A Flat Curve is Not Enough

by | April 6, 2020

Global equity markets dipped again last week, albeit modestly compared to the sharp declines of prior weeks. Asset class volatility also peaked, and government bond yields stabilized.

Some market strategists are expressing a more hopeful outlook based on those indicators, as well as signs that peak infection and mortality rates may be soon visible in some of the hardest hit countries and regions (e.g., northern Italy). The same strategists also cite unprecedented monetary, fiscal and credit-backstop policies adopted by a number of countries as reasons to anticipate a market bottom.

According to public health officials, however, the coming week will bring more bad news from the US, particularly in the hard-hit New York metropolitan area. And even if the rate of New York infection peaks in the coming days, new Covid-19 curves are popping up elsewhere in the US, particularly in the South and upper Midwest.

Still, one piece of evidence is quite clear and reassuring: Social distancing is effective in limiting the spread of the Covid-19 virus. To the extent that social distancing slows the rate of infection, it will alleviate pressures on stretched healthcare systems, and will also contribute to a reduction in fear and uncertainty. Everyone, including investors, will welcome those outcomes as they materialize.

As we have pointed out in this space before, investors ought to be wary of overstating the economic and market benefits of pandemic curve flattening.

Asset prices represent claims on future cash flows—appropriately discounted—over the short-, medium- and long-term. As we have shown using valuations and probable earnings outcomes, the sharp declines to date in global equity markets and bond yields have largely reflected only the near-term risks of economic and cash flow disruption due to a combination of supply-side and demand-side shocks.

We do not believe, however, that markets have properly discounted the risk of longer-term impairments to economic activity and corporate profits that will arise if the economic slump persists and greater financial stress ensues. We see few reasons to assume that the recession will be brief, followed by a rapid recovery. The path looks more extended to us, with the implication that the impairment to profits, valuations and credit risk remains underestimated by current asset prices.

One example highlights our concerns. Last Friday, Singapore mandated new social distancing policies, including stay-at-home orders for workers and a closure of schools. Previously, Singapore had done relatively well in slowing the pandemic by restricting foreign arrivals and engaging in extensive testing and monitoring, while allowing a modicum of ‘normality’ in commerce and other activities. Over this past weekend, however, the number of new Covid-19 cases spiked to its highest rate (120 new cases on Sunday alone, bringing the total to 1,309), confirming the need for the adoption of the latest stringent measures.

Why might the Singapore example be telling? Unfortunately, it suggests that even where extensive testing and monitoring are applied with a ‘flat curve’, new outbreaks can occur. And, perhaps most worrisome, the bulk of the new Singapore cases appears linked to domestic transmission, not foreign arrivals.

For markets, the risk—simply put—is complacency. A one-time flattening of the curve is not an ‘all-clear’. As various epidemiologists have noted, the risk of renewed contagion will exist until either ‘herd immunity’ is achieved or an effective vaccine is introduced. The implication for investors is that the damaging economic consequences of isolation and social distancing will not recede even when pandemic curves are flattened.

With over a million reported Covid-19 cases globally and over 300,000 in the US, and even allowing for gross under-reporting due to many asymptomatic cases and the lack of available test kits, the reality is that only a fraction of one percent of global or US citizens have been infected. ‘Herd immunity’ is nowhere in sight—nor is an effective vaccine (or antiviral treatment) likely in the near-term.

The implication is that social distancing measures cannot be sustainably lifted even after the initial success of curve flattening is achieved. Accordingly, the probability of a ‘V’-shaped economic recovery remains low, even if some resumption of activity and declines in uncertainty may ensue in the aftermath of peak infection and mortality rates. The risk of repeat shutdowns—the worrying message from Singapore—suggests that stop-start scenarios are more likely than sharp recoveries. In the nomenclature of the alphabet, a repeating ‘W’ looks more likely than a ‘V’.

Moreover, economic policymakers may not have yet faced their biggest challenge. Despite the unprecedented scale of recent fiscal, monetary and debt-backstop measures, the underlying fragilities posed by diffuse global supply chains, complex financial interdependencies and enormous private sector debt burdens may overwhelm the abilities of even the most determined and well-intentioned policymakers to address the economic and financial disruptions that will occur if shutdowns remain in place for longer.

In sum, we are encouraged by signs that social distancing is working. Those measures will save lives and allow healthcare systems the space they require to ensure that even more lives are saved. But we are skeptical that financial markets can experience durable recoveries so long as the only viable strategy to prevent further infection spikes remains social distancing. As investors, we expect market recoveries to be brief and unsustainable, at best offering astute investors an opportunity to trim risk and re-balance portfolios.

Filed Under: Economics

About the Authors

Larry Hatheway

Larry Hatheway has over 25 years experience as an economist and multi-asset investment professional. He is co-founder, with Alexander Friedman, of Jackson Hole Economics, LLC, which offers commentary and analysis on the global economy, policy & politics, and their broad implications for capital markets. Prior to co-founding Jackson Hole Economics, LLC Larry worked at GAM Investments from 2015-2019 as Group Chief Economist and Global Head of Investment Solutions, where he was responsible for a team of 50 investment professionals managing over $10bn in assets. While at GAM, Larry authored numerous articles on the world economy, policy-making and multi-asset investment strategy. Larry was also the lead investment manager for various mandates, funds and an actively managed multi-asset index. Larry also served on the GAM Group Management Board, was Chairman of the GAM London Limited Board and served as member of the GAM Investment Management Limited Board. Larry was also Chairman of the GAM Diversity & Inclusion Committee. During his tenure at GAM, Larry was based in London, UK and Zurich, Switzerland. From 1992 until 2015 Larry worked at UBS Investment Bank as UBS Chief Economist (2005-2015), Head of Global Asset Allocation (2001-2012), Global Head of Fixed Income and Currency Strategy (1998-2001), Chief Economist, Asia (1995-1998) and Senior International Economist (1992-1995). During his tenure at UBS, Larry was also a standing member of the UBS Wealth Management Investment Committee. While at UBS, Larry worked in Zurich, Switzerland, London, UK (various occasions), Singapore and Stamford, CT. At both GAM Investments and UBS Investment Bank Larry was widely recognised for his appearances on Bloomberg TV, CNBC, the BBC, CNN and other media outlets. He frequently published articles and opinion pieces for Bloomberg, CNBC, Project Syndicate, and The Financial Times, among others. Before joining UBS in 1992, Larry held roles at the Federal Reserve (Board of Governors), Citibank and Manufacturers Hanover Trust. Larry Hatheway holds a PhD in Economics from the University of Texas, an MA in International Studies from the Johns Hopkins University, and a BA in History and German from Whitman College. Larry is married with four grown children and a loving Cairn Terrier, and resides in Wilson, WY.

Alex Friedman

Alex Friedman is the co-founder of Jackson Hole Economics, LLC, a private research organization which provides commentary and analysis on economics, politics, the environment and finance, and develops actionable ideas for how sustainable growth can be achieved. Friedman is a senior business leader with two decades of experience growing and transforming businesses in the financial and non-profit industry. He was the CEO of GAM Investments in London and chairman of the firm’s executive board. Previously, he was the Global Chief Investment Officer of UBS Wealth Management in Zurich, chairman of the UBS global investment committee, and a member of the executive board of the private bank. Before moving to UBS, Alex Friedman served as the Chief Financial Officer of the Bill & Melinda Gates Foundation. He was a member of the foundation’s management committee, oversaw strategic planning, and managed a range of the day-to-day operating functions of the world’s largest philanthropic organization. Friedman also created the foundation’s program-related investments group, the largest impact investing philanthropic fund in the world. He started his career in corporate finance at Lazard. Friedman served as a White House Fellow in the Clinton administration and as an assistant to the Secretary of Defense. He is a member of the Council on Foreign Relations and the Chairman of the Advisory Board of Project Syndicate, the non-profit opinion page that provides world-class commentary to over 500 newspapers globally. In addition, he is a board member of the American Alpine Club and the Jackson Hole Community Housing Trust, and has served on the boards of the Gates-Cambridge Trust, the Seattle Art Museum, and a number of other non-profits. Friedman is a regular contributor to several newspapers and thought leadership groups and has published numerous opinion editorials on topics including economics, finance, philanthropy, and politics in Project Syndicate, Bloomberg, The Wall Street Journal, The Financial Times, The Guardian, CNBC, The South China Morning Post, The Chronicle of Philanthropy, and other news outlets. He is also the author of Babu’s Bindi, and The Big Thing, both children’s book. An avid mountaineer and rock climber for 30 years, Friedman has climbed some of the world’s highest mountains and led the first major climb to raise money for charity through an ascent of Mt. McKinley. He holds a JD from Columbia Law School, where he was a Harlan Fiske Stone Scholar, an MBA from Columbia Business School, and a BA from Princeton University.

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