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Extraordinary circumstances require a very ordinary approach

When the circumstances we face become extreme, the temptation to panic is great. As Daniel Kahneman, the great psychologist and Nobel Prize winner, explained, the human brain is subdivided between a fast brain focused on the risks to our survival and a slow brain useful for grasping complex problems. Now more than ever, it is crucial to apprehend the situation with our slow brain.

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Use your slow brain
Daniel Kahneman is a psychologist and Nobel Prize-winning economist, who focuses his research on choices and decisions. According to the scientist, the human brain is subdivided between a fast brain focused on the risks to our survival and a slow brain useful for grasping complex problems.

The current pandemic scenario touches us emotionally at the heart of our most precious asset, our survival. Nevertheless, more than ever, it is crucial to apprehend the situation with our slow brain. Uncertainty has rarely been so extreme. Nevertheless, we believe that a calm approach is the most effective one to protect our wealth in the medium-term. So let’s use our slow brain and review what we know, what we don’t know, and what the markets discount at current prices.

Well-functioning markets
Since the last week of February, trading volumes have approximately doubled in the markets. To date, markets have functioned normally, providing investors with the ability to transfer risk and adjust their positions to developments in a rapidly changing environment. The market impact of investment pools trading large sizes seems moderate so far. From this point of view, evidence confirms that we do not have a systemic risk problem, at least not yet.

Is Italy trying to break its fiscal straightjacket?
In Italy, faced with a rapid rise in coronavirus deaths, the government has decided to quarantine nearly 16 million citizens.

The decision is obviously unprecedented in peacetime. As we discussed last week, governments face a dilemma between the measures needed to contain the spread of the virus as quickly and effectively as possible and the risk of killing the economy. 

No one can answer this question even in a vague manner, as the biological phenomenon is so unpredictable. The measures decided this weekend by the Conti government are so radical that one wonders whether Rome is not trying to kill two birds with one stone. Indeed, Italy could both contain the epidemic and break the fiscal straitjacket imposed by the European Union, as exceptional circumstances require massive support from macroeconomic policies. 

This COVID-19 crisis will not be without political consequences in the near future. It could, as already mentioned, accelerate the transition to non-orthodox macroeconomic policies such as negative taxes. However, these political consequences will not be discernible either quickly or easily, which will maintain volatility in the markets for an extended period of time. Please brace yourself for more ups and downs (ups as well, no typo).

Oil-producing nations inflict a second shock to the world economy
It constitutes an additional external shock at a time when the capital structures of oil companies are already under significant pressure. In any case, the shock to the economy worsens in the short-term as the credit crunch intensifies and, with it, deflationary pressures. 

Demand for oil has been reduced while supply will increase as a result of the Saudi reaction. The situation is similar to the 1973 oil crisis, but in reverse! Given the damage it will inflict on the US shale oil industry, Washington’s reaction may be interesting. 

The energy sector was already under stress before the latest events and a collapse in the oil price below USD 30 a barrel will lead to many credit defaults, if it does not recover quickly. In turn, the high-yield bond sector will suffer from the fund and ETF redemptions that can be expected. In the medium-term, however, the economies of oil-importing countries will benefit from lower energy prices, which will support household disposable income. Not everything is negative.

The (negative) wealth effect will start to play out
Added to the list of problems that the coronavirus has triggered is the negative wealth effect. Developed economies, especially the United States, have indeed become sensitive to changes in wealth caused by sharp rises or falls in the prices of financial assets.

At recent highs, the US equity market alone accounted for around USD 30’000 billion in market capitalisation. Each 10% drop in the market therefore represents a loss of wealth of USD 3’000 billion. 

The effect on the economy and in particular on consumption cannot be underestimated from a certain level onwards. We reiterate our view that the Federal Reserve will be forced to intervene decisively, including by buying shares, if we reach levels below 2,400 points on the S&P500 index.

No easy fix to the credit crunch
As already mentioned in these columns, the unique nature of the problem is that a pandemic confronts the global economy, which makes fiscal or monetary intervention ineffective, as long as the spread of the virus is not under control. The more damage is inflicted on the economy in the short-term, the faster the epidemic will be contained, but the higher the risk premiums in the markets will be in the immediate future. 

At most, policymakers can ensure relative stability in the markets in order to prevent the negative wealth effect and the fall in the speed of money circulation in the financial system from worsening. They should show determination to ensure a swift recovery by the time the virus goes dormant again.

Extraordinary circumstances require a very ordinary approach
Everyone realises, I think, the exceptional but above all unprecedented nature of the current health crisis and the risks it poses to the world economy and even to the world order. Faced with such a situation, the temptation to believe the Cassandras is immense. In reality, the only certainty is that market visibility has rarely been so low. We are fundamentally hostage to the time it will take to contain this coronavirus, allowing a return to normal. At the time of writing, the situation has gone beyond the simple context of a temporary adjustment of risk premiums. Some assets in the oil sector or in tourism, transport or events industries are definitely impaired.

Unlike in the financial crisis of 2008, where the main uncertainty was when the policymakers would make the required decisions (they did so in March 2009), in the current case nobody knows how the epidemic will develop. Moreover, no one knows what the political consequences of current events will be. While the virus may continue to spread, requiring more measures damaging the economy, markets have significantly discounted this scenario in record time. The spring is getting compressed and it is important to remember that it can get released violently at the first signs of a downturn in the epidemic.

Three recommendations
We have three recommendations to share in the present circumstances:

  1. Pay particular attention to distinguish between assets that are or will be durably or definitively impaired by this crisis and those only experiencing a temporary change of valuation
  2. In the face of this maximum uncertainty, the fall-back position is the strategic asset allocation of a portfolio, not cash
  3. Gold is not an effective hedge as long as counterparty risk does not rise. US Treasuries are a better hedge.