Keep Calm and Carry On

Simon Lewis, CEO of Partridge Muir & Warren, provides an update on recent events driving financial markets.

A lot has happened since my last market update less than two weeks ago; Covid-19 has tightened its grip on the world and the economic consequences for the global economy have escalated. Financial markets are now in panic mode but our message is unchanged. The primary economic impact of this pandemic will be transitory. The global economy will recover, confidence in financial markets will return and investors who wait patiently for this to occur will be rewarded. In the meantime, the best strategy for investors with a medium to long-term horizon is to keep calm and carry on.

At a time of crisis, strong leadership is needed from those that govern and competence is necessary from those who guide policy. So far, the UK appears to be handling things in a calm and steady way. Clear communication and honesty seem to have proven helpful both in keeping the economy functioning and slowing the spread of infection. Unfortunately, recent events are demonstrating that throughout the rest of the world, leadership and competence are not as abundant as we would hope.

My summary of the timeline of significant events over the last couple of weeks is as follows:

  • Putin baits OPEC
  • The Saudis retaliate
  • The oil price collapses
  • Investors panic
  • Trump makes promises
  • Trump disappoints
  • Carney purrs reassurance
  • Sunak fires his fiscal bazooka
  • Investors despair
  • Trump loses the plot
  • Investors capitulate

Here is some more detail on what has been happening.

China is, or has been, responsible for 80% of global demand growth in oil. The economic slowdown as a result of dealing with the Covid-19 outbreak has therefore had a significant effect on the demand for oil. The virus has also locked down the industrial heartland of Italy and with other nations likely to be similarly affected, the demand for oil is unlikely to recover soon.

Even before the crisis, the global oil surplus had risen to 3.5 million barrels per day.  OPEC was initially keen to cut oil production to stabilise prices but Russia refused to cooperate, forcing Saudi Arabia to act over the course of last weekend.

Saudi Arabia is particularly dependent upon the sale of oil as it is the only significant source of revenue for the nation. With demand for oil falling, the only way for the Saudis to slow the rate of decline in their revenues was to increase their share of the shrinking market. Their tactic to achieve this was to force prices down further by flooding the market, with oil that is not needed.

In normal times, a fall in the oil price acts as a stimulus to the global economy because it reduces costs for business. However, these are not normal times and investors are fixated on the likely collateral damage.  The main casualty of a sustained fall in the oil price is likely to be the US shale industry, an industry that has successfully transformed the US from being an oil importer to an oil exporter. However, this expansion was financed by a mountain of debt and if producers are not making a profit, they are at risk of defaulting on interest payments to investors. There is every reason to believe that Putin had the US shale industry in his sights when deciding how to negotiate with OPEC.

Trump’s propensity to formulate policy on the hoof finally backfired – spectacularly. He is creating the impression that he is an increasingly desperate man, fixated on the probability that his chances of re-election in November recede as his legacy of a strong US economy disintegrates at breakneck pace. On Tuesday, he attempted to provide reassurance that the US government would pursue a strategy of “very substantial relief” that would total “a big number”.

He promised loans for small businesses, assistance to the travel industry, as well as a possible payroll tax cut. The problem was that these promises were largely unscripted and had therefore not even been properly formulated by his team and certainly not agreed by Congress. The initial relief of stock markets, which resulted in a strong recovery the following day, turned to despair as any meaningful economic stimulus subsequently failed to materialise.

Such concerns are compounded by the impression that the US administration is not on top of the containment strategy for Covid-19. Until very recently, Trump has attempted to downplay what some see as the inevitable spread of the virus across the US and has failed to give appropriate prominence to the views of medical professionals. This has unnerved investors, particularly as the US does not have a fully functioning national health service and a significant minority of the population are not insured.

Wednesday started with the announcement of a significant stimulus by the Bank of England. Mark Carney announced a reduction of 0.5% in the benchmark interest rate to 0.25%; the lowest level since the Second World War. It is questionable how much benefit the UK will derive from this measure, so of much greater significance were two further announcements. Firstly, a Term Funding Scheme for Small and Medium-sized Enterprises, will provide funding of £100 billion to eligible businesses at the Bank’s benchmark rate. Secondly, the ‘countercyclical buffer’, part of the capital reserve requirement for UK banks, will be relaxed in order to support lending of £190 billion to business. This is equivalent to over 12 times the amount actually loaned to businesses in 2019. These measures will help the UK economy bounce back later this year and next, once the pandemic has peaked.

The Bank of England announcement was early in the morning so there was plenty of time for markets to digest the news before our new Chancellor, Rishi Sunak, stood up to present his Budget. In essence, there were two budgets in one, the first dealing with the immediate crisis and the second aiming to deliver on the Conservative Party’s election promises.

In an assured performance, Sunak described the short-term measures as a coordinated, coherent and comprehensive response to the crisis. A substantial cash giveaway to the smallest of UK businesses, the abolition of business rates for the leisure and hospitality sector and the extension of statutory sick pay will help to keep small businesses afloat while they wait for the opportunity to recover. The promise to spend whatever it takes to get the NHS through the crisis was also reassuring.

Looking to longer-term measures, Government is going to spend an extra £175 billion over the next 5 years. It is an audacious plan, tempered by the fact that UK governments do not have an unblemished record of spending well on large infrastructure projects. Let us hope that this money is spent well, for the sake of future generations.

The eye watering escalation in government borrowing required to finance all of these measures are forecast to total £100 billion over the next 5 years, but is almost certain to be more. However, there is no doubt that the UK needs something to help it improve productivity and spending on improved infrastructure, as well as investing to support technology and innovation have a good chance of assisting this.

To our good fortune, this increase in borrowing is taking place at a time when the cost of borrowing is exceptionally low. The global economy is awash with cash looking for a safe home and this is something to exploit for those that are able.

Now, back to President Trump for the final chapter of this installment. His announcement of a 30-day travel ban from Europe (excluding the UK and Ireland) seems to be part of a strategy of trying to pin the blame for the virus spread and the economic consequences on ‘foreigners’; Covid-19 is already referred to as ‘China Flu’ in the US. The reality is that he is behind the curve in formulating a comprehensive domestic strategy and this is why investors are running for cover. This lack of competence is likely to be his undoing.

Later today, Christine Lagarde will tell us what the European Central Bank is going to do to provide life support to the stagnating Eurozone economy. Expect a substantial stimulus package but ultimately, the ECB lacks firepower so markets are likely to be disappointed.

Keep calm and carry on. Everything should look a lot better by the year-end.