During sporadic outbreaks of the bird flu, we used to shoo our feathered friends indoors. Now it seems the chickens have come home to roost – this time around, it’s us who are confined to narrow quarters. We have turned into an army of ghost workers trying to keep the demons at bay. Some of us will appreciate the additional time with their families, others will miss their colleagues – but all of us face the possibility of human suffering and economic hardship.
While our red-hot telecommunication lines still connect us to the outside world and grant access to analyzing tools, let’s recap what happened in the past few weeks. The quick-fire spread of the new coronavirus took us by surprise, upending our moderately optimistic growth scenario for 2020 supported by favorable data until very recently (see the March edition of the Investors’ Outlook). Particularly worrying to us was the unprecedented and almost simultaneous collapse of global supply and demand. Our central scenario for 2020 has changed to a “sharp slowdown”, and we now expect the economy to shrink in most countries (see chart 1). The best we can wish for is a massive yet temporary shock. All other possible developments seem even more dismal.
To put this pandemic and its possible consequences into perspective, we need to take a bird’s eye view covering the 2008-2009 aftermath of the collapse of US investment bank Lehman Brothers, the “Black Monday” event of 1987, and the Great Depression in the 1930s. These three examples stand for the basic categories the health crisis could fall into: an event-driven shock, a cyclical downturn, and a structural breakdown, listed in the order of severity. Technical analysts would point out that the sell-off during the past few weeks mirrors the fall on stock markets during the initial phase of the three examples mentioned above. In theory, each of the three scenarios could come to pass.
An event-driven shock is a clearly identifiable incident – the current pandemic, a war, a natural disaster, or a multiple-day power cut – resulting in a market rout, usually followed by a flight to quality. For instance, investors transferred funds into safe havens after the “Black Monday” slump that was triggered not by one, but a series of negative developments. In October 1987, high US trade deficit figures, among others, put pressure on the US dollar as well as stocks, causing a sudden mood swing and eventual panic selling. In such an environment, equities and corporate bonds typically post losses while government bonds, gold, the Swiss franc, and the Japanese yen, gain ground. Event-driven shocks are, for the most part, completely unexpected. For all the harm they can cause, they remain transitory events if governments and central banks respond appropriately.
What distinguishes a cyclical crisis from an event-driven one is that the former puts economies and markets under stress for a long time. For instance, the global economy took years to recover after the financial crisis of 2008-2009. A cyclical crisis typically occurs at the peak of an economic cycle, as was the case in the early 2000s, and the financial crisis ten years ago. Whether we are already transitioning from a shock to a cyclical downturn is anybody’s guess. Recent panic selling suggests the more negative outcome, but there have also been notable intra-day gains. Were the worse scenario to materialize, the sell-off would continue. In such a case, the outbreak of the new coronavirus would have been the straw that broke the camel’s back, ushering in a period of more than one year of economic woes.
The economic doomsday scenario would be something resembling the Great Depression of the 1930s that resulted in mass unemployment and a decade-long bear market. Those catastrophic events were exacerbated by the authorities’ lack of experience and coordination – the US Federal Reserve, established only a few years previously in 1913, didn’t support markets in a way they do today. We currently see no indication of a structural breakdown, partly because decision makers have realized how serious the Covid-19 outbreak is. Hardly a day goes by without some central bank or government announcing huge stimulus packages for their economies (see chart 2). This is the main difference to the 1930s, which will also be remembered for authorities’ inaction.
Before things can start looking up, the rate of new infections with Covid-19 must slow in the coming weeks, especially in Europe and the US. Because corporate bonds will probably need to recover before stocks can rebound, credit spreads and credit default swaps (CDS), a measure for the cost of insuring against a counterparty’s default, will be important to watch. Moreover, yields on government bonds issued by southern European countries need to move lower and stay contained. Such data will tell us whether the steps by central banks and governments are effective, and whether markets believe they will ensure sufficient liquidity supply, and keep defaults under control.
Psychology will play an important role: bans and restrictions on our daily lives must be lifted towards summer at the latest, and government-led support needs to be credible enough to reassure the population. After all, who would spend money on anything fancier than food or rent without some confidence of getting paid three months from now? By contrast, a massive increase in defaults and unemployment rates could spook the markets, and concerns over bad loans could infect banks.
Earlier in March, we changed our equity positioning to underweight. This unusual stance seemed sensible while traders were hitting the panic button. But given that many shares are now at attractive levels, we have adjusted this negative equity view slightly, going neutral on developed-market stocks but keeping emerging-market ones on underweight. On the fixed income side, we overweight corporate paper versus sovereign bonds. The incoming liquidity flood will reassure companies seeking financing, calming fears of spiraling defaults. This will also benefit the corporate bond market. As we expect the US dollar to weaken over the coming months, and the easy fiscal policies adopted globally to increase governments’ debt-to-GDP ratios, we upgrade gold to overweight.
As changes in our investment strategy do not require a physical presence, we will try to keep the doors of our chicken coops tightly shut until further notice. However, we hope to burst into the open in summer as if waking from a bad dream full of black swans and other unwelcome guests.