Markets rebounded sharply yesterday – have we seen the bottom already?

Markets shot up yesterday on hopes that coronavirus infection rates are slowing. Could we be seeing the bottom? And if so, asks John Stepek, what happens next?

We continued to have plenty of grim news from the real world yesterday, culminating in the news that the prime minister, Boris Johnson, is in intensive care. Here’s hoping he recovers fully.

In the financial world however, things were looking up, with markets bouncing strongly. So what’s going on?

Markets have rebounded sharply

In the US, the main stock index – the S&P 500 – shot up by more than 7% yesterday. What gives?

The market appears to have been inspired by news that – despite the mounting death toll across the globe – “the curve” does indeed seem to be flattening. In other words, infection rates are levelling out.

Italy and Spain seem to be over the worst. There are even tentative signs of slowing in the UK and the US (although don’t be surprised if these pick up again). Meanwhile China had its first day without any new cases recorded.

The market is presumably thinking: “OK, this thing passes. If this passes, then business will restart at some point. If business will restart at some point, and the central banks are printing all this money, then it’s basically back to business as usual.”

In short, this is a temporary glitch. The damage can be neatly compartmentalised. It’s massive, sure. The whole of 2020 can probably be written off. Individual companies will go bust. Lots of people will lose their jobs, temporarily or maybe even permanently. Some people will lose their lives.

But nothing systemic has happened. The trajectory remains the same. And as a result, at some level, the “buy the dip” mentality remains intact.

So is that it?

I’ve just read an interesting interview with respected investor Felix Zulauf on this very topic. Zulauf has similar views to MoneyWeek on many points – central banks have encouraged rampant moral hazard which has created a fragile and over-indebted economic backdrop.

Zulauf is not especially optimistic, in light of the huge debt built up over the years. Indeed he reckons that this recession will start “a domino process” where we’ll need to have a reckoning with the indebtedness within the global economy.

But that said, he also accepts that the actions taken by central banks have meant that even though he expects to see “some spectacular bankruptcies… given the speed with which central banks have acted… this will no longer threaten the financial system per se.” So we aren’t facing a financial system meltdown as in 2008.

(The eurozone remains a potential splintering point – the politics of the euro, and whether Germany ends up standing behind France's debt pile or not, does mean that there’s a lot of vulnerability there. But thus far the actions taken by the European Central Bank point to yet another fudge that pushes the eurozone countries ever closer together through emergency measures.)

So what does that mean for markets?

Zulauf reckons that “stockmarkets are at the beginning of a bottoming process.”

That said, “setbacks to the lows of late March or even slightly below cannot be ruled out.” There will be a reality check as companies start to report on just how badly they have been hit by the pandemic. There may be debt problems in emerging markets. And we might get a nasty shock if the pandemic returns.

However, “over the course of the coming weeks, we should gradually gain more visibility, and after that a sustained recovery in equities can begin.”

That sounds pretty optimistic. Doesn’t it?

Inflation is the destination

The problem is – what happens afterwards? Zulauf likes investing in solid companies: “good companies can always adapt to the environment and generate more income for the investor over time than a normal fixed-income asset” (ie, a bond).

But in terms of the backdrop, he’s not upbeat at all. The problem, he reckons, is that “we are headed towards more and more government intervention and less and less freedom and free markets. This is not a climate for structurally increasing prosperity. And over time, this expresses itself in financial markets.”

A lot of this comes back to the fact that the same unprecedented intervention that we’ve seen in this crisis is going to continue to make itself felt long after the actual coronavirus has passed.

In a recent note, financial historian Russell Napier (listen to my colleague Merryn’s recent podcast with him here) makes a similar point. Putting it simply, the risk we face now is that all the actions by central banks have pushed a lot of extra money into the system.

That need not matter while the lockdown is in place because “velocity has collapsed” – ie, no one is out and about, shovelling money around the place. But as a recovery starts, this extra money will “very likely have inflationary impacts when velocity returns to near-normal levels."

In short, “the more governments rely upon their effective capture of the commercial banking system to directly fund businesses and households through this crisis, the more they risk an inflationary blow-off when the economic lockdown ends.”

Of course, inflation is part of the plan. That’s how you get rid of debt. But at the same time, you need to hold down interest rates. That’s “financial repression”. Napier argues that for governments to do this successfully – in other words, running inflation hot enough to eliminate our levels of debt in a relatively quick timeframe – we’d be looking at hitting an annual inflation rate of 6% or above.

That sounds quite drastic by recent standards, but lots of smart investors reckon on something similar happening. As Zulauf notes, “we will have an inflationary economy policy that will drive up inflation but not prosperity.”

The obvious asset to add to your asset allocation in that sort of environment is gold.

So the short takeaway is this: do what we’ve been suggesting you do. Buy decent companies at cheap prices where you can get them. Try to build in some flexibility to your portfolio (ie, always have some cash spare to take advantage of opportunities). Own some gold.

And subscribe to MoneyWeek if you don’t already. You'll get your first six issues free, and not only that, you’ll get a free book looking at previous crashes and what we might be able to learn from them. Sign up here.

Recommended

Money Minute Wednesday 4 December: Britain's economic sentiment and American job figures
Economy

Money Minute Wednesday 4 December: Britain's economic sentiment and American job figures

Today's Money Minute looks ahead to the UK's latest all-sector PMI survey, and America's private payrolls report.
4 Dec 2019
The British equity market is shrinking
Stockmarkets

The British equity market is shrinking

British startups are abandoning public stockmarkets and turning to deep-pocketed Silicon Valley venture capitalists for their investment needs.
8 Nov 2019
Share tips of the week
Share tips

Share tips of the week

MoneyWeek’s comprehensive guide to the best of this week’s share tips from the rest of the UK's financial pages.
23 Oct 2020
Shaniel Ramjee: tech stocks, China and Japan – where to find the best returns
Investment strategy

Shaniel Ramjee: tech stocks, China and Japan – where to find the best returns

Merryn talks to Shaniel Ramjee of Pictet Asset Management about where to find the best returns in global markets right now – the continued growth of t…
20 Oct 2020

Most Popular

How will we repay our vast debt pile? Do we even need to?
Sponsored

How will we repay our vast debt pile? Do we even need to?

In his recent articles looking at different aspects of the fixed-income investing world, David Stevenson looked at inflation. Today he looks at a clos…
19 Oct 2020
Buying bitcoin could be the best way to play the remote working boom
Bitcoin

Buying bitcoin could be the best way to play the remote working boom

The coronavirus pandemic has accelerated the move to home working, flexible employment practices and the rise of the “digital nomad”. One of the best …
21 Oct 2020
Negative interest rates and the end of free bank accounts
Bank accounts

Negative interest rates and the end of free bank accounts

Negative interest rates are likely to mean the introduction of fees for current accounts and other banking products. But that might make the UK bankin…
19 Oct 2020