Wary investors weigh looming market headwinds

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As volatility rips through markets battered by recent economic shocks, just how bad could conditions get and how can investors best gauge the timing and direction of their own market moves? Newton global strategist and member of the Real Return team, Brendan Mulhern, reflects on recent events and what might come next.

With global recession increasingly seen as inevitable by many economic analysts¹ and no immediate end to the Covid-19 coronavirus crisis in sight, many investors’ thoughts are focusing on the likely scale of the challenge ahead and possible market responses.

Commenting on potential trouble ahead, Newton global strategist Brendan Mulhern says a key question now is how deep the contraction will be and, more importantly, how long it will last.

We are currently witnessing a decline in economic activity unlike any other – a health crisis which has become an economic crisis. Yet on the flipside, what is also unprecedented is the response of Western democracies,” he says.

Never before has there been a suspension of social and economic life on the scale we have witnessed in Europe and in some other countries. Governments’ actions took place against a backdrop of historic, and in some cases record-breaking, market events.

While investors and the general public have been inundated with analyses assessing the scale of the economic and financial damage wrought by the virus and while behavioural investment analysts seek to identify winning strategies (see box below), Mulhern believes investors should discount many current economic forecasts.

Forecasting economic outcomes is a fool’s errand even under ‘normal’ conditions and the extraordinary circumstances that define today will only magnify the shortcomings of the statistical methods used to produce such forecasts. The only thing we can say with certainty is that the range of economic outcomes is huge,” he says.

Recession or financial crisis?

While Mulhern believes a downturn in the business cycle is a foregone conclusion, he adds that whether markets see something akin to a depression, depends on whether we see a downturn in the financial cycle, adding state intervention has a key role to play.

Without state action, there will almost certainly be such a downturn. Given the collapse in cash flows, it seems inevitable that the chains of credit that constitute the monetary economy will come under stress, fray, and, left to their own devices, break,” he says.

Avoiding a downturn in the financial cycle is dependent on the extent to which authorities are willing and able to expand their own balance sheets to offset the contraction of private-sector balance sheets that is driving the collapse in cash flows and incomes. If a downturn in the financial cycle is to be avoided, authorities must be successful in preventing idiosyncratic credit stress from mutating into a systemic credit event.”

Mulhern believes liquidity will be critical to how solvency and systemic risk evolve in the weeks and months ahead. While the outbreak of the coronavirus may well have been the catalyst for the recent market declines, he says neither the unprecedented speed of the equity-market decline nor the broader market dysfunction can be attributed solely to Covid-19, pointing also to an acute contraction of liquidity in the real economy, with households and businesses facing the prospect of lost incomes and a need to cut expenses.

In financial markets, he adds, a self-reinforcing dynamic was recently established as a deterioration of liquidity combined with increased perception of risk, higher volatility and deleveraging further undermined liquidity.

As the flight to safety and deleveraging gained momentum, many financial markets became completely illiquid, leading to the usual stampede into US-dollar funding. Stress was writ large across the funding markets that form the visible edge of the world’s financial plumbing, and was evident in the surge in the dollar’s value,” he adds.

While Mulhern does not expect everything to return to pre-crisis ways, he believes a key legacy of the Covid-19 crisis could be the return of big government and a possible return of inflation.

Sharp increases in the role of the state have historically taken place during times of war. It is already clear that the coming surges in public debt and public spending will be on par with those seen during prior periods of major military conflict. Before too long, we are likely to see the return of a related but forgotten phenomenon ­­­- inflation,” he says.

Mulhern believes it will be necessary for investors to navigate the deflationary shock that a locked-down global economy has created. Initially, he says, financial markets are likely to remain volatile and the range of possible outcomes is vast. Over the short term, he adds, greater clarity around a path to exit the current restrictions on social and economic life will be key.

A big question mark hangs over the ability of authorities to prevent an insolvency crisis from mutating into a financial crisis and economic depression, and we will continue to monitor how the situation develops. Beyond the near term, if we are indeed in the foothills of a new monetary regime that puts us on the road to inflation, investors are facing a world potentially very different to the one they have grown accustomed to over the last three decades,” he concludes.

Box out: Nerves of steel? Why the fear factor matters

The current market backdrop is triggering a range of psychological responses from investors. The blizzard of news and data provided on markets – and its ever quickening delivery – appears to be driving reactions of fear and panic just when some investors most need to keep cool heads and strong nerves.

Recent research by Morningstar’s behavioural insights team² suggests it is important for investment advisers to protect their clients against the psychology of panic and herd behaviours, tune out irrelevant noise and take the emotion out of investing in volatile markets.

It points out that many people run away from falling markets, and because of that, bear markets often do present opportunities for finding good value investment. It adds that because short-term volatility is an inevitable part of investing investor advice and emphasis should be placed firmly on long-term performance and ultimate investor goals with an eye to future opportunity.

Newton also warns investors should be wary of selling assets at the wrong time. It believes that at some stage markets will normalise with asset prices recovering as volatility recedes. While no one can accurately predict the length of the current crisis, some investors may in fact emerge well placed to benefit from opportunities that arise coming out the other side of the current crisis.

¹FT. Global recession already here, say top economists. 15 March 2020.
The Psychology of Volatility: A checklist for client conversations during turbulent markets. April 2020.

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