Why it's too early to call a bottom on the market
03 April 2020 | Marchés et économie
By Peter Westaway, chief economist and head of investment strategy, Vanguard Europe
There's never been a fall in economic activity like it in modern times. By our estimation, the UK and euro economies could shrink by as much as a fifth in the second quarter this year as a result of the Covid-19 crisis. This is compared with the previous quarter, which itself also took a big hit. The good news is that this sharp dip could pave the way for a similarly sharp economic rebound, not least because of the unprecedented efforts being made by policymakers to protect businesses and jobs as people are forced to stay at home.
The bad news, though, is that we can't know this for sure until we have greater clarity on the likely path of the Covid-19 pandemic – that is, whether it peters out, is stopped in its tracks by a new vaccine, or potentially returns in secondary waves or even mutates.
So it's still way too early to call a bottom on the market.
Looking at the global financial crisis (GFC) a little over a decade ago we did see that market sentiment started to turn once investors began sensing that the policy stimulus from governments and central banks was kicking in and had started to work. It was the start of a lengthy bull market.
But unlike the current crisis, the GFC was caused by stresses requiring gradual relief. Excessive credit and bloated balance sheets had built up in the global economy over many years, so when the correction came there was a long period where firms and households needed to correct their balance sheets with lower spending.
What we have currently looks more like a one-off shock, which would under most circumstances suggest a faster economic turnaround.
In the GFC, it took about eighteen months for the UK economy, for example, to complete its fall from peak to trough. This time we think it could take as little as three to six months – and it's a similar story across Europe.
Impact of coronavirus on euro area GDP (stylised example)
Patterns of GDP recovery relative to length of lockdown
Source: Vanguard ISG. This chart is for illustrative purposes only. Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.
If the lockdown is lifted by mid-May, the overall hit to expected 2020 GDP growth in the euro area, we believe, would be large, in the order of about 5% to 8%.
But the risks are skewed to the downside and if the lockdown stays in place for longer, say until the end the end of December, the regional contraction could be twice as large. And the more the crisis drags on, the greater the potential for so-called economic scarring if jobs and businesses are permanently lost, making it even harder for output to recover to its former level. Such a scenario would hardly be supportive of markets.
What it means for investors
But despite all this potential gloom and doom, there are grounds for optimism from an investment point of view.
Fears of an unprecedented slump in global demand have to an extent been reflected in markets, which have sold off to an unusually big degree in exceptionally quick time. The net result is that shares are now cheaper than they used to be.
From a long-term perspective, I think it's reasonable to say that over a few weeks, shares have moved from being overvalued in US markets and close to fair value in UK and European markets, to now being fairly valued or undervalued. This is important because it has the potential to boost long-term investment returns.
In addition, what this crisis has underlined – in spite of a few well-publicised wobbles as the flight to cash accelerated – is the role bonds can perform as a counterweight to shares. Even at these very low levels of yield, we see that the very safest bonds such as US Treasuries have by and large continued to play a crucial role in portfolios by helping to offset the falls in shares with price rises. So despite concerns about possible market dislocations, having a diversified portfolio comprising a mix of bonds and shares has paid off.
Taken together, it's all the more reason to look beyond possible turning points in the market to the long term and ensuring investments are appropriately diversified.
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