Looking Ahead: Market Volatility and Preparing for Possible Outcomes


Looking Ahead: Market Volatility and Preparing for Possible Outcomes

March 11, 2020

Host: Hello and welcome to Talking Markets: exclusive and unique insights from Franklin Templeton.

Ahead on this episode: We’re continuing to talk about the ongoing market volatility, following not only coronavirus concerns but also the oil price war. Gene Podkaminer and Wylie Tollette from the Franklin Templeton Multi-Asset Solutions team join Jack Bailey for this discussion.

Transcript

Jack Bailey: Gene and Wylie, thank you both for being here.

Let's start with you, Gene. As you process what you're seeing in markets, how are you viewing the base case scenario right now and how has that changed over the last few weeks?

Gene Podkaminer: So we've disaggregated our base case into two components. The first has to do with the coronavirus and its fallout. The second has to do with the underlying fundamentals that really underpinned the economy. We used to have them put together but realized that we needed to separate them out so that we could understand what was happening in one area versus the other area.

Let me start with coronavirus thoughts first. Our base case has moved generally to a mild recession. That was not the case earlier and that is based on new readings that we're getting, both from coronavirus and from the economy at large and also from how we're seeing sentiment change. So, in our base case, the first thing that we're looking at is that the virus continues to grow moderately and that the peak growth of the virus is towards the end of the second quarter.

In China, we see that virus growth continues to fall, that there's pickup in economic activity, but less so in the service sectors, so folks aren't out and about yet. The seasonal effect that impacts the virus may show some impact on transmission in our base case and that certainly helps the growth rates slow. And, the mortality rate hovers around 1%, especially as testing rises in new countries, so US and Europe and also outside of elderly folks and those with pre-existing conditions.

From an antivirus perspective, we see in our base case that there's some efficacy from using these antiviral drugs. It's not a slam dunk, but there's some efficacy there.

From a policy response perspective, now, our base case is, first of all, interest rates and monetary policy that there's convergence around what the effective lower bounds are. And what I mean by that is, we've started cutting rates from a place that wasn't that high. Now we're not that high again and at some point we'll be at the lower bound of that. Other economies, specifically in Europe, are much closer to that lower bound. So, the amount of freedom that central bankers have around monetary policy is still a big question mark. We're also seeing some additional liquidity measures put into place and those are introduced to ensure that liquidity is there to help funding.

From a fiscal perspective, and by the way, fiscal has been getting a lot of airtime recently, both in the US and especially in Europe and Asia. Our base case is that demand is focused on some stimulus and that we raise consumption, that is really what the fiscal stimulus is going to be about, improving consumption. The size of those packages, maybe 0.5% of global GDP [Gross Domestic Product] and the timing is a little bit slow. That all leads to global growth of GDP of around 2.4% a year, which importantly, is right under the threshold for a technical recession and that's why our base case is a mild recession. We think there's a 60% chance of this happening.

So, both what's going on with the virus and what's going on with the underlying fundamentals, there's a 10% chance of a much better outcome and that will lead to global GDP growth of about 2.7% with the bottom in early second quarter of 2020. So that's the optimistic case.

The pessimistic case, there's a 30% chance of GDP growth being a fairly anemic 2% the bottom in the third quarter of 2020 and some different assumptions around how the virus spreads and the efficacy or not of the antivirals. A lot of folks have been talking about letters of the alphabet and what that means for a correction, right? A V-shaped correction, a U-shaped correction, an L-shape correction. So let me put this into our scenarios, as well: base case, U-shaped correction; our optimistic case, V-shaped correction; bear case, pessimistic is an L-shape correction.

So, there we have the letters of the alphabet.

Jack Bailey: Great. Wylie, anything to add?

Wylie Tollette: Yeah, I would say that what's been interesting to watch and it's quite typical of markets, which is they tend to move on sentiment in the short term, but they really respond to fundamentals over the medium- and longer-term. And so, what we've seen very recently is a sharp move on sentiment, really driven by, I think, the fact that valuations through 2019 and early 2020 and stock markets had grown pretty dramatically. You know, we had a great couple of years and so, when valuations are extended, you do tend to see very sharp reactions, either up or down to any sentiment change. And we clearly saw a sentiment change with coronavirus. I think the other thing that's been impacting stock markets recently is the fact that the coronavirus is more a biological issue than an investment issue. And when you're talking about biological issues impacting humans, you're actually beginning to start to trigger people's fight or flight response. Much more fundamentally, you're dealing with some pretty primitive sections of the brain. And I think a lot of that actually gets reflected in stock market behavior, believe it or not. And so, some behavioral finance theories would indicate that people become more risk averse, more loss averse when they're faced with something like the coronavirus, and I think we've seen that recently. We think that perhaps that market reaction, if it's not done, it may be a bit overdone, in the short term. And so, we think the medium- and longer-term outlook for stocks is actually much more positive than it is for some of the other asset classes we have available to us, like fixed income, cash and alternatives. Fixed income has had a great run, particularly if you have been in long duration sovereign bonds, like Treasuries. They've had a positive reaction, as a risk aversion trade. And so, we're seeing an opportunity. Although we do think we're going to see another few months of volatility as the coronavirus news flow continues to play out.

Jack Bailey: So we've talked so far about COVID-19 or the coronavirus and that was obviously the catalyst for this market retreat as investors are getting concerned about supply chain disruptions and that sort of thing. But on top of that, now oil prices have also tanked, faced with a sort of perfect storm of reduced demand caused by the coronavirus and then you've got excessive supply as the Russians and the Saudis are no longer cooperating in terms of limiting output. So Wylie can you speak a little bit about the role of oil and maybe it's broader than oil, maybe it's energy more broadly in the context of the global economy?

Wylie Tollette: Certainly. So, if you think about oil 10, 15, 20 years ago, when oil prices fell, it was actually broadly viewed as a positive cause it essentially would put more money back into consumers’ pockets. The change that's really happened over the last 10 or 15 years, is that America is now a large oil producer as well. So from a US economic standpoint it has mixed blessings, now when the price of oil falls. It puts more money back in consumers’ pockets, but it also can cause job losses, particularly in the oil production side of things. In the fracking industry, specifically. That industry is largely financed through debt and specifically a lot of high yield debt. And so, what we could see is that the price of oil falling, globally could impact US oil producers, specifically frackers and cause some turmoil in the high yield market, which can translate into turmoil and other markets. So in the short term, we were sort of balanced on the view of oil, in terms of it has positive impacts on the consumer side, but that's going to take a while to translate to more money in consumers’ pocketbooks. But it may drive some negative employment statistics as the frackers, potentially take wells out of production.

The other element of energy is it's embedded in so many other sectors, asset classes. It's in transportation, it's in real estate. It’s in almost everything has some dependence on energy to some degree or another, which is why when you see the price of oil fall, you see an immediate reaction across many financial markets. I think now that we're starting to digest it, I think we can start to look at that price of oil falling with some balance. I think the market reaction was largely negative, at least in the stock market. However, again, putting the price of oil, lower, actually, for example, in the US, puts another $100 billion into consumers’ pocketbooks potentially over the course of the next 12 months, as reported by Barron's. However, again, putting the price of oil lower, actually, for example, in the US, puts another $100 billion into consumers’ pocketbooks potentially over the course of the next 12 months as reported by Barron's. So that's a pretty significant, positive stimulus. So you have to look at this with some balance and I think that markets will start to do that again over the medium- and long-term.

Gene Podkaminer: When I think about oil, I'm thinking about inflation because oil and energy are really key component in our inflation numbers. And our inflation numbers, as Wylie mentioned, drive so many things. When we see a collapse in oil prices like we have earlier this week that is a deflationary impulse. And what's interesting here, is that that change in energy prices, first of all, dominates what we see in headline inflation, but also probably outweighs the supply and demand shock dynamic that's being caused by the coronavirus. So what I mean by this is, that there is a view around inflation and coronavirus and that the coronavirus causing a supply shock and a demand shock—less supplies inflationary, there's less stuff, so perhaps prices go up. But also, less demand is deflationary—less people buying means prices go down. That's being overshadowed by what's happening in the energy sector. So before the oil issues came up, we were trying to balance this supply shock versus demand shock and understand how inflation would end up. Now, that's all out the window and we're just looking at how energy impacts inflation.

Jack Bailey: Gene, you mentioned previously the Fed's response to COVID- 19, you know, 50 basis point rate cut.

Jack Bailey: Gene, you mentioned previously the Fed's response to COVID- 19, you know, 50 basis point rate cut. So now we've got cheap oil and really low interest rates. And you know, I think a time traveler from say 1972 would be more than a little confused by all the consternation in turmoil around cheap oil and low interest rates. So, what would you tell that time traveler?

Gene Podkaminer: First of all, I think a time traveler from 1972 would be shocked by how skinny all of our pants are. After getting over that shock, which actually could take a while. There are some similarities that that time traveler would probably feel to what's going on in the economy now. There's a mini oil shock, certainly nothing like we would end up seeing in the 70s with gas lines and the real impact on society that energy had at that point.

The interest rate situation is a little bit different in that we're scraping bottom for how low interest rate policy can go and potentially negative interest rate policies in other parts of the world. So that time traveler from 1972, would maybe see a familiar situation with oil and a little bit of panic in the market. I think that's fair, but the tools that we have on the monetary policy side are very different than what we had in the 70s and a lot of them were defined and honed in the mid-to-late seventies and early eighties by very muscular action from the Fed. So let's talk for a minute about what's going on with interest rates. And this is not just a US issue, over the last couple of weeks, we've seen rate cuts in the US, in Canada, in Australia, in China, in Japan. The list goes on and on and there's probably more coming.

Why? The question is why? Monetary policy is something that can be relatively quickly put into place to help us deal with crises and shocks. The problem is while it can be quickly put into place, it doesn't act very quickly. So it takes time for this to trickle through the economy. A more powerful policy measure is fiscal. It's more powerful in that its action is almost immediate. It puts money back into the economy, it helps consumers hold on to their money instead of spending it on things like taxes for instance. So fiscal policy is very effective, but the catch is, it's hard to implement. It means people need to agree. And by people, I mean people in government need to agree that this fiscal policy package is the right answer and we're going to roll it out and get over our political differences to do that.

In some parts of the world that's a far stretch. We have seen fiscal packages come out in Italy and of course in Asia, there's talk about a fiscal package here in the US. Based on our scenario analysis, a fiscal package that's around 0.5% of global GDP is probably to be expected. And that may not necessarily be enough, even with really low interest rates.

In a more extreme scenario, if we get more pessimistic fiscal packages of 1% or 2% of global GDP alongside some pretty serious monetary policy, activity may be necessary. So the answer to your question about the time traveler and interest rates and oil prices also has this other element of what can the government do with fiscal policy. So there's going to be some things that look awfully familiar, but we're going to be doing them in a different way.

Jack Bailey: So both of you are key players along with CIO Ed Perks in Franklin Templeton, Multi-Asset Solutions where your mandate is to use multi-asset solutions to produce specific investor outcomes. So let's consider two outcomes investors may be pursuing. And as you know, the desired investor outcome is completely independent of what the market is doing on a given day or the economy. What investors are after is what investors are after. So Wylie, if the desired outcome is growth, how are you looking at allocation decisions today?

Wylie Tollette: Yeah, a great question. And, there's one thing I would highlight here is that, you know, growth is what most investors are actually looking for. If you just look at sort of the broad spectrum of investors from young to old, you know, particularly think about folks saving for retirement or saving for that down payment on that house or saving for their children's college education, most of those are going to be growth-oriented investors, where they don't need cashflow right off their investments in the short term. And even in that situation, you know, sort of folks, immediate instinct is, well, if I want growth I should buy as many stocks as possible, and really load the portfolio up. And why don't I just put 100% of the portfolio in stocks? Well I think this recent past history has once again illustrated the wisdom of broad diversification. It's really much easier to prepare for economic shocks, even in a growth-oriented portfolio, by broadly diversifying than it is to repair a portfolio following, an economic shock. And we've seen time and time again that some diversification in a portfolio allows them to recover more rapidly following the types of shocks that we've just experienced.

Jack Bailey: So Gene, same question for you, but this time income is the desired outcome. How are you providing income for investors today?

Gene Podkaminer: So, income can be tricky because a lot of times the first thing investors think of is fixed income, so bond markets. But our approach is really multi-asset. So, it's not just about loading up on fixed income securities. It's also looking at what does the equity market have to offer? What do other components in the capital structure have to offer so that we can get to an income level that's satisfactory for an investor? In some sense it's a little bit of a harder problem because you have a more circumscribed universe here. You want to invest in securities that do throw off a dividend or a healthy yield and you want to put them together in a way that you're not overly concentrated in a specific region or a specific sector or industry.

So, you still want broad diversification, but in addition to trying to maximize return for given level of risk, what you're really trying to do is maximize income and to do that having more degrees of freedom is a good thing. And having the ability to shift between bonds and equities, and even securities that straddle the line between bonds and equities is really helpful.

One thing that's being discussed right now by our analysts is how are we viewing equities versus fixed income, given the current changes to the equity market i.e. prices moving all around, but recently mainly down. And in fixed income where yields have been moving around a lot as well mainly down because prices have come up. So how are we thinking about that trade off? I could hold a stock, I could hold a bond, which looks better now versus a month ago or a year ago? And we're coming to the conclusion that the relative valuations between equities and fixed income really start to favor equities. The lower interest rates that are out there in the economy, the weak inflation is also supportive of equities—bottom up return forecasts also supportive of equities, we still see some pretty strong fundamentals. And as I talked earlier about policymakers, both central bankers and also elected officials seem to have at least one eye on supporting markets and the financial economy, along with the real economy and workers and everybody else. So when we compress this down into an income generating portfolio, equities are going to be a really important aspect of that. Not the only aspect, but really important. So, when we think about income, it's not just about bonds, it's about what does our overall investment universe look like? How do we smartly and thoughtfully put things together in a way that generates the income that our investors demand in a way that doesn't take on risk that they're not really compensated for?

Jack Bailey: Well, thank you both for the time today, it's been very informative.

Wylie & Gene: Thank you. Thank you. Yeah. Pleasure to be here.

Jack Bailey: And thank you for listening to this episode of Talking Markets with Franklin Templeton. If you'd like to hear more, visit our archive of previous episodes and subscribe on iTunes, Google Play, or just about any other major podcast provider and we hope you'll join us next time when we'd uncover more insights from our on the ground investment professionals.

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