MARKET UPDATE
09th March
2020
The impact of the Coronavirus together with the sudden sharp fall in the oil price (over the last five days down in the region of one third) has seriously concerned financial markets that a significant economic downturn has now already started. For markets the critical question will be at what stage investors feel the situation is being brought under control. In the case of the Coronavirus, primarily from a medical perspective, but where from an economic perspective the consequences of both the virus and fall in the price of oil can be clarified. One lesson from the GFC is that there can be secondary effects when problems in one asset class spreads to have economic impact on another and thus perhaps seemingly unrelated asset classes can suffer serious contagion. Thus, secondary effects in markets also need to be understood.
Dealing first with the Coronavirus, for
investors to feel comfort that things are coming under control, at least one and probably more of the following three things need to happen. There is some level of positive news regarding a vaccine or drug currently under development. Even if widespread distribution was at least a year away, the news would put a timeframe around the global economic downturn, and thus psychologically would be a positive for investors. Many companies, perhaps around 30 globally, are at relatively advanced stage of laboratory testing with outcomes likely to be known over the next 1-2 months. At that point clinical trials can begin, with Phase1 typically lasting for three months. In the case of antiviral drugs, some clinical testing is already underway, noticeably in respect of Remdesivir (which was used to fight Ebola and has shown some success against the virus in preclinical trials or against strains of virus with similar genetic characteristics to COVID-19). Positive news regarding potential vaccines or drugs on their own would likely trigger a short term rally in stock markets, rather than a sustained recovery, given the timeframe for full testing and subsequent production. Positive announcements hitting markets at a time when they are deeply oversold could see a sharp rally as machines or algorithmic traders would rapidly cover market short positions.
When there is evidence that the disease has reached peak intensity of new cases (deaths are a lagging indicator) or the markets can see that this is likely to occur imminently, there is the potential for a market rebound. If countries where the disease impacted earlier start to see a drop off in new cases and a gradual resumption of economic activity it is likely market participants would view this as at least some form of positive sign. China is central to this. While there is always concern about how robust Chinese data is, it does appear outside of Hubei there is a downtrend in the number of new cases and some recovery in activity in manufacturing, although firms are still operating well below full levels of output because many employees still face restrictions on travelling back from the Chinese New Year holidays. Last week Foxconn, which is one of the world’s largest electronic companies and a key supplier to Apple, announced it expected its huge Shenzen facility to be back at full production by the end of March. If correct, and not a politically inspired statement, it is a promising sign. Furthermore, J.P. Morgan’s daily tracking data of goods movements through ports also point to some uplift in economic activity in China, as do increased domestic flights. Other countries which announced severe and stringent containment measures such as Hong Kong and Singapore, which are admittedly small populations globally, have put in place measures which seem to be working at least at this time.
Unfortunately, at present there is no sign the intensity of new cases in the developed world is anywhere near the peak. In fact, the pace of the spread seems to be increasing and it could be argued certain Western governments have been lax in putting in place measures likely to contain the rapid spread of the virus. For now this is likely to have been more impactful on markets than the improvement in the rate of disease spread in China, or even improving economic data from that region. A further concern is that the virus spreads to Third World countries in Africa and Latin America and we have already seen in countries where healthcare is less well developed, such as Iran, the mortality rate is far higher. The contagious nature of this virus with carriers not realising they are spreading the disease, because symptoms have yet to appear, is at least weeks or more likely months away with therefore the potential for deeper and more prolonged negative economic effects. The US in particular seems not to be well prepared for a spread of the virus where evidently testing deficiencies means there is likely to have been an understatement of the spread of the disease. The economic impact of the virus is far wider than the number of reported cases in terms of lost man hours, as a visit to London last week demonstrated. Traffic into central London was very light, there was an absence of tourists and all the leading hotels in London have seen a fall in occupancy rates to 40% or below. Corporates are able to cancel events such as conferences with no loss of deposit and are therefore playing safe and pulling back from commitments months ahead. This will of course have knock on effects on economic activity, as will widespread measures for employees to work at home if this occurs. Another economic impact is that now certain countries and even businesses are not allowing visitors from certain regions, or anyone who has visited those regions in the last 14 days. Some officials in Hong Kong are now calling on a travel ban on anyone who has been in Italy or other infected regions in Europe, and clearly an escalation of these restrictive measures will further impact negatively on global economic activity.
top oil exporter. While Saudi has the ability to win market share from its rivals, its economy is no longer strong enough to remain immune to the financial stress caused by oil at current levels.
One element that may slowdown the spread of the virus is the arrival of warmer weather in the northern hemisphere. Sunnier weather is known to build up immune systems via higher levels of Vitamin D. Furthermore, a study by a team at the University in Guangzhou has suggested that the virus is less effective at spreading in warmer countries, whilst the opposite is true in colder climates. Their preliminary studies suggested the pathogen appeared to spread fastest at temperatures of 8.72oC or lower. After a long period of easier monetary policy it had already become clear prior to the outbreak of the virus that monetary policy alone was becoming less effective at stimulating economies. Today with rates at such low levels it would seem that significant fiscal measures on a global basis are necessary to offer some reassurance that worst case economic impacts stemming from the virus can be avoided. Whilst a number of central banks around the world have announced rate cuts such as the US Federal Reserve, central banks in Asia and in Australia the RBA it has become apparent that this by itself is not going to stabilise markets. In complete contrast to the 2007/2008 downturn it is not weakness in financial markets causing an economic downturn, often referred to as a balance sheet recession, but the reverse. Lower interest rates alone will not do much for economic activity when the downturn is a consequence of both weak demand and also supply disruption, particularly as on the demand side consumers and businesses now lack the confidence to spend.
The collapse in the oil price is another deflationary blow to the global economy at a time when it is least needed. During the previous and most recent collapse in oil and commodity prices in the late 2015 and early 2016 period it was apparent that whilst in theory a low oil price is positive for consumers, at certain levels for the price of oil there are secondary effects caused by countries and corporates facing such financial difficulties credit impairment is likely to occur. The GFC demonstrated that a downturn in one asset class can impact rapidly on others in a globalised and integrated world economy and this is still a fact today. In the US corporate bond market, especially in high yield or junk bonds, the Energy sector had already been showing signs of distress prior to the start of an oil price war. Over the weekend, crude oil suffered its biggest one day fall since the end of the 1990s Gulf War. In response to a lack of agreement at Opec, with the Russians seemingly taking the view that marginal US shale production could be permanently closed by not adopting production cut backs, Saudi Arabia responded by threatening to discount its crude oil and significantly raise production. Saudi has wanted to lead Opec and Russia in making deeper cuts to oil production to support crude prices in the face of the likely reduced demand due to the Coronavirus outbreak. The Saudi’s and Russians had worked as allies to support the oil price since 2016 and now Riyadh seems to want to punish Russia for abandoning the so called Opec + alliance. Saudi also looks to want to cement its position as the world’s
As well as concerns over the credit worthiness of businesses exposed to the oil sector, especially in the US, some countries are highly commodity export dependent and there are rightly concerns about contagion spreading from these areas through the global economy. Commodity exporting countries will see a significant deterioration in their terms of trade as occurred in 2015. Today debt levels post the Financial Crisis are at extremely high levels. Markets have accepted this as low rates meant debt affordability was not a problem. Significant loan impairment could result in tightening of credit standards with a knock on effect throughout the wider economy outside of commodity related areas. A combination of both fiscal and monetary measures globally is important to forestall fears that the downturn in economic activity if prolonged could start to impair the integrity of the financial system. As mentioned the debt to GDP ratio globally is at an all-time high, with particular concern over the huge rise in corporate debt since the GFC. Credit standards amongst corporate issuers has declined (lower quality covenants) and in certain sectors in high yield stresses were starting to appear. Credit spreads are likely to continue to rise in the short term, especially in sectors with economic difficulties and investors should remember that in high yield one of the reasons default rates are low is that refinancing is readily available. In a world starved of yield this has been a persistent trend post the recovery from the Financial Crisis and a significant deterioration in the ability of corporates to raise fresh borrowing would have knock on effects globally. Today leading banks are in a much stronger capital position to absorb defaults on corporate loans, but investors need to watch to ensure a wider credit crisis does not develop down the road. If this did happen, needless to say it would have an extremely damaging effect on stock markets.
CONCLUSION The Coronavirus has a number of concerning features, it appears to be extremely contagious and can be transmitted by people showing no symptoms (asymptomatic). There is evidence that it can re-occur in previously affected patients, although whether they will be contagious again has not yet been resolved. To date the mortality rate is low outside of Third World countries but is significantly worse than influenza. The main problem with the disease is its rapid rate of spread and there have been some predictions that it will increase at a tenfold rate globally every 19 days. These characteristics mean that there is the potential for a prolonged and severe hit to economic activity globally, in other words a recession. As a result it is impossible to rule out significant further falls in stock markets notwithstanding the sharp declines to date. Shorter term equity markets are oversold but valuations in absolute terms are not yet at bargain basement levels, especially with so much uncertainty as to what corporate earnings actually will be. Equity markets have been able to live with higher valuation levels due to a belief that corporate profitability will remain robust. While this at first sight seems a gloomy outlook, investors should remember that markets will react quickly to any sign of better news. The economic disruption from the Coronavirus now has to be combined with the effects of an extremely low oil price on economic activity. This will clearly impact certain countries and sectors much more seriously than others and it is therefore important to gauge whether contagion effects from this negative oil price shock impair credit quality to such an extent that wider sectors are impacted. A further important driver of short term volatility is the market impact of risk parity funds and algorithmic trading with losses forcing other short-term market participants to sell. In commodities particularly oil forced margin selling could be substantial. Some corporates and investors could be placed in serious financial difficulty by the speed and pace of price falls which can result in market correlations rising and selling patterns unrelated to fundamentals. Markets hate uncertainty as was seen during both gulf wars and also the more recent Brexit process. An outcome affording some sort of visibility on corporate earnings and the lower discount rate applied to these earnings (even if not appearing to be good news) is necessary for a sustainable market rally both regarding the impact of the coronavirus and the fall in the oil price. STRATEGY TEAM IRC 09.03.20