COVID-19 – the black swan of our lifetime
The onset of this recession is unique
The spread of the COVID-19 virus to half of the world’s countries weighed heavily on risk assets in February, raising the likelihood of a technical recession in 2020. The MSCI World Index declined some 8.5% in US dollar and 4.0% in rand, while emerging market equities fared slightly better, declining some 5.3% in US dollar and 0.6% in rand. Even before the onset of the virus, the growth outlook for Japan and Italy was already negative, with a recession now a foregone conclusion. The demand- and supply-side shocks to the global economy from COVID-19 have now only served to exacerbate the risk of a full-blown global recession, with no countries likely to be spared the rout from this black swan event. Even though the release of extremely weak Chinese purchasing manager indices data for both the manufacturing and services sectors highlighted the quantum by which global growth could slow, the envisaged recession is different in many respects from a normal recession.
Normal recessions typically originate in the financial payments and settlements system and is preceded by high interest rates. None of these conditions are present in the current environment, although default and liquidity risks in the credit market would need to be closely monitored.
Global growth forecasts
The OECD in its Interim Economic Assessment report has revised global growth lower to some 2.4% for the year, down 0.5% from its November assessment.
Assumptions underpinning this view include a peak in the epidemic in China in the first quarter of 2020 and that outbreaks in other countries prove to be mild and contained. In this instance, Chinese growth slows to 4.9% from 6.1% last year, accelerating to 6.4% in 2021.
However, in the event that the virus outbreak lasts longer and is more intensive, spreading widely throughout the Asia-Pacific region, Europe and North America, global growth could halve to 1.5% in 2020. Given the uncertainty of how the virus will affect global supply-chains and consumer behaviour, consensus earnings revisions will, in all likelihood, be reactionary rather than forward looking.
Although consensus earnings estimates were revised lower in February from the month before, further downward revisions are expected as the virus spreads.
Adding fuel to the fire in March was the oil price war that broke out between Russia and Saudi Arabia. The failure of the OPEC+ countries to reach an agreement on oil production cuts of some 1.5m barrels per day triggered an all-out price war with Saudi Arabia aggressively cutting prices and announcing production increases from April. Russia responded by announcing production increases of its own, causing a collapse in the oil price. Since talks are unlikely to resume before May or June, low oil prices will increase default risks particularly amongst US shale producers. Equity and high yield credit markets collapsed on the news with some equity markets triggering daily down trading limits. At the time of writing, the MSCI World Index had dropped a further 17% since the start of the new month.
A China-led recovery
While infection and mortality rates have dropped sharply in China in recent weeks, signaling the worst may be over in that country, morbidity and mortality rates are rising in Europe, the US and elsewhere. Given a rebound in capacity utilization rates to around 80%, China is expected to lead the economic recovery in the second half of 2020. However, with Europe and the US still playing catch-up to China in terms of the spread of the virus, it could take a further one to two quarters before infection and mortality rates begin to decline in those countries. This would represent a clear signal to the market to up-weight risk assets to overweight given attractive equity market valuations. In the event of a U-shaped recovery, earnings could rebound in 2021 and 2022 as global growth returns to trend.
Global fiscal measures
Many countries across the globe have announced fiscal stimulus measures designed to ease the plight of consumers and producers from a collapse in economic activity. Measures have included the suspension of mortgage payments and other household bills, paid sick leave for hourly workers, extended insurance benefits, tax cuts for small- and medium-sized enterprise (SMEs), and even deferred tax payments for individuals and corporates. Although the Trump administration had pushed for a payroll tax cut until the end of the year, the Democrats pushed back fearing political mileage for the Republicans ahead of the November elections. But bipartisanship will almost certainly result in more balanced benefits for consumers and corporates alike in the coming weeks.
The size of fiscal measures recently announced include GBP30bn in fiscal stimulus from the UK, a 50-basis point cut in rates from the ECB and GBP100bn in SME low-cost loans over the next four years. Germany, in turn, announced deferred tax payments and loans from the state development bank totaling around Euro550bn, a Euro93bn increase on this year’s budget. The government, however, indicated there was no upper limit to the loans, suggesting further increases if needed. Italy and Spain banned short-selling on 154 stocks, while Italy committed Euro25bn in fiscal stimulus.
The US announced USD50bn in National Emergency funding, while the Pelosi Virus Bill provided for two weeks’ paid sick leave, unemployment insurance, free testing and family leave of 12 weeks at 2/3 normal pay. The US Fed, in turn, cut rates twice by a cumulative 150 basis points over the past few days, dropping the base rate effectively to zero, while loans via the discount window were extended for a 90-day period. The Fed also cut the required reserve ratio to zero, while committing a further USD700bn in additional quantitative easing (QE), with some USD200bn earmarked for the mortgage backed securities market. This should help push mortgage rates lower, which have risen in recent days despite the Fed’s initial 50 basis point rate cut. Given these aggressive interventions by governments and central bankers, the world is well poised for a sharp rebound in 2021 once COVID-19 has run its course. The Fed’s earlier announcement of a USD1.5 trillion liquidity injection into the repo market is timely and will prevent a systemic crack in the financial system, while the reintroduction of USD-swaps will ensure sufficient foreign exchange to trading partner countries.
Although the ECB disappointed markets with no further rate cuts, it did expand its QE programme by an extra EUR120bn of bond purchases until the end of the year and launched a programme of cheap loans to banks to encourage lending to small businesses. In addition, its existing targeted longer-term refinancing operations were made considerably more favourable, by offering loans to banks as low as -0.75%, while continuing its EUR20bn monthly QE programme.