Turning on the fiscal taps

How bad will the economic fallout from COVID-19 be? Could it be worse than the Global Financial Crisis (GFC)?

These are difficult questions to answer with any certainty today. What is clear to us is the need for a large scale and co-ordinated fiscal response to the crisis (in combination with the already announced monetary measures).

Thankfully we are starting to see national governments step up their fiscal efforts. It is fast moving, but we have attempted to provide examples that highlight the scale of the announced plans for the key European countries – as well as the European Central Bank (ECB) – both fiscal and liquidity measures.

• Germany: Announced measures are in excess of €500bn or 15% of GDP. This consists of extending the ‘Kurzarbeit’ programme – making it easier for companies to claim subsidies to support workers on reduced working hours. State guarantees for lending of €500bn have been made available.
• Italy: To date, the government measures equate to €25bn or 1.4% of GDP. These include funds for topping up wages and have/are issuing a moratorium on debt on mortgages. Additional funds have been made available for SMEs affected by the virus.
• France: As it stands, the various measures are equivalent to €350bn or 13.5% of GDP. These include a mechanism to pay workers temporarily laid off (€45bn or 1.5% of GDP) and bank loans guaranteed by the State for businesses affected by the pandemic (€300bn or 12% of GDP).
• Spain: In total, €200bn or 17% of GDP has been made available by the government. This package includes discretionary fiscal measures worth €18bn, public loan guarantees of €115bn and other facilities such as support for people laid off.

ECB: Total commitments, including the most recent new Quantitative Easing (QE) package, equate to nearly €800bn or 6.5% of Euro Area GDP.

Will that be it or is it reasonable to expect more action?

Given recent headlines there could well be more on the way – important as measured by size and type – “Merkel says Germany will consider Joint Bonds to fight virus” (Bloomberg, 17 March 2020). To us this is a seismic development. Nobody, virtually anywhere, believed there was a chance Germany would allow joint/cross border EU bond issuance to happen. It was presumed to be a red line. Whilst it is still premature to believe this is a certainty, the fact that it is even being discussed strikes us as very significant. Do not forget that many doubted QE would ever happen in Europe! At the same time, the mechanism for ‘Helicopter Money’ – effectively giving cash to businesses/households – is being debated in public in the US.

Have European equity markets reacted well to these events?

In a word no. They’ve been dismissive so far, arguably concentrating on bad news flow in the here and now – seeing exceptional actions as confirmation that things must be really bad and looking for the GFC as the playbook for leadership.

We’re not in complete disagreement with the market; COVID-19 and containment measures are hugely damaging to the global economy. Likewise, the magnitude of the fallout, indeed the duration of disruption, is impossible to model until we know when and how effective treatments and vaccines are developed. However, where we do disagree is that we believe it is right that the government/central institutions do as much as they can to limit the impact of COVID-19 on the economy. Without these actions the impact could be a whole lot worse. We believe that the actions taken mean that the fiscal genie has been taken out of the bottle.

We’ve long argued many of Europe’s problems – social and financial inequality, for example – have in part been caused by over-reliance on monetary levers and not enough use of expansive fiscal policy. A mix of the two would be a significant change after a decade of austerity in Europe and so too will lead to different equity market leadership. Excessive fiscal measures need funding. Long bond yields had risen sharply over the last couple of days, before falling back after the announcement of the new QE package.

We have discussed bond market gyrations with some colleagues in our Fixed Income team and they tell us: given the seismic events currently rocking financial markets, it may be too much to assume that what we are seeing on the screen in bond markets is necessarily a finely reasoned reaction to events: liquidity in bond markets has been very poor and markets are in no shape to price outcomes efficiently just yet. However, in due course the fiscal and monetary kitchen-sinking underway may well prove inflationary.

QE is back, but bond issuance will certainly be going up. The market’s knee-jerk ‘read’ of the situation stands a good chance of being the right one. Higher risk-free rates will have implications for bond like equities – those stocks that have led the market into Jan 2020 highs. Equally importantly, we think it’s wrong to use the GFC as the cookie cutter for how equities will perform in the coming days, weeks and months.

Our strategy at these difficult times remains to challenge our holdings and take advantage of the opportunities the sell-off creates. Valuation is the bedrock of our process and indiscriminate sell offs like these generally create meaningful opportunities. In some cases, we have been able to increase even further the overall quality of the portfolio, as share prices of high-quality business models have fallen hard. We are encouraged by policy developments and we think the equity market will be too: it’s just a question of time.