What we’ve read about the coronavirus impact on markets: “equities over bonds”

Klaus Kaldemorgen, a fund manager at DWS, on why the coronavirus crisis makes equities even more attractive than government bonds.

There is often only a fine line between fear and hope. Although the fall in equity prices at the beginning of the corona outbreak in Europe was not the strongest in historical terms, it was by far the most rapid.

Within eight trading days, the Dax fell by almost 33 percent. After a short breather, prices then climbed by 23 percent in just five trading days. The stock exchanges in the USA followed this pattern. By engaging in active trading activities, investors could do more wrong than right during this phase.

Measured by the MSCI World Index, since the beginning of the year equities have suffered a loss of around 20 percent. Significantly less compared to the losses incurred during the financial crisis between June 2007 and March 2009 and less than when the dotcom bubble burst  between June 2001 and May 2003.

Both events resulted in stock market losses of around 50 percent, calculated in euros and taking dividends into account. In view of the fact that the economy has largely come to a standstill for one to two months, combined with considerable income losses due to short-time work and unemployment, the losses in equity prices that shareholders have had to pay as a tribute to the Corona crisis so far appear rather small.

This is due to the fact that many countries are absorbing the costs and income losses with budget deficits of an unprecedented magnitude. This can be justified, as this time it is not a self-inflicted crisis of the economy or capital markets, but force majeure. Consequently, the state is stepping in by absorbing the damage through debt purchasing, in order to minimise the negative consequences for individuals and companies.

However, the rescue measures are not financed through the free capital markets, but through major central banks such as the Federal Reserve, the European Central Bank or the Bank of Japan. They buy the debt – in the case of the USA, it’s unlimited – and thus they are also printing money to facilitate this.

This helps to avoid liquidity bottlenecks and makes it possible for government debt to explode at falling interest rates. There is probably no alternative to this approach by The States, but it should be clear that we will have to bear considerable costs in the future.

The following scenario is conceivable: The level of national debt increases massively in relation to gross domestic product. Without sustained support from the central banks, interest rates would then rise to an extent that would call into question the debt sustainability of the nations.

In order to prevent this, the central banks keep interest rates close to zero by purchasing government bonds. This would not be so bad if inflation remained at the current low level. However, should it accelerate, the central banks’ hands would be tied.

For a rise in interest rates would not only drive the economies into a severe recession, but would also call into question the debt sustainability of the states. In this scenario, a debt cut would pose a threat to monetary stability, since money is essentially covered by the government debt purchased by the central banks.

In this scenario, money and public debt are two sides of the same coin.

For investors this means that government bonds, especially those with longer maturities, are not a suitable tool for investing assets. This does not mean that short-dated government bonds, from the USA or Germany for example, do not still have their quality as liquidity reserves.

The stability of money as a reflection of government debt should in future be measured by investors primarily in terms of the equivalent value in gold, as gold is a valuable asset that is independent of debt and largely stable in the amount available, and at least in the past was also seen by central banks as an important part of covering money.

In the current environment, it is interesting to note that some central banks – above all the Swiss National Bank and the Bank of Japan – are taking an alternative route to financing government debt, which at least reduces the risks to monetary stability: in addition to bonds, they are also buying shares of companies to hold as productive assets – even if their debt has increased more strongly in recent years.

As a source of wealth for any state, they generate income and prosperity. Even if they make losses in the current crisis, they are the substance for a future upswing. The relative strength of the Swiss franc and the yen appears to support the strategy of the two central banks.

Investors should use the fall in equity prices during the Corona crisis as an opportunity and do the same as the central banks in Japan and Switzerland. While companies create added value, government bonds are assets where you are not only a creditor and debtor at the same time, but are not even remunerated by the paying of interest.

© 2020 funds europe



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