Almost 10 months into the COVID-19 crisis, the pandemic has spread across more than 200 countries, grinding economies to a halt. As part of their crisis-response strategy, leaders have had to manage two equally important responsibilities: first, to get control of the situation; and second, to institute mechanisms that mitigate the risk of the crisis happening again.
Following the coronavirus outbreak, most countries went into immediate lockdown to stop the virus from spreading and effectively threw their economies into recession. Governments naturally had to respond, with many employing a slew of fiscal and monetary policies to mitigate the damage created by the pandemic-induced lockdowns. These policy responses are helping economies navigate the storm in unique ways, creating promising long-term asset-allocation opportunities for investors.
Fiscal policy responses
The economic toll brought about by the pandemic has been ubiquitous as the GDP of most countries has suffered the worst contraction in history. Fortunately, policy stimulus measures have dampened these contractions in some parts of the world, evidenced by improvement in growth conditions, even in the face of the second wave of the virus.
The pandemic situation in the second wave is now different from the first, as many countries that went into immediate lockdown have since realised how difficult it is to reopen and are now aggressively pursuing measures of flattening the curve whilst keeping their economies open. The pace of recovery, however, has been drastically different across countries, depending on how each is responding to the pandemic.
Fiscal support is coming in various forms – direct payments to individuals, loans to struggling businesses and tax relief, both for individuals and corporates. One traditional fiscal-policy tool has been the sharp increase in government expenditure for those countries that implemented aggressive stimulus measures. Consequently, their fiscal deficits as a percentages of GDP have worsened. Countries that had minimal fiscal support, on the other hand, have seen budget shortfalls remaining largely steady.
Taken together, aggressive fiscal-policy responses helped blunt the economic impact of the pandemic and fostered a stronger growth recovery. Manufacturing and Services PMIs (Purchasing Manager’s Index), which give an indication of corporate earnings and are closely watched by equity investors and the bond markets, have surged in the aggressively responding countries, underscoring a massive rebound in business activity.
Improvements in the more conservative countries have been far smaller.
Monetary policy responses
To save jobs while keeping inflation in check, most central banks lowered interest rates in support of economic activity. This supported consumers and businesses by lowering payments on existing and new loans throughout the economy. A wide range of liquidity facilities and asset-purchase programmes to keep markets functioning and credit flowing were implemented to allow interest rate cuts to work their way through the economy. Local banks intervened through mortgage- or loan-repayment deferral programmes against the backdrop of commitments to continue large-scale asset purchases of long-term debt by their respective central banks. The combination of the very-low-interest-rate policy and asset purchases provided considerable monetary stimulus to economies.
Compared to most developed-market countries, which already had low-interest-rate environments, most emerging market countries had more room to cut their policy rates and indeed took advantage of that.
Countries that actively used asset purchases as a response to the pandemic now have their long-term rates below pre-crisis levels. Other countries pursued more cautious asset-purchase programmes with the intention of supporting the functioning of their markets rather than lowering government funding costs.
The divergence in responses has been pronounced. Take Brazil and Mexico, for example.
Both countries were hard hit by COVID-19. Brazil’s policy response has been extremely aggressive, which is helping to prop up a sharper growth rebound, but with questionable longer-term sustainability. In comparison, Mexico’s policy rescue has been modest to conservative, which has so far led to moderate growth recovery but also minimised damage to the country’s debt load and its currency.
The contrasting policy responses is a classic example of two countries that are both creating unique opportunities for investors for asset allocation.
As investors decide on how to allocate assets across countries to capture opportunities created by the COVID-19 policy responses, it is important to take a broad-based approach. To the extent that country-specific policy responses will affect each country differently, investors should consider two imminent issues that may have knock-on effects. The US election results, which are just around the corner, may shift global economic policy, geo-political relations and trade agreements, depending on which party takes control of the White House in January 2021. The latest developments in the Brexit talks may create an acrimonious UK/EU divorce, which will not be convenient for businesses across Europe.
All economies are expected to benefit when the global cycle picks up, despite the immediate resurgence of virus cases, most pronounced in Europe, which may force large-scale lockdowns once more.
Countries that implemented extreme monetary expansion at the expense of their currencies will produce higher nominal growth and stronger stock-market returns. Exports in local currency terms will be boosted where terms of trade are favourable. This could further increase corporate earnings.
Additionally, the aggressive rate cuts will continue to significantly lower the cost of hedging currency exposures in those countries. Investors may consider going long on equities, paired by currency hedges to manage foreign-exchange risk.
Where government debt is primarily denominated in local currency, the risk of a sovereign default will be highly improbable. This gives such countries the option to further ramp up borrowing and spending. The net effect of such aggressive policies will be reflected in weaker currencies and, possibly, higher inflation over time. In other words, these countries will be in pursuit of a mixed policy that props up growth at the expense of a weaker currency.
For countries that took conservative policy responses, currencies and fixed-income assets should benefit from their policy stances. Reasonably low interest rates will still provide room for some yield pick-up in fixed income. Where foreign currency-denominated government debt relative to GDP is significant, maintaining exchange-rate stability will be of paramount importance for their debt sustainability, hence a strong currency.
Overall, should cyclical inflation remain in check across the globe, conservative fiscal and monetary responses will bode well with currencies and fixed income. On the other hand, despite the pronounced currency depreciation in aggressive countries, any stable inflation outlook will encourage them to continue being ultra-stimulative, favouring equities.
Richard Maparura, CFA, is a Portfolio Manager at Butterfield Bank (Cayman) Limited.
Sources: CNBC News and USBank
Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.