The recovery is now the biggest risk

The FTSE 100 bottomed out on the very day the UK’s lockdown began.

Which means that stocks crashed as Covid-19 first emerged, rallied as we reacted to it, and have since gone sideways as the economic impact hits the news cycle.

This is what you’d expect if you believe markets are good at predicting the future.

They priced in the pandemic before governments reacted to it. They recovered a little as the pandemic went from being a known unknown to a known known. And they went sideways since, suggesting that the economic data we’ve had was what markets expected.

But I can’t hear any ladies singing.

If we truly have sorted out the health risks of the pandemic, does that mean we’re through the crisis?

Today I’ll argue that we’re in the eye of the storm. And the other half of it will be worse for investors.

Of course, there is the chance that we’ll see second waves of Covid-19. Or even just fears of second waves. That’d trigger an impressive amount of chaos.

But it’s not what I’m expecting when I say we’re in the eye of the storm. I’m worried about how the virus and the lockdown will do economic damage that we haven’t priced into stockmarkets yet.

Those markets are pricing in an alphabet soup of economic recoveries. Vs, Us, lazy Ws and a Nike tick. But none of those get at the heart of the matter.

If GDP crashes 20% and then recovers 20%, it’s still down 4% – an impressively bad shock. The point is that a return to growth is not as good as it looks, especially when the initial shock is large.

Not that I’m expecting a decent bounce back to occur. For a simple reason.

An economic recovery is born out of the failures of the crash. That’s where future economic growth comes from – the unemployed looking for new jobs which contribute more GDP than their old ones did, factories manufacturing something better than they used to, new companies with better prospects emerging where the old ones used to be.

But if you don’t allow the failures to take place, you don’t get a renewal. The recovery will be slower and poorer than ever before.

This is especially true if asset prices aren’t allowed to fall. That’s why Greece’s depression after the European sovereign debt crisis was so bad.

Usually the drachma would’ve cratered, making Greece cheap. That cheapness is what triggers the recovery.

Instead, Greece had the euro. And so, in order for it to become cheap, asset prices actually had to fall the hard way. And this is far more painful than a currency devaluation. Especially in a country like Greece, where government policies on things like pensions are a major cost.

Few politicians can implement the austerity which causes the required price declines. The Germans did it in 2003, but that’s only something they can remember.

The point is that, for a recovery to be strong, a correction in asset prices has to happen somehow. But our governments are doing their utmost to prevent this.

Government policy is assuming that the economy can be put on hold if the government papers over the freeze. But that simply won’t be the case.

When the lockdowns end and the furlough is exposed as permanent, there will be trouble.

The signals of this are already out there. This chart shows the number of active companies with employees in Spain. It’s hit levels of the European sovereign debt crisis already.

Source: The Market Ear

Without new companies forming, where does the recovery come from?

The Spanish stockmarket hasn’t recovered from the initial bear market at all.

Companies unable to access government rescues are failing. Small cap stocks aren’t participating in the stockmarket rally in the US. And unemployment is spiking around the world despite furlough programmes.

In other words, the big risk to financial markets is now a lacklustre recovery. Not just because that’d reduce company earnings, sinking stocks. It’s defaults I’m worried about, as we’ve discussed in past Exponential Investors.

A poor recovery undermines everyone with debt. Which is everyone these days.

Rates are close to zero. Emergency lending is only papering over a problem – a solution to a lack of liquidity, not solvency. Governments are top of the list for most indebted already.

Where does the rescue come from if the economy underperforms in the recovery?

You can see how temporary solutions which don’t allow for a true recovery are dangerous.

So, if you’re even considering buying stocks, I think you need to look at this first so that you know how to protect yourself from another plunge, if there is one.

Sure, I may be wrong about being in the eye of the storm. But ensuring you know how the manage the risks of your portfolio properly is a good idea regardless.

This tool shows you how to do that by simplifying key decision-making processes. The challenges that investors struggle with after deciding what to buy.

Find out what those challenges are and how you should battle them here.

Nick Hubble
Editor, Southbank Investment Research

Category: Commodities

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