Patience required on the path to recovery

We hopefully have all the tools we need to deal with the pandemic in 2021, but investors need to prepare for rising unemployment, corporate insolvencies and loan defaults.

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  1. Garry White

The growing confidence that 2021 will be much better than the year we have just endured is probably correct. That these positive emotions are stirred over Christmas and new year is right and proper – as feelings of optimism and renewal are central themes in our winter celebrations. There is also real evidence to support these hopes of a brighter 12 months ahead.

Science has delivered a selection of vaccines against Covid-19 that are already being rolled out. Asian nations that were first engulfed by the virus are also recovering well. There are logistical challenges to overcome, but the tools to end the pandemic appear to be slotting into place.

However, the path to recovery will not be easy. Decision making by central bankers and politicians in 2021 are arguably more significant than they were in 2020 because they are so finely balanced. There is plenty of scope for missteps ahead to temper any unbridled optimism.

There will be a spectacular recovery in corporate revenues and profits in the second quarter, as the comparable 2020 period was during the peak of global lockdown. Many companies will also return to the dividend list.

These upbeat prospects have already been reflected in markets, with the MSCI World Index, which tracks a basket of developed-market equities, hitting a new all-time high this month.

However, alongside the corporate recovery, the true cost of the pandemic will start to reveal itself. This is likely to temper any exuberance caused by rebounding corporate profitability.

Many businesses – including property companies and oil and gas operations – will be forced to slash the book value of their assets because they are no longer worth what they paid for them.

Some businesses will also discover that their markets have permanently shrunk. Many businesses may therefore find it difficult to survive, as online rivals make their business models defunct. The pandemic may also result in people changing their behaviour by, for example, avoiding large crowds.

Pressure to withdraw economically crippling social-distancing rules will intensify – and the expensive financial scaffolding that has buttressed companies, markets and employment will start to be dismantled. As these supporting structures are removed, we will get a clearer understanding of the permanent scarring the pandemic has inflicted.

So, central bank policy and government fiscal responses will become a challenging balancing act against an unpredictable news backdrop. Those individuals making fiscal and monetary policy decisions will be faced with many difficult and contradictory choices about the quantum and rate of any change in policy. In such circumstances, mistakes can easily be made.

Businesses will go bust

The winding down of state support schemes will trigger an increase in corporate defaults and insolvencies. Zombie companies that have been kept on life support by taxpayer handouts will no longer be able to stumble on.

It is a necessary process – but it needs to be carefully managed to prevent any fallout spreading into the wider financial system.

The sectors most at risk of insolvencies and defaults are energy, retail and property. High-yielding debt issued by the US energy sector is likely to be problematic and default rates have already been on the rise.

The “green revolution” that is front-and-centre of the European Union’s post-pandemic recovery plan will also become a central policy of the new US administration under Joe Biden. That means the energy sector, which represents the lion’s share of the US high-yield bond market, faces an existential crisis too.

Nevertheless, current expectations of the total US default rate next year remain quite low. Moody’s current high-yield 2021 forecast stands at 5pc – 6pc, with the credit ratings agency guiding to the lower end of that range. Its 2022 projection rises to between 5pc and 7pc.

UK employment an issue too

The UK Coronavirus Act allows the UK government to offer any financial support required to prevent, mitigate or compensate for the impact of Covid-19 on UK businesses. This has included government-backed and guaranteed loans, material contributions to the salary and wage bills of furloughed workers – and financial support for the self-employed. When Chancellor Rishi Sunak issues his budget on March 3, it is likely that this support will be reduced.

Mr Sunak extended the UK’s furlough scheme earlier this month. The Government will now continue to contribute 80pc towards wages until the end of April 2021.

Britain’s government has supported about 10 million jobs since the start of the pandemic at a cost of almost £50bn. This cannot continue. As this support is wound down, UK unemployment will rise – but it’s difficult to predict by how much.

Unemployment will probably spike in most other western countries too as their costly job-support packages are unwound. Last week, Congress passed a $900bn pandemic relief package as part of a broader $1.4 trillion government funding bill – but these measures are significantly less generous than the package unveiled in March.

The US hospitality industry has pointed out that unemployed restaurant workers will receive just half the amount they received under the previous provisions. Clearly, a confidence issue could emerge if unemployment rises too fast.

Nevertheless, despite the torrid year, a rising a wave of optimism has produced a traditional Santa rally. But the outcome for financial markets in 2021 will be determined by how some major pieces of positive and negative news interact.

An increase in defaults, massive asset write downs by companies and a significant rise in unemployment will need to be weighed up against the improving financial performance of companies and progress in defeating the virus. It’s right to be upbeat about markets next year, but that optimism should not be rose-tinted.

A version of this article appeared in the Daily Telegraph.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

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