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Market Comment  22/07/2020

Uncharted Financial Markets

Investment Director Ewan Millar assesses the economic impact of COVID-19 and the post-lockdown outlook for equities.

As the Great Financial Crisis (GFC) unfolded in 2008, equity markets collapsed as its scale became increasingly clear. Bank balance sheets were, in many cases, irreparably damaged. The knock-on consequence to the economy of a banking sector no longer able to lend was the risk of an economic collapse, the like of which had not been seen since the Great Depression of the 1930s. Policy makers and central banks eventually combatted the potential catastrophe with an, at the time, unprecedented coordinated policy response. 

Interest rates were cut to near-zero levels, quantitative easing was widely adopted across the developed world and huge state bailouts of banks and businesses deemed too big to fail were sanctioned. In 2009, after an 18-month bear market, risk assets began to rise again.

In 2012 the Euro crisis was ultimately averted when Mario Draghi, the ECB President at the time, uttered the words “the ECB is ready to do whatever it takes”. It was then that confidence returned to financial market participants and stock prices began to rise. Policy makers had a playbook, providing an unquestionable backstop of financial support - the central bank ‘put’.

Policy makers... had their ‘go-to’ playbook and announced policy responses that have dwarfed those seen during the GFC.

When countries around the world began to impose societal lockdowns to prevent the spread of COVID-19 it was immediately clear that the economic consequences were going to be stark. Policy makers, by this stage, had their ‘go-to’ playbook and announced policy responses that have dwarfed those seen during the GFC. As the old adage goes, ‘markets stop panicking when central banks start panicking’.

From a stock market perspective, the impact has been quite remarkable. Despite what will undoubtedly be the deepest recession in living memory, European and US equity markets are only down 11% and 3% respectively, during the first 6 months of 2020. So, why is this and where do we go from here?

The profits outlook for businesses in aggregate is going to be subdued at best until 2021, possibly 2022.

Assuming no significant second wave of COVID-19 infections, the worst of the economic fallout may be behind us but the great re-opening, following the great lockdown is going to be fraught with difficulty. Although a minority of companies have benefited from the lockdown environment, and some are relatively less affected than most, the profits outlook for businesses in aggregate is going to be subdued at best until 2021, possibly 2022. Only once the policy stimulus and support measures are removed will it become clear how many furloughed employees have jobs to go back to, how many boarded-up shops and restaurants actually re-open, and what the longer-term impact is on business and consumer confidence. It seems abundantly clear that there is significant earnings uncertainty ahead for the corporate world.

A significant portion of the traditional ‘downside risk’ of investing in equities has gone, perhaps permanently.

It also seems clear that a significant portion of the traditional ‘downside risk’ of investing in equities has gone, perhaps permanently. The market and policy makers know what the playbook is when the market goes into freefall – massive fiscal and monetary stimulus. All of the upside risk of equity investing remains, without as much of the downside risk. Further, other attractive investment opportunities are scant – sovereign bonds earning near-zero returns and credits on arguably unattractive spreads.

The path ahead is uncharted. How will global economies be weaned off their financial lifelines? Will businesses be allowed to go bankrupt and workers jobless? Politically, that would be hugely unpopular but perhaps unavoidable. Government debt has ballooned but given historically low interest rates, the cost to service this debt is manageable. Whilst this remains the case, the policy maker ‘put’ will likely remain the playbook of choice thus limiting the downside risk to equities.

Ewan Millar
Investment Director

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