UK Economic Outlook: The Earth Moved
Last week financial markets experienced the big one. Interestingly if you had asked people 3 months ago what was likely to cause an equity market correction, “global viral pandemic” would probably not have been top of the list. Instead you would have heard people discuss stretched valuations, geopolitical events, trade policy or the debt cycle. However as is so often the case in finance, the source of the shock is rarely what you would expect.
However, a shock there was, and the aftershocks are still being felt. As at the end of January UK equities had fallen by around 14% from their local peak in mid-January and 11.5% since worries about coronavirus became widespread. Global equites have performed in a similar way. So far, so normal, 10% corrections in equity markets are not uncommon; there have been 5 drawdowns greater than 10% in the MSCI world since 2009 of which 4 were greater than 15%. However there is reason to believe this correction is different.
First, it is necessary to examine what drives equity corrections. Ultimately all equity corrections are rooted by what is happening in the real economy, in real businesses around the globe. If these businesses are expected to have lower profits and pay lower dividends equity markets will fall in expectations of lower returns. We therefore need to look at what is happening in the real economy to understand why this time really might be different.
Normally (at least since the 1980s) when there is an economic slowdown central banks respond by lowering policy rates. This lowers interest rates on things like mortgages, thus putting more money into people’s pockets; discourages saving versus spending; encourages firms to invest, and can encourage people to buy equities and corporate bonds thereby reducing the cost of capital. It can also encourage governments to spend more as debt costs are lower. Eventually this encourages spending, supporting employment and the economy recovers.
However, this strategy does not work if shops and restaurants are closed, if sporting events are cancelled and planes are no longer flying. If you are quarantined at home, either due to fear or government edict, it doesn’t matter how low interest rates go you are not going to spend money; transactions will stop and an economy is nothing more than the value of transactions that occur within it. If this lasts 2 weeks it’s not so much of a problem, but if it lasts 6 months companies will have no revenue but will have costs like rent, debt interest, taxes and, to an extent, staff who still need paying. Eventually firms will go bust, staff will be laid off and we enter recession. The length and severity of disruption is therefore critical, a lengthy hiatus has the power to be extremely destructive whilst a short one should not be cause for undue concern.
As well as equity markets falling the main market move of note over January was falling yields. Long dated nominal yields fell by around 0.10% whilst long dated real yields fell by 0.07%. These are not large moves but when combined with falls in January real yields have fallen 0.27% and nominal yields have fallen by 0.4% since the start of the year. These moves have occurred as investors seek safe haven assets to shield them from equity market volatility, but also in expectation that central banks will indeed cut policy rates.
These moves represent a significant change from the relationship between bonds and equities that have mostly prevailed for the last 10 years. For much of this period equites have risen as gilt yield have fallen. For pension funds this has been partly beneficial with rising asset prices protecting funding ratios from falling yields. However this month schemes suffered the dreaded double whammy of falling yields and falling risk assets. This is why it is vital that most schemes have a considerable interest rate hedge. Not only is not hedging an unrewarded risk, but when times are tough it is the ultimate insurance policy to ensure you do not suffer the dreaded double whammy.