How to explain yesterday’s market crash?
The global economy is undergoing a major, severe, but temporary shock. As the exact timing of the bounce back is highly uncertain due to the evolution of the coronavirus, investors face a considerable worsening of the near-term outlook. We know that the necessary containment measures have a significant adverse impact on activity.
We are in a confidence crisis that was triggered by two key events on Thursday. Firstly, US President Donald Trump shut down non-essential travel from continental Europe for one month, the US’s main historical trading partner, which does not illustrate a willingness to act in a coordinated manner. Secondly, the package announced by the ECB yesterday was at the low end of market expectations and undermined by an awkward communication.
While priority number one is to contain the spread of the coronavirus, markets are desperately looking for a quick, ambitious, action to mitigate the (temporary) lockdown. Those actions will be on the fiscal and monetary side. Both are important to restore confidence.
- “We will use all means at our disposal”
Germany pledged today “at least” EUR460bn in guarantees and announced that there will be no limit on credit programs to help firms; and that it will provide tax relief to companies, including deferred payments. Further, Finance Minister Olaf Scholz announced the government's readiness to take on additional indebtedness. Importantly, Scholz offered to help those countries in the EU who have not the same margin of manoeuvre in their public finances. This follows the message from French President Emmanuel Macron yesterday evening, in which he repeatedly stated that he will support activity “quel qu’en soit le prix” (at any price).
So Europe seems to be ready to act; we now need a coordinated plan which shows more solidarity within the Euro area.
Are central bank actions appropriate?
- The ECB has disappointed, why?
A significant package. If actions could speak louder than words, the unanimous decision announced yesterday represents an unprecedented package of measures.
The comprehensive package included three items on top of the accommodative monetary policy stance. First, QE asset purchases will be scaled up by an extra EUR120bn through year-end, on top of the current monthly EUR20bn. Second, the ECB will offer the banking sector generous access to longer-term liquidity (LTRO) and sweeten the one-year TLTRO-3 in June 2020 by an additional 25bp discount and collateral easing measures. Further, the ECB Supervisory Board announced an easing in capital and liquidity buffers “as they were designed for this kind of situation”.
Christine Lagarde insisted on using all the flexibility embedded in the framework of the asset purchase programs, and converge to the issuer limits at the end of the program. Further, she is clearly anticipating likely higher debt issuance.
At the end of the day, the European banking sector has more capital buffers thanks to the Single Supervisory Mechanism decision, cheaper liquidity access and and plenty more liquidity. Altogether, and in particular as the ECB did not cut rates, the overall package was EPS enhancing for the banking sector.
But a misstep in communication. We got the impression yesterday that the ECB did not cut rates because there was no consensus within the governing council. Answering a question of journalists on the ECB response, Christine Lagarde said that the ECB is not “here to close spreads..." In the present circumstances, this was pretty awkward. The result was an unprecedented 0.7σ, one day spread widening in Italian (and French) government debt markets vs. German Bund yields. Lagarde later on 'walked back' on this comment, saying the ECB is fully committed to avoid fragmentation.
- The Fed acted as a lender of last resort
As liquidity bottlenecks appeared in some parts of the financial markets yesterday, the Federal Reserve initiated three repo operations of USD500bn each to ease funding stress in the US markets, on top of the USD175bn of overnight repo and the USD45bn of 14-day repo. In short: the Fed is ready to add USD1.5tn in liquidity. Further, the Fed expanded its Treasury purchases beyond short-term bills and conducted purchases across the maturity range. On its side, the Fed appears ready to do the right thing, and to fulfill its role as buyer of last resort.
Have we changed our central scenario?
- We revised our economic outlook earlier this week
We maintain the idea of a temporary shock on the economy. Of course we will continue to closely monitor the impact on economic activity of the increasingly numerous containment measures.
We underscore that the nature of the COVID-19 shock, and uncertainty around any forecast, is unusually high at this stage. In our main scenario, we have assumed the shock to the economy is temporary; ie, a couple of months. But we cannot exclude either a shorter, nor a longer, flu episode. In this latter case, the impact on the economy is likely to be much more severe, with growing financial vulnerabilities. In such a scenario (our “recession” scenario), we assume the downward shock to be half of what was observed in 2008-09.
Overall, we hold to our GDP growth expectations in the US of 0.8% for 2020, and expect a pick-up in GDP growth in 2021 towards 2.6%. We also stick to our 0.3% growth for 2020 in the Euro area, and expect GDP growth to recover in 2021 towards 1.9%.
What is the impact on asset allocation?
- How do we handle this in our portfolios?
We have been more cautious since the end of January; we had purchased protection and have been underweight equities since the last week of February. We have bought back into equities and sold part of our protection during the correction, but remain slightly underweight for now.
- What might be the trigger for us to become more constructive?
We will watch for better newsflow around the spread of the virus. Any sign that Italy manages to contain the spread of the virus would be encouraging. Mortality rate is also critical. The peak of the epidemic in one country will be a trigger to boost confidence. All eyes are now turned to Italy…
Meanwhile, a forceful intervention of governments and central banks to mitigate the risk of financial crisis will be key to riding out the storm. On this point, we should start to see a series of announcements that should start to reassure investors.
- Building huge upsides on risky assets?
If we admit that by nature an epidemic is temporary, then we must also acknowledge that for a medium-term investor this rapid and over-reactive market can create huge upsides for equity and opportunities in bond markets. As of yesterday (12 March), the valuation of the S&P500 US equity index had dropped by 25% YTD and was well below its historical median trailing P/E (14.8 vs. 16.2), while the European market posted a P/E around 10! We now have a cushion on the valuation side. On the bonds side, the US High Yield rate jumped to over 8% while the Euro High Yield rate has now offers a yield of 5.5%.
We believe any positive newsflow could trigger surprisingly positive reactions: fast down and then fast up. This is clearly a clearly difficult market for investors to navigate.
So far, we remain cautious but are ready to act.
