The Great Lockdown Recession

The IMF published new estimates for the global economy, which weren’t great – to put it mildly. The coming quarters will be historically poor and the risks will remain thereafter. Nevertheless, the financial markets have shown a strong recovery in recent weeks. Can these developments be reconciled with one another or will markets come under pressure again?

Source: International Monetary Fund

Biggest contraction in almost 100 years

The IMF predicts that the global economy will contract by no less than 3% this year. This represents the biggest global economic downturn in almost a century. It’s no coincidence that the IMF has called it the ‘Great Lockdown Recession’, because along with the Great Depression and the great financial crisis, this too will go down in history.

Unsurprisingly, the countries that have been hit the hardest, and had to take the most drastic measures to fight the coronavirus, are also the ones showing the biggest declines. Italy, the epicenter of the outbreak in Europe, will see its economy shrink by no less than 9% in the coming year, according to IMF estimates. Spain (-8%), Germany (-7%) and also the US (-6%) will also see a massive slump in GDP.

And that’s not all. These IMF estimates are based on the assumption that there won’t be a second wave of outbreaks later in the year. However, despite the fact that the outlook for economic growth spells the worst year since the Great Depression, the financial markets have shown an upward trend in recent weeks. The MSCI World Index has climbed more than 20% since its trough in the last week of March. High yield bonds and investment grade bonds have also pared back a significant part of their losses. Does this mean markets are getting ahead of themselves?

Swift and decisive action

Perhaps not that much. In contrast to the great financial crisis of 2008/2009, for example, the response of central banks and governments has been both substantial and swift. The fiscal stimulus is worth around 3% of GDP – twice as much as in 2009. The Federal Reserve has unveiled an unprecedented QE program, allowing it to buy massive amounts of corporate debt and leverage its unlimited balance sheet. The ECB has also launched a huge bond-buying program, covering sovereign and corporate debt.

The latter is good news for investors, especially as the Fed is buying bonds in both the primary (bond issuance) and secondary (trading) markets. In addition, companies are allowed to lend the Fed an amount in excess of their current debt. The ‘rolling over’ of maturing loans into new debt is therefore guaranteed.

Last week, the Fed went a step further by buying bonds that have seen their credit rating downgraded from investment grade to high yield as well. All of these measures are aimed at helping companies stay afloat and keeping workers employed. The result has been a significant tightening of spreads on both investment grade and high yield bonds.

Corporate bonds more attractive than stocks

And stocks? The Fed and the ECB won’t be buying stocks for now. Yet their buying programs will most likely have a positive knock-on effect for this asset class, as they guarantee liquidity on the bond markets. Moreover, the stimulus measures will ensure that the recession is relatively short and profits can recover later in the year.

That said, we are more cautious on stocks than on corporate bonds. The S&P 500 is now valued at 18 times trailing earnings, making it less attractive than corporate bonds. The valuation has also fallen less than in previous big recessions. In addition, it is extremely difficult to say how far profits will fall.

The new earnings season might be able to provide more clarity, although it will be exceptionally difficult for companies to say something meaningful about the coming quarters.

In summary, a key part of the recovery on the financial markets can be explained by the decisive action of both central banks and governments. This should mean that, albeit deep, the Great Lockdown Recession will be over relatively quickly. In particular, the outlook for corporate bonds – which are being bought in huge quantities by central banks – is less gloomy than a few weeks ago.

Now it’s clear that economies are reopening only slowly, the risk of a setback on the markets should not in any case be underestimated.

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