Equity markets globally stabilised on Thursday (Eurostoxx 50 +2.86%, S&P 500 +0.47%) and bond markets recovered after the European Central Bank announced its Pandemic Emergency Purchase Programme on Wednesday evening.
Also oil prices registered their biggest-ever one-day rebound (+24% on WTI) after a three-day sell-off, as investors assessed the impact of massive central bank stimulus measures, and China’s and the US’ decision to increase strategic oil reserves. In addition, President Trump said to intervene in the oil price war between Saudi Arabia and Russia when needed.
Central banks have continued to announce additional stimulus measures around the globe.
The economic impact of the spread of the corona pandemic cannot be underestimated. The first activity indicators now show the advent of it in the developed world too.
Yesterday’s economic data comes as no surprise. Economic activity has been severely impacted around the globe in order to contain the spread of the coronavirus. Growth expectations will be well below our initial estimations. In the corporate sector, this will be followed by downward revisions in earnings and cuts in dividends.
In our main scenario, in which we maintain the idea the pandemic will result in a deep, but temporary shock, this negative economic news flow is already integrated to a great extent in todays’ market prices, but with a fat tail risk. We have gradually started to increase our equity exposure with the objective to become neutral in the coming weeks.
After Tuesday’s rebound, equity markets tumbled again on Wednesday (Eurostoxx 50 -5.7%, S&P 500 -5.2%) near their worst levels. The relentless worldwide spread of the coronavirus and a series of profit warnings related to activity disruptions overshadowed the additional announced economic support measures, that resulted in a bond market sell-off
Governments continued to work on additional measures to support businesses and contain the economy from the pandemic.
Concerns about the magnitude of these fiscal stimulus plans pushed global interest rates higher and resulted in a global bond market sell-off. Long-term bonds underwent a strong decline since the beginning of March. For the 30-year US Treasury Bond for instance, the price decline already exceeds 10%. Also corporate bond spreads increased as markets fear rising defaults. Overall, the rise in volatility is now widespread among all asset classes.
Especially Italian government bonds had an extremely volatile day. The closely watched gap between Italian and German 10 year government yields widened to more than 320 basis points before ending the day at 266 basis points i.e. 12 basis points tighter than the day before!
In the meantime, oil remained strongly under pressure. Brent crude oil dropped another 10% to below 26 USD/barrel, the lowest level since September 2003. Oil continued to be hit by both global demand worries due to the coronacrisis and supply concerns related to the price war that followed the failed cooperation between the OPEC and Russia.
In our central scenario, the expected upcoming negative news flow linked to the pandemic is already to a great extent integrated in todays’ prices, but with a fat tail risk. We are gradually looking to further increase our equity exposure with the objective to become neutral, in combination with a limited protective derivative strategy, where possible.
Equity markets now have a better risk-reward but we know that any positive news flow around the epidemic and confidence in the authorities’ actions will be key for a more durable market rebound.
There are numerous transmission channels at play. But containment measures are the factors which have the deepest impact on economic activity.
China has been the first country to be hit, so activity numbers released for February provide an order of magnitude of the depth of the shock. The plunge in industrial production is in line with our assumption of a 15% decline in the level of GDP after the lockdown.
Activity seems now to be resuming, but the resumption is progressive rather than an immediate return. For example, daily coal consumption in China is 20% below average, as against -40% at the trough.) Authorities remain cautious, because as firms reopen, a second outbreak of COVID-19 cannot be excluded.
COVID-19 has become a global pandemic and countries are hit one after the other. We expect more cities/countries will be placed under lockdown in the coming weeks and activity will be significantly affected. The fall in activity will thus depend on the length of this lockdown and the strength of the rebound on the economic policies that will be put in place.
In the US, the Fed delivered again on Sunday: it is “prepared to use its full range of tools to support the flow of credit to households and businesses.” But, as Powell acknowledged, directly providing funds to households and SMEs is not within the Fed’s remit, and the role of fiscal policy is “critical.” For the time being measures announced by Congress are far from sufficient to reinstate confidence and provide the needed offset to the economic shock.
In the Euro area, the ECB under-delivered and President Lagarde’s misstep (“the ECB is not here to close bond spreads”) did not help. Governments’ announcements have been a step in the right direction: they will provide income replacement to households (the short-time work subsidy scheme has been made more generous in Germany for instance); tax offices are being given the ability to permit tax deferrals for companies; and credit support to companies will be enhanced (KfW, the German state bank, will lend as much as €550 billion to companies to ensure they survive the pandemic, while in France, Bpifrance will provide similar guarantees to companies whose activity is affected). Already announced measures if correctly implemented, mean that governments will directly absorb a significant part of the shock. To avoid the risk of market tensions, the Euro area will however also have to show how far it is prepared to go to help Italy in the present situation.
If we take the Chinese pattern as a guideline (and assuming there is no second Covid wave), the shock – while deep – should prove temporary. This scenario continues to be our baseline. But for this to prove correct, we need an even more forceful action from governments, especially in the United States. Barring such an action, the possibility of a longer and more entrenched fall in activity with negative financial feedbacks loops (i.e. a recession) cannot be excluded.
In this context we have remained slightly underweight until Monday evening, 16 March, with protective derivative strategy where possible. We nevertheless acknowledge the better risk-reward for equity markets following the 35% decline of the European market, and have decided today to progressively move back towards neutral on our equity exposure.
Since the end of last week, investor psychology has fallen in the “depression phase”: they believe that announced measures will have no positive impact whatsoever. This corresponded during previous financial crises to a capitulation phase and market trough. We consider that there are still downside risks. The negative news flow around additional containment measures, and the ongoing spread of the virus is likely to continue to fuel doubts about policy efficiency, but we are approaching levels where markets rebounded in 2003 and 2009 in the Eurozone. Any positive news flow around the epidemic will be key for a more durable rebound of markets. The very strict containment measures that are being taken should show their first positive results in the coming weeks.
On the heels of Covid-19 and the oil shock, financial markets experienced a third blow yesterday (12 March) with a major confidence crisis. Speeches from US President Donald Trump and ECB President Christine Lagarde have shaken investor confidence in the ability to lead a timely and bold approach worldwide. Candriam revised its economic outlook scenario earlier this week. On the Asset Allocation front we remain prudent; we wait for a peak in infection rates, a resumption in activity and more meaningful fiscal measures. The recently-announced measures by the German Finance and Economics minister is clearly a step in the right direction.
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.
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.
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.
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.
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%.
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.
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.
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.
In addition to the rapid evolution of the Coronavirus epidemic outside China, market participants witnessed a breakdown in talks between Russia and OPEC, followed by Saudi Arabia’s announcement it would increase oil production. Candriam has revised its economic outlook scenarios and assessed the impact on asset allocation.
The Covid-19 epidemic has continued to spread outside China but appears to have peaked in mainland China in mid-February 2020. Control measures, such as Italy’s shutdown over the weekend or the confinement in Wuhan, are being taken to slow the spread of disease and reduce the burden on hospitals. The alternative would be an uncontrolled transmission scenario in which emergency rooms, intensive care units and other parts of the healthcare system would be overwhelmed. In such a system, mortality rates would be much higher and those infected may not receive the treatment they need. Hence, protective measures are not about the ‘ego’, but about public health.
Places that identify cases more rigorously appear to report lower death rates. China outside the province of Hubei shows a fatality rate of 0.9% as of March 9, 2020 (source: Johns Hopkins CSSE data). South Korea (0.7%) and the Diamond Princess cruise ship (0.9%) also performed extensive testing regimes for Covid-19 and relatively lower death rates. This implies that the current global fatality rate of 3.4% is likely overstated and could decline over time: high fatality rates might reflect low testing and/ or an overburdened healthcare system.
Looking forward, we maintain that the coronavirus will turn out to be a temporary shock. Currently, the measures that will minimize the human cost of the outbreak are likely to maximize the economic cost. Supposing strict quarantine measures similar to those in China are taken elsewhere, outbreak dynamics for South Korea, Italy, and Japan may plateau in about one month, as it did in China. The virus is likely to continue to spread within other European countries and the US with the same diffusion risks and quarantine measures to come. Hence, in the short term, economic growth will be below initial expectations, justifying our short-term caution. But signs that countries are able to contain the outspread of the virus will be key for market sentiment.
Last Friday, Russia refused to sign up to additional cuts proposed by OPEC oil producers. As a consequence, Saudi Arabia has decided to increase its oil production and launched an all-out oil price war. Oil prices fell by 30% on Monday. The first target, and victim, will be US shale producers, with some of them unlikely to survive at current oil prices. It is of note that this price war follows an unprecedented loss of market share of OPEC+ countries to the US. This adds further risk and uncertainty to markets already shaken by the coronavirus. In particular, we expect this will impact US corporate capex, and should trigger higher downgrade and default risk for US high grade and high yield credit. It will also probably exacerbate liquidity tensions in the credit markets.
We expect central banks to react rapidly, and inject liquidities to limit the risk of credit crunch.
Assessing the macroeconomic impact is complex as the channels at play are numerous (both external and domestic) and the impacts are difficult to quantify (e.g. supply chain disruptions, “social distancing” and confinement measures). If the epidemic subsides in spring, while stimulative measures both fiscal and monetary continue to be widely announced, the shock to the global economy – while possibly deep – should prove temporary.
Quantifying our main scenario
In the first stage, we estimate the domestic impact of a serious Covid-19 shock to the US economy. To calibrate the “social distancing” impact on US domestic demand, we used a 2005 study from the CBO. This shock subtracts 2% form Gross Domestic Product (GDP) growth over 1 quarter (or alternatively -6% over 1 month), i.e. 0.5% from annual 2020 growth. With activity returning to normal, growth in 2021 would mechanically be boosted by 0.5%.
In a second stage, we added an estimate of the external shock coming from Asia. We introduced a -1.5% fall in Asian GDP into our US macro-model, along with the stock market fall that took place before the epidemic expanded in the US. We also introduced a fall in net tourism income. Such a serious shock would subtract additional 0.6% from US growth in 2020.
As a result, we are cutting our GDP growth expectations in the US to 0.8% for 2020 (from 1.8%) and expect a pickup in GDP growth for 2021 towards 2.6% (“severe flu” but temporary).
As we have for the US, we are also revising our euro area scenario. Our main European scenario takes full account of a virulent strain of influenza and assumes authorities act as necessary to control possible financial disruptions. We reduced our GDP growth expectations in the Euro area to 0.3% for 2020 (from 1.2%) and expect GDP growth to recover in 2021 towards 1.9% (“severe flu”).
Other possible scenarios:
We have to 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 (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 financial vulnerabilities likely leading to a financial crisis. In such a scenario (our “recession” scenario), we assumed the downward shock to be half of what was observed in 2008-09.
In this environment, we expect central banks will continue to be accommodative. The Fed has already cut rates and is likely to do more. In the euro area however, policy room to cut rates further is much narrower. The ECB can cut interest rates a bit further while raising the share of excess liquidity that is exempted from the negative deposit rate, but we expect the impact on the economy would be nil... and the impact on financial stability could even be negative! We believe the ECB is more likely to take more targeted measures in order to facilitate liquidity assistance to Small and medium-sized enterprises (SMEs).
We think that, for the time being, fiscal policy is the main tool to respond to the crisis. In particular, a payroll tax cut and also a profit tax holiday would be a very logical policy response both in the US and Europe as it would quickly provide liquidity to firms.
The market is currently facing two black swans in a few weeks: the spread of a virus with quarantine measures never experimented in modern history and a major geopolitical crisis around an oil price war. This induces major stress on financial markets and leaves few possibilities to hedge risk.
We were overweight equities until end-January and became neutral on the 27th of January. We have been neutral equities since then and have put derivative strategies in place to protect our portfolios against rising uncertainties surrounding the impact and the spread of the new coronavirus. Thus, during the market drop in the second half of February 2020, we already had derivatives strategies in place to mitigate the negative impact. They played their role and reduced our equity exposure in our funds. Since then, we are tactically slightly underweight equities.
We acknowledge the improved risk/reward at today’s prices. After a 16% drop in the US market and more than 20% in the European equity market, we see an additional risk of further 5% to 8% decline on equity markets. This could come from potential renewed selling pressure from risk-managed funds (probably additional significant selling following Monday’s spike in volatility). In addition, negative newsflow could continue to come from virus spread to other countries, and new quarantine measures in big countries. Therefore, we remain prudent but we would gradually start buying at these and lower levels with the objective to remain slightly underweight equity for the moment. In our central scenario, the expected upcoming negative newsflow is already partially integrated in today’s prices.
Beyond equities, the new collapse in the price of oil has severely impacted credit markets. For now, government bonds helped to mitigate the impact of falling stock markets as correlations were deeply negative. Looking forward, the sharp decrease in yields implies that this “natural” hedge in a balanced portfolio will be less effective. We therefore diversify our hedges into other asset classes, such as gold and the Japanese Yen. We are neutral on EURUSD cross in a diversified fund.
We see today two key risks that could lead the market to integrate a more negative scenario and drop more than expected today. Firstly, we will continue to monitor the outspread of the virus and the mortality rates in the different regions. A renewed increase in the number of cases in China and/or an epidemic that would last until the autumn or longer would of course more severely impact the economy and investors’ sentiment. A second risk has emerged this week-end with the oil price war. This could trigger financial and liquidity risks and more severe market price dislocations. We nevertheless expect central bank interventions to avoid a financial/liquidity risk in current context.
Upcoming data on the spreading of epidemic and on recent economic developments indicate that Covid-19 will deal a blow to global growth, but we believe that the shock will be temporary.
Equity markets appear to be resolutely bullish. Nothing seems to have been able to cause the indices to deviate significantly from their upward trend since the start of the year.