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The Day After Tomorrow: Investment And Geopolitical Implications In A Post Covid 19 World

Covid-19 has wreaked havoc in every corner of the world. In addition to the tragic loss of human lives, the pandemic has led to a catastrophic decline in economic activities in almost every country in the world, painting a pessimistic view of global economic growth this year. China, which was the original epicenter of the virus, is slowly but surely returning to normalcy, and this has boosted the market sentiment in the last few weeks. However, a second wave of the deadly pandemic remains a possibility, and this needs to be factored into any evaluation of stock market performance in the future. This analysis will begin with commentary on the implications of the pandemic on an economic and geopolitical perspective and will go on to highlight the best course of action for investors.

The economic impact of the pandemic

As Covid-19 spread from China to Europe and the United States eventually, countries around the world imposed strict mobility restrictions to curb the spread of the virus in a bid to save human lives. While this was a necessary move to contain the pandemic, the global economy has suffered a massive blow as a result of manufacturing plants coming to a standstill and consumer spending declining drastically.

The United States economy contracted by over 4% in the first quarter, and China reported its first economic contraction in 28 years in the same quarter. These are unprecedented developments and the unemployment level in many countries has risen to historic highs as companies have been left with no option but to cut back on operating costs to remain solvent.

The budget deficits are expected to widen on a global scale as well because of the extraordinary measures taken by governments to help residents face the crisis better. These are the subject of the next segment of this analysis.

Government authorities and Central Banks are coming to the rescue

Prominent economists continue to blame the inactivity of the U.S. Federal Reserve and other Central Banks around the world for the collapse of billion-dollar banks and financial institutions in the wake of the global financial crisis in 2008. Probably learning from the mistakes, policymakers have been quite active this time around. Below are some of the actions taken by the Fed to save the economy from falling into an abyss.

  1. The Fed funds rate was cut to near zero in a move that saw interest rates across the board plummeting.
  2. Guidance was issued to maintain policy rates at record low levels to help the recovery of the economy in the coming months.
  3. Quantitative Easing (QE) policies were introduced to pump liquidity into the economy. For instance, the Fed has implemented an open-ended purchase plan of Treasury securities and government-guaranteed mortgage-backed securities.
  4. Through the Primary Dealer Credit Facility known as the PDCF, the Fed will offer loans to 24 large financial institutions in the country to support credit growth.
  5. Launched the Money Market Mutual Fund Liquidity Facility to lend to banks against collateral they purchase from money markets.
  6. Expanded the repo operations by offering $1 trillion in daily overnight repo, and $500 billion in one month and three-month repo.
  7. Lowered the rate it charges banks for direct lending from 1.75% to 1.5%.
  8. Relaxed the regulatory requirements pertaining to the lending activities of the largest commercial and community banks in the country.
  9. Launched the Primary Market Corporate Credit Facility to lend directly to corporations by issuing new bonds.

Similar measures were taken by policymakers in Europe and the majority of Asian countries as well, and these initiatives have already boosted the sentiment of investors. Trillion-dollar stimulus packages were introduced in the United States and India, whereas billion-dollar economic relief packages were introduced by many European nations.

Going forward, monetary and fiscal policymakers are likely to introduce innovative measures to help the recovery of the global economy, and many prominent economists believe that this will be critical to returning to normalcy.

Geopolitical tensions are on the rise

Investors need to carefully analyze geopolitical developments as these could make a massive impact on the performance of equity markets and any other asset class. For instance, the tensions between Russia and Saudi Arabia led the two countries to an oil price war that saw the price of a WTI crude oil barrel dramatically falling to below zero for the first time in history on April 20.

The Covid-19 pandemic has given the rise to new tensions between the United States and China, the two largest economies in the world. America has been quick to blame the virus on China whereas the latter has extensively denied such claims. The tensions are likely to play a major role in global stock market performance in the coming months. The geopolitical environment was quite similar in 2018 when the two nations implemented tit-for-tat tariffs on exports. As illustrated below, in each instance when trade tensions escalated, both U.S. and Chinese markets reacted negatively. Also, the U.S. markets diverged from the Chinese market index as investors favored America to eventually come out on top as a result of the trade war.

If things take a similar turn in the coming months, which is the very likely outcome of the rising tensions, stock markets might become very volatile. This risk needs to be factored into the analysis before reaching investment conclusions.

Investing in emerging market funds could become complicated as a result of Covid-19 and rising trade tensions as well. The iShares MSCI Emerging Market ETF (EEM) is one of the most popular funds used to gain exposure to developing regions of the world, and this fund is overweight on China.

This characteristic has served well for investors in the past as China emerged as a global economic superpower. However, Covid-19 outbreak has alerted investors to the flaws of depending on one country for supply chain operations, and countries such as India, Taiwan, and Brazil are likely to see an influx of capital in the coming years as multinational corporations diversify their business operations from China to other attractive regions of the world. Considering this expected development, investors might want to look for other emerging market funds that provide more exposure to these countries in addition to China.

The market performance seems detached from the reality but what meets the eye is not true always

From the outlook of it, it’s easy to claim that the performance of global stock markets in the last couple of months has been disconnected from the true state of the economy. For instance, in the United States, the S&P 500 index bottomed on March 23 whereas the country reported millions of initial jobless claims in the weeks that followed. However, the market seemed to brush off these negative developments. Global markets have soared since late March, led by U.S. indexes.

Many countries in Europe and even the United States have officially entered an economic recession during this period, but the markets seem not to notice. A careful study of empirical performance statistics, however, reveals that there is no disconnect between equity markets and the global economy.

According to data from Eikon, the S&P 500 index has bottomed 3 to 6 months before corporate earnings reached a low during the last three recessions: the global financial crisis, the dotcom bubble, and the Gulf War in 1991. This time around, corporate earnings in America are expected to bottom in the second quarter of the year and the stock market reached a bottom on March 23, which falls in line with the historical track record of the index. It’s important to note that equity markets are forward-looking, and therefore should be used to gauge a measure of what the future holds for the economy.

The spike in unemployment and the negative economic growth in the first quarter were already factored in the index value by the third week of March, and since then, investors have been focused on the expected resumption of business activities on a global scale. Right on cue, the United States reopened all 50 states for business and important regions such as the United Kingdom, Germany, China, and India are all reopening for business activities. As markets are forward-looking, these expectations led to a sharp rise in stocks over the last couple of months.

The global economy is expected to contract more than 3% in 2020, and the International Monetary Fund projects only India and China to report real GDP growth this year.

This is not an encouraging sign for investors, but the IMF goes on to project that 2021 will be a historic year as the global economy will expand by a staggering 5.8%, making this the best year in over 3 decades.

Considering such robust growth expectations for 2021 and beyond, equity markets can be expected to deliver stellar returns to investors who are patient enough to bet on undervalued companies today in the hopes of riding the storm in the coming months.

The best way forward is to be cautious

Time and again, the power of staying invested in equity markets has been proven, and this has been the best investment strategy by far. Timing the market, on the other hand, is destined to lead to massive losses for investors. Even when things look bleak, a strategy of remaining invested in stocks has delivered the best returns. As illustrated in the below chart, missing just the 5 best trading days in the U.S. markets from 1980 to 2018 would have reduced the investment return of an investor substantially in comparison to staying invested the entire 30 years.

This goes on to show the importance of staying invested even though the outlook for global economic growth is not positive for 2020. However, an investor needs to be cautious considering the risk of a second wave of infections. According to The Centers for Disease Control and Prevention in the United States, the second wave of the Spanish Flu pandemic in 1918 was the deadliest.

Taking this into account, the CDC has already warned that reopening the American economy without a vaccine could lead to a catastrophe. If this risk materializes, another nationwide lockdown would be unavoidable and stock prices are likely to tumble at a record pace. To account for this uncertainty surrounding the expected recovery in the latter half of this year, investors need to remain cautious and invest only in companies that are in strong financial health. A wave of bankruptcies can also be expected due to the poor liquidity position of some high-growth companies as well, and such occurrences will lead to permanent loss of invested capital. It’s best to err on the side of caution and bet on industry leaders that have ample liquidity to survive a second wave of infections.

Takeaway

Even though some investors are finding it difficult to rationalize the recent surge in global equity markets, a closer look at the empirical evidence suggests this was to be expected. The prospects for economic growth in 2021 are high, but at the same time, the possibility of a second wave of the pandemic is not completely out of the window just yet. Therefore, the prudent decision would be to conduct thorough due diligence and invest in sectors that are poised to grow as a result of the impact of Covid-19. The tech sector is a clear example of a business segment that would be at the center of the recovery and the pharmaceutical sector will also play a major role in helping 8 billion people around the world return to the normal state of business affairs. On the contrary, investing in banks and financial institutions will prove to be tricky as the low-interest-rate environment is not supportive of the expansion of profit margins.

Carefully analyzing companies, betting on identified opportunities, and remaining invested during these turbulent times will likely be proven a successful strategy in the coming years.

Fotis Papatheofanous, MBA
Head of Global Macro and Portfolio Research
Asset Management Department