Central bank stimulus across the world has been crucial in addressing the coronavirus crisis but a ‘fiscal cliff’ could be looming at the end of July, according to Carmignac’s Didier Saint-Georges.
Tax increases and spending cuts could be implemented during the recovery to deal with the rising level of corporate and household debt, warned Saint-Georges, head of portfolio advisors and member of Carmignac’s strategic investment committee.
He also outlined the growing uncertainty that the possibilities of further waves of the virus could spark in the equity market, in contrast to the relative predictability of the credit space.
Economically, the western world has acted efficiently to coronavirus, but growing cases in the US show it’s still struggling to curb the rate of infections. China, on the other hand, was swift in injecting stimulus and containing the virus.
This, according to Saint-Georges, is down to China’s experience of the SARS epidemic in 2003.
Though the estimates vary, the SARS outbreak in China cost the global economy about $40bn. Research from IHS Markit showed China accounted for 4.2 per cent of the world economy in 2003, whereas it now makes up 16.3 per cent.
“It witnessed a clean recovery and was able to crush the rate of infection completely before it opened up the economy,” he said.
However, it’s vastly different this time around as the contagion moved across the world to economies that have never imposed nationwide shutdowns.
“The economic cost of lockdowns became so heavy as opposed to 2003,” he said. “The re-opening of the economy needs to happen and is subsequently happening before the rate of new infections has been brought down to zero.”
As these economies lift restrictions, the chances of a winter Covid-19 spike pose further uncertainty over the equity space.
The head of portfolio advisors explains that the credit space is where some certainty can be found in these uncertain times.
“From an equity market standpoint, should you hold on to those cyclical stocks for recovery plays?” he asked.
“Or whether the very fact you have a strong resumption of consumption especially in the US raises the risk of infection or brings a second wave or continuation of the first wave, nobody can tell.”
Saint-Georges sees the potential in the credit space as an unfortunate reality of the times.
“The markets until March really priced such an economic space; it means a lot of defaults and bankruptcies in the credit space,” he said.
“The market, partly because of panic, partly because of lack of liquidity, has priced some of those issuers at high risk of defaults – that’s when a good credit researcher can make a difference.”
Performance of corporate bonds vs global equities year-to-date
Source: FE Analytics
While there is high visibility in the equity market, the credit market doesn’t hinge on when the economy starts booming again.
“Our sense is that hysteria will play out and its audacious to expect economic growth six months out that will not suffer from higher unemployment,” said Saint-Georges.
“Playing an economic recovery via the equity market is quite uncertain, whereas playing it through the value of the balance sheet of issuers is a safer bet.”
The risk of fiscal cliff at the end of July could be a real possibility, especially with an election year that pits two disparate philosophies vying for the presidency in the US.
Spending cuts and tax increases are the traditional two factors behind the ‘fiscal cliff’ which if allowed to happen simultaneously, have the propensity to spark a deep recession.
By cutting household incomes and seeing increased levels of unemployment, this both undermined consumer and investor confidence.
“Renew and increase stimulus policy to avoid this kind of cliff,” said Saint-Georges.
The market is expecting $1trn from the Federal Reserve, supporting the economy via that monetary boost.
“However, in Europe, it’s a different story because here the assumption is that the recovery plan is approved,” Saint-Georges said.
“In the meantime, the countries still must fund on its own budgets. But the European Central Bank [ECB] must continue doing the heavy lifting so it doesn’t translate into widening credit spreads.”
The targeted longer-term refinancing operations (TLTRO III) will continue to support bank lending into 2021 to help small and medium-sized businesses.
“Banks will be encouraged to buy more government bonds and while this is structurally an issue for the future,” the head of portfolio advisors explained. “These things will keep us going into 2021, without too much damage to the economy.”
However, he notes the potential dangers to the consumer side, which will see savings rate increase as the economy looks more unstable.
“The spending trend will be hampered, and the uncertainty will mean small and mid-cap expansion will be held off until confidence grows,” he said.
“This all should be enough to prevent us falling back into a complete collapse. But it’s a far cry from the position of the growth rate going into 2020.”