Friday, 13 March 2020

We are facing an increased volatility in equity markets across the globe.  It seems that every day there is a new precedent set by a shockingly fast sell-off in the market or new historically low bond yields.  However, despite the significant health concerns around the world, we believe both are pricing an economic scenario that seems too negative.

Despite the wall of worry that is upon us, we believe it is a good time to step back and consider the major factors impacting today’s markets.

First and most importantly is the novel Coronavirus.  Initially, the disease was relatively localized to China where it eventually brought the world’s second largest economy to a halt.  However, it has now entered into a new phase of expansion outside of China, which the WHO has now officially declared a global pandemic.  While many economies, including our own, are yet to fully know the repercussions it is important to remember that this disease is impactful, but likely does not have the mortality we initially feared. 

Data from places like China, South Korea, Singapore, and Japan appear to indicate the behavior of the epidemic is following the same pattern as many other contagious diseases.  We are not doctors nor do we pretend to be, but we do know data.  All of these countries are reporting that there is a repeating process at hand.  The disease is spreading, peaking and then diminishing.  The patterns are the same but happen at different rates depending on the process adopted by those countries to deal with the epidemic.  This pattern is telling us there will be an end to this event and our ride to the other side may be bumpy, but it is manageable.   

Economically, there will be impact to both demand and supply.  We have already seen how the supply side has struggled all along the value chain given the shock to the, manufacturing sector in China. Italy is also seeing supply-side pressures as they face draconian containment measures.  While supply has been drastically reduced, we can also add in a reduction in aggregate demand.  The impact to all is seen in a dramatic reduction in traveling, entertainment, and broadly in the service sector in general. 

While understanding the impact of these changes is difficult, we know that it mainly depends on the magnitude and length of this event; this will depend on the varying degree of containment measures of government and institutions. 

Regardless, the impact is already in place around the world.  As we analyze economies further ahead than ours, we believe the appropriate operating assumption is that the virus is likely to peak sometime before the summer and diminish over the following few months.  Should this occur, the impact of the virus will diminish in the second part of this year with a significant amount of stimulus behind the economy.

Second is the unexpected price war between Russia and OPEC.  In the midst of all of the global chaos and fear, global economies were thrown a major curveball.  Through the recent global slowdown, oil demand was already weak, but prices were contained by supply cuts managed by OPEC (especially Saudi Arabia) and Russia.  The recent events with both countries focusing on market share and liberating production added another element of turmoil in the financial markets.   

Oil price declines cause two different results.  One related to oil producer companies and countries.  Both of these will face financial difficulties.  In this environment, oil producing countries and companies will fare drastically different, depending on the indebtedness level and profitability.  At this juncture we worry about credit spreads and ratings, especially high yield and some EM oil producers, putting additional pressure on credit spread and increasing the probability of defaults.   However, on the other side oil price reductions, consumers around the world will generally benefit from lower costs.  This can boost aggregate demand through consumer spending.

While oil may drift lower, we believe it is reasonable to expect this issue to also be transitory and oil to rebound to $40 by the end of 2020 and around $50 at the end of 2021 as the effects of Coronavirus on demand recede. However, prices are expected to remain low as the price war between Russia and Saudi Arabia could extend well beyond the duration of the pandemic. 

The last, and maybe the most difficult risk to pin down at this time, is whether or not these events have caused a persistent shock to consumer and investor confidence.  Market volatility can create a scenario in which confidence, wealth effects, liquidity, and credit (especially in the energy sector) could also cause an impact itself (reflexivity), creating a vicious circle in the real economy.  This factor we caution against.  Extrapolating current events beyond their reasonable lifespan can lead to erroneous conclusions.

It is important to take a minute to step back and think about where we are and compare it with other major economic shocks, such as 2008.  There are no major structural imbalances, and without being comprehensive, we must assert that the financial system in the US and in Europe, as well as in the real estate sector, are in a stable and healthy position.   Given that there is not much room for public policy stimulus, the response up to now from major central banks, especially the Federal Reserve, has been quick and relevant.  Now, we are also starting to see fiscal stimulus around the world in China and Europe with the US to follow closely behind.

In conclusion, for markets to stabilize, we need to see that the epidemic is under control, and that stimuli around the world are effective, and promptly executed.  These conditions are likely to buffer the impact on economic growth and provide liquidity to companies and individuals affected.   Clearly the macro scenario and risk perspective have changed in the short term. That said, if anticipated epidemic containment measures are effective and the macroeconomic policy is implemented adequately, providing liquidity, access to resources and stimulus, then there is reason to believe and the long-term market impacts will be transitory.

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