In March, governments across the world scrambled to contain COVID-19 by imposing draconian restrictions on activity. As offices, shops, roads and rails emptied out, vast swathes of the economy were mothballed. Over the next six months, we witnessed both the sharpest contraction and the fastest rebound on record, driven entirely by governments’ decisions to restrict and then ease.
What happens next? The current pace of progress in therapeutics and vaccine development suggests that the road to a ‘virus free’ world is still some 9 – 12 months away. In the meantime, many businesses in the retail, leisure and hospitality sectors remain shuttered and the ranks of the permanently unemployed are on the rise. Moreover, the pandemic’s impact on the balance sheets of banks, households and businesses has yet to be felt. All these will likely hold back the pace of the recovery next year.
This challenging economic backdrop, however, seems to have had little bearing on the behaviour of financial markets: as Guy Monson writes in his Market View, global equity returns are positive for the year. Even emerging markets, which have poorer health systems and fewer policy buffers, have enjoyed positive equity market returns (figure 1). Only in the UK, where there is a potent mix of Brexit blues and excessive exposure to ‘old-economy’ sectors like financials and energy, have equity markets fallen.
Financial markets are rarely buoyant during recessions, particularly deep ones. Figure 2, which plots the S&P 500 Index during recessions and / or financial panics (1929, 1987, 1990, 2000, 2008 and 2020), illustrates this point. In this chart, the S&P 500 is indexed to 100 at the onset of a recession/correction and its subsequent course is then charted. A few points are noteworthy: in 2020, the S&P 500 (red line) initially fell as sharply as it had done in some of the deepest recessions (1929) and market dislocations (1987). Its subsequent bounce, however, has been remarkable, outpacing the recovery in both those episodes. Historically, equity markets have typically struggled after deep recessions and taken years to recover. The COVID-19 stock market has charted a very different course.
What is driving the disconnect?
Recessions are typically borne out of policy tightening intended to correct built-up imbalances within the economy. In contrast, COVID-19 is a ‘no-fault’ recession; it has been triggered by government action to restrict activity on account of public health concerns. In this context, policy makers have had little choice but to aggressively deploy fiscal and monetary policy to offset the government’s restrictions. Speed and agility replaced the hesitation and prevarication that typically accompany the start of a downturn. Countless emergency relief programmes were launched at a breakneck pace. While it is very easy to get lost in the details of these programmes, it vital to recognise the bigger policy shifts they represent.
This extraordinary crisis has jolted policymakers to break the mould. In particular, four specific policy shifts stand out.
- Central banks have tossed out the rule book
To avert panic, central banks introduced liquidity programmes that essentially backstopped not just vast swathes of financial markets but also small and medium businesses and state and local governments. Central banks typically shy away from lending directly to the economy. However, with 40% of the economy locked up, they took this extraordinary action to arrest the downward spiral in expectations and ultimately restored confidence.
- Central banks have updated policy frameworks
For much of the past few decades, central banks, tasked with delivering price stability, have operated on a regime of letting ‘bygones be bygones’; shortfalls in the 2% price level target were never corrected. In August, the US Federal Reserve shifted its policy framework to explicitly embrace a ‘make-up’ inflation strategy – were growth in the price level to fall below 2%, interest rate policy would be adjusted to allow for the growth in the price level to exceed 2%. Other major central banks are likely to follow suit. This policy shift implies that interest rates will remain at their lower bound for at least three years, providing not just easy financial conditions today but also a guarantee that they will remain easy for an extended period of time in the future. With this guarantee in place, forward-looking asset prices are able to sustain higher valuations.
- Fiscal and monetary policy have joined up
Clear coordination between fiscal and monetary policy is one of the most meaningful shifts that has taken place during this recession. This stands in stark contrast to the Global Financial Crisis of 2008, where austerity measures counteracted monetary easing, leading to a weak recovery that needed even more monetary easing. This time around fiscal spending has reinforced monetary easing, shoring up household incomes as layoffs spread throughout the economy. This shift was clearly captured by Jerome Powell in his speech on 6 October: “Even if policy actions ultimately prove to be greater than needed, they will not go to waste. The recovery will be stronger and move faster if monetary policy and fiscal policy continue to work side by side to provide support to the economy until it is clearly out of the woods.”
- New fiscal frameworks
For much of this millennium, restrictive debt thresholds have held back public spending and governments shied away from much needed public investment. The cost of COVID-19 fiscal support (circa 15%-20% of GDP) has meant that debt levels in most countries have smashed through their previous thresholds. Governments – forced to confront the value of such restrictive thresholds – are rapidly creating new fiscal frameworks. Debt constraints are being updated to reflect the low inflation/low interest rate economic reality on the ground. There is also a growing recognition that if debt levels rise by similar amounts across all countries there are no real losers. COVID-19 is inadvertently bringing forward a new fiscal agenda, one that increases public investment in much needed climate initiatives and ‘levelling up’ policies.
In sum, an aggressive policy shift likely explains the market’s sanguine behaviour in the face of widespread economic trauma. Central banks and treasuries are committing to do ‘whatever it takes’ and stand ready to support the economy until there is a viable medium-term solution to COVID-19. This expansive commitment has allowed investors to treat COVID-19 like an extended natural disaster; investors are being encouraged to look through the present dislocation to the inevitable restoration of normality. As long as such support remains in place, asset prices can appear dislocated from the economy.