve kept inventories very low and we are very dependent on that supply chain. We haven’t seen breaks in that as much as there could be, but partly that’s because of that first point that the demand in many things has gone down. Obviously, we have supply chain issues and issues directly related to the virus. But at this point, we have not seen a breakdown in the global supply chain, a lot of that was directed at concern within China, that the workers were not going to be able to go back to work and we wouldn’t be able to get the parts we need in other parts of the world. And as China is actually recovering at this point and workers are starting to go back, I think the likelihood of the supply chain shock that we were worried about as recently as just a week or two ago is less likely.
Ed Perks: I think as we think about the impact on supply chains, on the manufacturing infrastructure, there’s dealing with the pandemic. But as we kind of look back three or four quarters ago, we were actually far more concerned about deterioration in global trade policy and trade tensions, creating more disruptive backdrop for manufacturing, for supply chains, for ultimately the impact on corporate profits or on even a bleeding into inflation for consumers. So, I think, we are thinking about this element as a bit more unique of an event that while rolling around the globe at different paces and in different ways, as it does, ultimately play itself out and we do think that will happen, then we can start a concerted recovery for the global economy. And we don’t expect, manufacturing or real deep supply chain issues to be necessarily long lasting.
Ed Perks: But it’s clear, at least in the short run, I think we should be expecting a pretty severe contraction. But more importantly, how do we turn that fear? How do we turn the panic that’s gripping markets? How do we start to stabilise sentiment and give people a view that the economy will ultimately get past this period and move on.
Katie Klingensmith: Given the big squeeze that a number of companies are seeing right now in demand, do you think we will see a wave of downgrades and bankruptcies, I’ll give that one to Stephen first.
Stephen Dover: At this point, we don’t see a lot of bankruptcies, other than in industries that are very directly affected, which are the obvious ones that we hear about so much.The gaming, hotels and airlines are very likely to need some government assistance or they will have bankruptcy problems. One of the reasons monetary authorities are lowering rates, but also they are trying to increase liquidity is to in essence give an extension to some of these companies, so they have lower rates, but they also have an extended time and have liquidity to pay back their debts. By and large, because of the way that the market has been really nothing but up over the last almost 10 years, there are companies that are going to go bankrupt, so we will see more than we have in the past, that’s almost certain. And that’s why we think it’s really important to analyse the companies and know those that have cashflow as well as strong balance sheets.
Ed Perks: I think in the short run we will not see a very rapid spike in credit downgrades or even actual defaults. I think while it’s looking increasingly like it’s a severe one to two quarter impact, I don’t think the longer-term fate is sealed yet for the economy and for companies in particular. So, I do think you are going to see a lot of the stimulus measures directed at supporting companies that are most challenged in the short run due to the decline in demand. The broad backdrop for companies is still pretty healthy. They have certainly benefitted from the low debt financing costs. So, while debt maybe has grown in certain areas, the financing cost of carrying that debt certainly needs to be taken into account. There’s also been a substantial increase in cash and in equity for companies.
While the market value of the equities has dropped, I still think there’s a substantial ability for companies to deal with this in the short and medium term. If this does become a more protracted recession, something that truly, we have a hard time moving beyond and we do not think there’s a very high likelihood of that occurring at this point. We are certainly taking our cues from other regions of the world where the pandemic has been in existence for a little bit longer and taking those cues. So, I think the thing to watch I think policy isn’t going to want to focus on those companies that have been living off of the debt markets for a long period of time. But I think that default cycle really feels like it’s a bit of a different issue than the immediate impact that the pandemic’s having.
Katie Klingensmith: There has been a really sharp fall in the price of oil. I know this has had a big impact on oil companies and perhaps as part of the broader selloff in credit. How much is the drop in oil prices really responsible for the challenges in credit markets right now?
Ed Perks: Katie, you know, so two questions there, one just addressing the impact that the decline in oil is having on that industry and I guess whether or not we think that that’s responsible at all for the broader moves in credit. And maybe to tackle that one first, I think, and we can go back and really look at kind of the last time we experienced the major downdraft and global oil prices late 2014 through the better part of 2015 before bottoming out in early 2016. And at that time, while the energy sector was hit very hard, credit generally performed pretty well. Now, towards the end of 2015, we did see credit spreads move, you know, substantially wider. But you know, I think at that time there were some other pressures beyond just the downdraft in the energy complex that was starting to impact it.
So I think today this very more significant move we are seeing now in credit and it has been muted somewhat by the sharp decline in rates in the US, but we really feel it’s a bit more driven by this uncertainty around the impact that the pandemic is going to have on the economy, that once again, back to what’s the depth of this and what’s the duration of it. And until we get some kind of comfort that we have answers to those questions, which will largely come from the response of these measures now being taken to constrain that the spread of the virus and certainly in the US but in the eurozone economy as well.
And back to the oil question, I think that’s certainly related to the pandemic, which was having a pretty material impact on demand expectations, but it’s really a longer story than that. And it’s really a response to the breakdown that’s occurred over a very long period of time in OPEC, which has really been a controlling force for the energy markets, for the oil markets globally, but the reality of the shale oil markets in the US over the last decade or so, really changing the dynamic on the supply side globally, making the US one of the largest producers of oil in the world. And, I think we are just seeing that, it’s now moving to a bit more of a market dynamic. I’m not ruling out that we might see some coordinated or rejuvenated movements from OPEC, but I think at this point we are moving to more of a market based and I think, economics will drive where production comes from on a go forward basis based upon the quality of the assets, the reserves, the ability to produce at low cost and I think the adjustments will happen in that industry, in that segment of the economy, regardless of the path that the pandemic takes.
Stephen Dover: Remember we are in a demand shock, consumers are hurt, but low oil prices are a very big positive for consumers globally. Low oil prices are very positive for some countries like India, that really imports oil. So, you want to parcel parts of the world that are going to actually really benefit from lower oil prices. And by and large, the global economy is stimulated by lower oil prices. So, this is yet another stimulus that we probably won’t see the pass-through till the end of the year, but we are likely to see.
Katie Klingensmith: There are very different scenarios. And part of this is just about how the pandemic plays out. The part of it is also learning from history. I’d like for both of you, and maybe I’ll start with Ed. Just talk through what the different scenarios might be and what we are looking for that would give us some indication that we’ve perhaps ended up in one scenario or the other or we’ve seen the bottom.
Ed Perks: Yeah, Katie, and clearly markets are very forward looking, but we’ve touched on two things. One, the actions now being taken similar to those that have been taken in other parts of the world that have shown to be successful in slowing the spread of the virus. So, we are at that stage now, I think the fear and the sentiment angle, the panic that’s gripped markets is also a very important point and much harder to gauge. But you know, I do think they are interconnected and as we see hopefully some positive aspects of some of the measures that are being enforced now in areas that are dealing with the virus in the most severe way right now, as they hopefully get some traction that we can start to pivot. And then ultimately, I think we will see a level for markets to become at least less volatile. And that is something that we have seen volatility move to all-time record levels and it’s just a very difficult environment for markets to stabilise. So, I’m optimistic that, you know, we could be just a couple of weeks from really seeing some of that positive data and I think that would make a very significant difference in market volatility and then will enable us to think about the implications for the economy and companies and markets.
So, I think we are really seeing an opportunity here. And I would say as a CIO of a multi-asset team, starting to think about, kind of leaning into some of the opportunity that the selloff in risk assets is happening. And certainly, those [investors] that had adequate diversification, probably feel a bit better about starting to take advantage of some of that opportunity. And then, maybe if I have my portfolio manager hat on, thinking about lessons that I’ve learned throughout my career, when we’ve had market environments, with this type of correlation, it’s really when active management, being able to look for unique opportunities where the mad rush to get out of risk assets causes such a severe decline. You really, truly define some of the best opportunities of your career in these environments. So, the team’s very focused on not just thinking about the shift in our multi-asset portfolios, but also those unique opportunities that come from these exact events.
Katie Klingensmith: I want to thank Ed Perks and Stephen Dover for joining us. Thank you so much.
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