COVID-19 Fog Of War: 3 Knowns, 3 Unknowns

US equities capture the mood of investors well. We saw equities collapse 35% over four weeks from late February, then a 25% rally from late March until now. If the collapse reflected the shock of COVID unknowns, then the rally reflects unknowns becoming knowns. The three critical new knowns are:

• Lock-downs and social distancing work. The fear was that an exponentially growing virus could engulf whole populations and crash health systems. This was especially the case for countries like Italy or the US that were late to implement countermeasures. But now it seems that lockdowns can bend the curve. They make COVID case growth more manageable no matter how late countries are to identify the risk. This new known reduces the COVID uncertainty.
• Central banks will buy everything. During the Global Financial Crisis (GFC), central banks faced constraints. Politicians were wary about bailing out banks, hence the Lehman default. Economists were fearful of hyperinflation, hence the hesitation to buy government bonds and start QE. And both were worried about government debt defaults, hence caution around fiscal policy.

All of these constraints have been lifted. COVID is the fault of no single sector, so everyone can be bailed out. Inflation has been missing from action so expanding the central bank balance sheet is not an issue. Austerity led to populism and the 1% getting rich, so now it’s time for fiscal policy for all. These have all contrived to allow central banks to buy any assets if needed, whether of government bonds, junk bonds or even equities.

• Economies can bounce back. While US and European data has been collapsing, Chinese data has been bouncing. The January PMI was 50, the February PMI was 35.7 (all-time low) and the March PMI was 52. Taiwan meanwhile saw its PMI go from 56.2 (Dec) to 51.3 (Jan), 52.7 (Feb) and 53.1 (Mar). These show that countries on the “other side” of COVID can re-open their economies and things can return to some semblance of normality. Other countries could therefore follow.

So can we all return to normal after a few months? Unfortunately, no. We still have many unknowns. The three biggest are:

• Can we prevent second waves? Viruses are biological processes so do not stick to mechanical timetables. They can mutate, appear in unexpected places and have effects still incomprehensible to us. Well-run Singapore is facing a new wave of cases as foreign worker dormitories become hotspots for infections. In China, just as Wuhan was re-opening, the country saw a jump in cases on the border with Russia as infected Chinese nationals returned home. Past pandemics typically show second and third waves appear as restrictions are lifted. Sometimes second waves can be worse than the first. Only as countries start to lift restrictions will we know the size of second waves.
• Does central bank buying risk assets support prices? A central bank sets interest rates, and bond prices largely reflect expectations of future interest changes. So, a central bank can most easily control bond markets; it controls most of the variables. But central banks don’t set companies’ earnings. That depends on the company itself. So, when a central bank buys equities, it controls less variables. It can certainly influence supply and demand in the equity market, but it would struggle to control equities as well as it can control government bond markets. Take Japan. It has been buying equities for years. It is hard to discern how much this has affected the path of equities. Early on, yen weakness, governance reform and the global recovery likely helped Japanese equities as much as BoJ purchases. More recently, say the past year, the Niikkei is down 13% despite sizeable BoJ buying. Over the same period, the S&P is down 4%, the DAX is down 14%, Chinese stocks are down 7% and the KOSPI is down 17%.
• Permanent economic scarring? The larger question remains as to how the economy will look after re-opening. Certainly, there will be an initial growth spurt as businesses go from closed to open. But will consumers be more risk averse? Will companies make do with fewer workers? Will the digital economy eat up the labour-intensive physical economy? Will protectionism become the accepted norm? Will growing social divides disrupt political systems?

These are the unknowns to which we have yet to find answers. They also determine trends in productivity and earnings. Without these answers, we don’t know what the new normal will be – no matter what short-term moves we see in equity markets.