In addition to the rapid evolution of the Coronavirus epidemic outside China, market participants witnessed a breakdown in talks between Russia and OPEC, followed by Saudi Arabia’s announcement it would increase oil production. Candriam has revised its economic outlook scenarios and assessed the impact on asset allocation.
Evolution of the epidemic
- Is China ex-Hubei a reasonable model?
The Covid-19 epidemic has continued to spread outside China but appears to have peaked in mainland China in mid-February 2020. Control measures, such as Italy’s shutdown over the weekend or the confinement in Wuhan, are being taken to slow the spread of disease and reduce the burden on hospitals. The alternative would be an uncontrolled transmission scenario in which emergency rooms, intensive care units and other parts of the healthcare system would be overwhelmed. In such a system, mortality rates would be much higher and those infected may not receive the treatment they need. Hence, protective measures are not about the ‘ego’, but about public health.
Places that identify cases more rigorously appear to report lower death rates. China outside the province of Hubei shows a fatality rate of 0.9% as of March 9, 2020 (source: Johns Hopkins CSSE data). South Korea (0.7%) and the Diamond Princess cruise ship (0.9%) also performed extensive testing regimes for Covid-19 and relatively lower death rates. This implies that the current global fatality rate of 3.4% is likely overstated and could decline over time: high fatality rates might reflect low testing and/ or an overburdened healthcare system.
Looking forward, we maintain that the coronavirus will turn out to be a temporary shock. Currently, the measures that will minimize the human cost of the outbreak are likely to maximize the economic cost. Supposing strict quarantine measures similar to those in China are taken elsewhere, outbreak dynamics for South Korea, Italy, and Japan may plateau in about one month, as it did in China. The virus is likely to continue to spread within other European countries and the US with the same diffusion risks and quarantine measures to come. Hence, in the short term, economic growth will be below initial expectations, justifying our short-term caution. But signs that countries are able to contain the outspread of the virus will be key for market sentiment.
Oil price shock
- Oil Producers and Financial Markets: Who Blinks?
Last Friday, Russia refused to sign up to additional cuts proposed by OPEC oil producers. As a consequence, Saudi Arabia has decided to increase its oil production and launched an all-out oil price war. Oil prices fell by 30% on Monday. The first target, and victim, will be US shale producers, with some of them unlikely to survive at current oil prices. It is of note that this price war follows an unprecedented loss of market share of OPEC+ countries to the US. This adds further risk and uncertainty to markets already shaken by the coronavirus. In particular, we expect this will impact US corporate capex, and should trigger higher downgrade and default risk for US high grade and high yield credit. It will also probably exacerbate liquidity tensions in the credit markets.
We expect central banks to react rapidly, and inject liquidities to limit the risk of credit crunch.
Adapting the economic outlook
- Our new scenario for the US and the euro area
Assessing the macroeconomic impact is complex as the channels at play are numerous (both external and domestic) and the impacts are difficult to quantify (e.g. supply chain disruptions, “social distancing” and confinement measures). If the epidemic subsides in spring, while stimulative measures both fiscal and monetary continue to be widely announced, the shock to the global economy – while possibly deep – should prove temporary.
Quantifying our main scenario
In the first stage, we estimate the domestic impact of a serious Covid-19 shock to the US economy. To calibrate the “social distancing” impact on US domestic demand, we used a 2005 study from the CBO. This shock subtracts 2% form Gross Domestic Product (GDP) growth over 1 quarter (or alternatively -6% over 1 month), i.e. 0.5% from annual 2020 growth. With activity returning to normal, growth in 2021 would mechanically be boosted by 0.5%.
In a second stage, we added an estimate of the external shock coming from Asia. We introduced a -1.5% fall in Asian GDP into our US macro-model, along with the stock market fall that took place before the epidemic expanded in the US. We also introduced a fall in net tourism income. Such a serious shock would subtract additional 0.6% from US growth in 2020.
As a result, we are cutting our GDP growth expectations in the US to 0.8% for 2020 (from 1.8%) and expect a pickup in GDP growth for 2021 towards 2.6% (“severe flu” but temporary).
As we have for the US, we are also revising our euro area scenario. Our main European scenario takes full account of a virulent strain of influenza and assumes authorities act as necessary to control possible financial disruptions. We reduced our GDP growth expectations in the Euro area to 0.3% for 2020 (from 1.2%) and expect GDP growth to recover in 2021 towards 1.9% (“severe flu”).
Other possible scenarios:
We have to underscore that the nature of the COVID-19 shock and uncertainty around any forecast is unusually high at this stage. In our main scenario, we have assumed the shock to the economy is temporary (a couple of months). But we cannot exclude either a shorter, nor a longer, flu episode. In this latter case, the impact on the economy is likely to be much more severe, with financial vulnerabilities likely leading to a financial crisis. In such a scenario (our “recession” scenario), we assumed the downward shock to be half of what was observed in 2008-09.
- Policy response
In this environment, we expect central banks will continue to be accommodative. The Fed has already cut rates and is likely to do more. In the euro area however, policy room to cut rates further is much narrower. The ECB can cut interest rates a bit further while raising the share of excess liquidity that is exempted from the negative deposit rate, but we expect the impact on the economy would be nil... and the impact on financial stability could even be negative! We believe the ECB is more likely to take more targeted measures in order to facilitate liquidity assistance to Small and medium-sized enterprises (SMEs).
We think that, for the time being, fiscal policy is the main tool to respond to the crisis. In particular, a payroll tax cut and also a profit tax holiday would be a very logical policy response both in the US and Europe as it would quickly provide liquidity to firms.
Assessing the asset allocation
- We are tactically underweight equities but acknowledge improved risk/reward
The market is currently facing two black swans in a few weeks: the spread of a virus with quarantine measures never experimented in modern history and a major geopolitical crisis around an oil price war. This induces major stress on financial markets and leaves few possibilities to hedge risk.
We were overweight equities until end-January and became neutral on the 27th of January. We have been neutral equities since then and have put derivative strategies in place to protect our portfolios against rising uncertainties surrounding the impact and the spread of the new coronavirus. Thus, during the market drop in the second half of February 2020, we already had derivatives strategies in place to mitigate the negative impact. They played their role and reduced our equity exposure in our funds. Since then, we are tactically slightly underweight equities.
We acknowledge the improved risk/reward at today’s prices. After a 16% drop in the US market and more than 20% in the European equity market, we see an additional risk of further 5% to 8% decline on equity markets. This could come from potential renewed selling pressure from risk-managed funds (probably additional significant selling following Monday’s spike in volatility). In addition, negative newsflow could continue to come from virus spread to other countries, and new quarantine measures in big countries. Therefore, we remain prudent but we would gradually start buying at these and lower levels with the objective to remain slightly underweight equity for the moment. In our central scenario, the expected upcoming negative newsflow is already partially integrated in today’s prices.
- How to hedge portfolios in current circumstances?
Beyond equities, the new collapse in the price of oil has severely impacted credit markets. For now, government bonds helped to mitigate the impact of falling stock markets as correlations were deeply negative. Looking forward, the sharp decrease in yields implies that this “natural” hedge in a balanced portfolio will be less effective. We therefore diversify our hedges into other asset classes, such as gold and the Japanese Yen. We are neutral on EURUSD cross in a diversified fund.
- What if… we are wrong?
We see today two key risks that could lead the market to integrate a more negative scenario and drop more than expected today. Firstly, we will continue to monitor the outspread of the virus and the mortality rates in the different regions. A renewed increase in the number of cases in China and/or an epidemic that would last until the autumn or longer would of course more severely impact the economy and investors’ sentiment. A second risk has emerged this week-end with the oil price war. This could trigger financial and liquidity risks and more severe market price dislocations. We nevertheless expect central bank interventions to avoid a financial/liquidity risk in current context.