Virus update: In the eye of the storm – Special Report


Marios Hadjikyriacos, XM Investment Research Desk

With world stocks collapsing and entire economies going into lockdown, everyone is wondering how much worse this crisis can get and how long it will last. In a nutshell, the situation will probably get worse before it gets better, both in financial markets and the real economy, as most of Europe and America are still far from ‘peak virus’. Ultimately, this shock will subside and given the overwhelming stimulus measures lately, the market rebound could be meteoric. However, we might be months away from that point, and for now, the Japanese yen and gold look quite attractive.  

Recession fears

Financial markets are in absolute chaos. The coronavirus continues to spread rapidly across the globe, igniting fears of a deep recession as consumers are told to stay home and demand collapses. The biggest European economies – Italy, France, Spain, and to a lesser extent Germany – have gone into full lockdown to slow the outbreak, and it might be just a matter of time until America follows along.

While necessary, these measures will paralyze economic activity over the coming months, having a devastating impact on industries like tourism, airlines, and anything related to entertainment, from bars to cinemas to cafes. Although most governments have announced sweeping stimulus measures to support smaller businesses, ranging from wage subsidies to loan guarantees, there’s only so much that fiscal policy can really do to negate this shock. And the longer the shutdowns last, the bigger the damage will be.

Central banks have taken even more powerful steps to cushion the impact, but unfortunately, monetary policy is the wrong antidote for a crisis like this one. Slightly lower interest rates won’t lift demand in a situation where consumers are stuck at home.

Hidden risks

Beyond the first-round shock to demand, there are feedback loops to worry about too. Consider what happens if this pandemic is prolonged enough for corporations to start laying off employees, exacerbating the demand shock.

Or imagine how long it will take, after the lockdowns are lifted, for consumers to truly regain confidence. Would you go to a restaurant the following day, or ‘play it safe’ and wait longer?

Or what the long-term impact will be on the industries that will need bailouts – most clearly the air travel sector.

Worse yet, an event like this is exactly what reveals hidden market distortions. How many companies have overborrowed in the past decade to take advantage of rock bottom interest rates and might now face bankruptcy as their cash flow dries up? To borrow a line from Warren Buffet: “only when the tide goes out do you discover who’s swimming naked”.

How long does it last?

That’s the central question. Locking a country down for two weeks is completely different than a two-month shutdown. Remember, these are quarantines we are talking about, meaning an almost complete halt in economic activity, not a mere slowdown. In most of Europe, you can’t even get a haircut today.

Unfortunately, nobody knows how long things will stay shut. The assumption is that this will last around two weeks, but the risk is clearly a more prolonged shutdown. To get a sense of when most of Europe will re-open, look at Italy. It was locked down first, meaning it’s likely to reopen first. As for the US, the virus spread there last and the American government has taken fewer steps to contain the outbreak, so it will probably be the last region to come out of this.

Remember that Wuhan, the Chinese city where the virus first appeared, has been in lockdown for 7½ weeks now despite dramatically lowering the number of new infections. Relaxing lockdowns too early could lead to renewed waves of infections, according to some commentators.

Overall, the longer things stay shut, the bigger the economic pain and the less effective any stimulus measures will be in nullifying the damage. Governments can support small businesses for a few weeks, but can they do it for several months – especially in EU countries with already high debt?

Other scenarios that might hinder a quick recovery are the possibility of additional waves of infections over the next 12-24 months or a mutation of the virus that would make the fight against it even harder.

Worse before it gets better?

All told, the situation might deteriorate before it improves, and a recession seems all but inevitable – at least in Europe – as supply chains take a severe hit and consumption craters.

In financial markets, although stocks have already collapsed, things may still get uglier. Investors are still ‘flying blind’, as they are merely guessing how big the impact will be. Once official data for March reveal the extent of the damage and multinationals start to downgrade their earnings guidance, market sentiment could sour further.

Recession concerns are intensifying, and if the Fed slashing rates by 100bps and restarting its QE programme couldn’t lift the US market, it’s difficult to see what will in the short-term outside of an improvement in the virus saga.

Even more so because the fiscal policy responses have been inadequate so far. The European Commission just announced a fiscal package worth 1% of GDP, which is underwhelming consider the scale of this shock. In the US, Congress is trying to deliver a much bigger package, but with the House on a recess to protect lawmakers from the virus and with partisan deadlock in Washington during an election year, it could be a while until anything is approved.

Gold and yen look attractive here

It’s not just that both are traditional safe havens. Both assets also benefit from low interest rates, and central banks around the world are cutting rates like there’s no tomorrow. Gold for example, which pays no interest to hold, becomes more attractive when bonds yields are also near zero, or negative. Similarly, the Bank of Japan already had the biggest stimulus program globally, so the more other central banks cut their own rates, the more attractive the yen becomes as rate differentials between Japan and the rest of the world narrow.

Gold hasn’t behaved like a safe haven lately, but that could change. The losses in bullion are owed mainly to a ‘liquidate everything’ approach. With leveraged funds absorbing heavy losses in stocks, many players are likely forced to close (profitable) positions in gold to cover margin calls. However, in an environment characterized by fear and zero interest rates, gold will probably shine again before long.

On the opposite side of the fence, commodity currencies – especially the Canadian and Australian dollars – look highly vulnerable, even after their recent losses. These economies will likely suffer most as the virus kneecaps global consumption, and the loonie could be hit the hardest, as collapsing oil prices ravage Canada’s energy sector.

But ultimately, the sun will shine again

Looking beyond the next few months, this storm will pass, and the financial markets will probably lead the real economy in rebounding.

The question is, what will be the ‘trigger’ for a sustained recovery? The obvious one would be a vaccine or a drug that can treat the virus – that would be a game changer for sentiment. However, medical experts warn it could take several months before a vaccine is developed, and many more before it’s tested, and mass produced. Therefore, the vaccine looks to be a story more for 2021 rather than 2020.

More likely, the selling could take a breather in a few weeks as the draconian quarantine measures in Europe start to take effect and new infections slow down. Many believe the warmer weather in the spring could also slow the contagion, but there’s no real evidence of that yet. The fact that African and Latin American countries with warmer temperatures have reported fewer cases might come down to a lack of testing. South Asian countries, which are hotter this time of year, are still reporting outbreaks albeit more moderate ones than Europe for now.

Once sentiment turns around, the ensuing rally could be just as meteoric as the recent meltdown, considering how much liquidity has been pumped into the system lately and unprecedented fiscal stimulus measures worldwide. That said, we might be far from that stage still.