Investing Through the Pandemic

Fiscal and monetary responses from governments and central banks in both developed and emerging economies since March are without precedent, far surpassing actions taken during the global financial crisis. Do you believe enough has been done to avoid a much deeper global recession than the one we are expecting?

The first point to make is that the size and speed of the policy response on the monetary and the fiscal side—
particularly from the Federal Reserve (Fed) and the U.S. government—was truly breathtaking. It took a little time for investors and business to appreciate quite how much had been done, and how quickly. The powerful policy response was one of the things which helped me to form a view of the coronavirus crisis. In the U.S., Congress quickly approved three fiscal packages worth USD 2.4 trillion (over 11.0% of GDP) and despite recent delays, further stimulus is widely expected. The Fed was also very quick to act, taking interest rates all the way to zero, while introducing unlimited quantitative easing (QE) and direct support for the credit markets by buying corporate bond ETFs (exchange traded funds).

There’s been a very strong signal from governments the world over that they are committed to do whatever they can to help small businesses, their workers and the unemployed, to get through the economic crisis caused by COVID‑19 and emerge the other side. So, it’s not so much a question of whether governments have done enough. They have already done more than nearly anyone expected at the start of the pandemic and they stand ready to do even more if needed. 

Globally, QE by central banks in 2021 is expected to more than double the previous peak in 2010 after the financial crisis (Fig. 1).

How do global equity valuations appear now after such a strong market rebound, and with so many risks still brewing on the horizon?

The first point is that the starting level for equity valuations before the selloff began in February is an important consideration. They were a little above the long‑term average but were far from extreme. Global equities at the start of 2020 were broadly trading at mid‑to‑upper teen multiples of forward earnings. This is very different to the tech bubble in 2000. Then the developed world was trading at much higher market valuations of 25 to 27 times forward earnings, with many internet and technology companies even more richly valued. So, the starting point for valuations when the coronavirus first struck in 2020 was quite reasonable, in my view.

At the top level, this simple analogy may help to think about valuations. As an educated guess, the world may lose around 18 months of GDP because of the recession triggered by COVID‑19. It could be a bit less or it could be a bit more. But if we take the midpoint of the forecast range as 18 months, then by the middle of next year we will be roughly back to the pre‑COVID level of GDP.

Markets today are quite close to where they began the year. If they, as some equity strategists currently assume, rise by a moderate 5% to 7% over the next 12 months, then essentially, we are going to end up at a market level and a GDP level that are broadly similar to where we started. From a top‑down macro perspective, that doesn’t strike me as a totally unreasonable outcome for global equity valuations. Though within a similar market valuation there will, of course, be many new winners and losers on account of the changes brought about by the coronavirus, providing fertile ground for bottom‑up stock pickers like T. Rowe Price.

A final caveat on valuations is that we are clearly now in a world where interest rates are going to be lower for even longer than we previously thought, perhaps much longer. Sovereign bond yields have been compressed to ultra‑low levels throughout the developed world countries and are now also falling sharply in emerging markets (EM). The dividend discount model, other things equal, suggests that in a world where the risk‑free rate is expected to be much lower, there is a respectable argument that equity valuations can be meaningfully higher. 

Do you believe COVID‑19 could change the growth profile of the EM, where many countries have flagged weakening fiscal positions?

To answer this question, it makes sense to divide EM into a number of different buckets. In the first bucket is China, an economy so large that it is really important for all investors to understand what is happening there. While China was the original center of the coronavirus, the year‑to‑date return on China A‑shares has been as good as the return on NASDAQ, for good reason. Under the global pandemic, China has been the best performing major economy in the world this year and the first to recover.

In the second EM bucket are exporters of manufactured goods like Korea and Taiwan. Essentially, these are countries that for various reasons are included in the EM universe, although they should really be seen as part of the developed world’s technology supply chain. In the third bucket are the EM commodity exporters, countries such as Brazil, Russia, South Africa and the Middle East.

Global equities surprised investors with the strength and timing of the rebound, making this the shortest bear market ever. What comes next given that markets have returned close to pre‑correction levels?

I think we’re now at a point where tactically it makes sense to be more prudent than two or three months ago as there are still a number of significant risks for investors to contend with. Firstly, we are seeing a second wave of the coronavirus or an extended first wave in many places and the economic costs of fighting the coronavirus may be greater and more prolonged than was initially assumed. The economic recovery remains fragile and there is still considerable uncertainty over the growth trajectory beyond the initial rebound phase. Secondly, China‑U.S. tensions are flashing amber and could worsen ahead of the U.S. presidential election in November. Thirdly, the election itself is a difficult call at this point. A Democrat victory would likely see a major switch in policy direction and a different regulatory and tax regime.