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Sitting on the edge between extreme outcomes

In his latest CIO Talk, Group Chief Investment Officer Yves Bonzon summarises all the probabilities and potential consequences for the economy and markets.

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At the beginning of February, developed equity markets reached new record highs, driven by the control of the coronavirus epidemic in China and the macroeconomic stimulus implemented by the government in Beijing. At the end of February, when market participants realised that the epidemic had spread further to South Korea, but above all also to Italy and Iran, this news triggered a 180-degree turnaround in sentiment leading to the fastest decline in the US equity market in history from an all-time high.

We are sitting on the brink between an increase in deflationary pressures that would benefit US Treasury bonds and gold or a normalisation in a context of massive stimulus.

Yves Bonzon, Group Chief Investment Officer

The market integrated the potential consequences on the world economy and measures to contain the pandemic in record time. The closure of one of Europe’s most prosperous regions around Milan and then the whole of Italy is an unprecedented step in peacetime. 

All major market downturns are associated with the fear of losing one’s wealth. The current one is associated with the potential loss of the most important things a person has: their loved ones and their health. The cocktail is perfect for triggering emotional investment decisions. Yet, as Daniel Kahneman’s work (Nobel Prize in economics 2002 for his work on how our brain makes decisions) has taught us, investment decisions taken in survival mode can be costly. Panic is not the answer. Nevertheless, let’s try to summarise what we know, what we don’t know and the potential outcomes. Their extreme nature should more than ever encourage us to think about all the probabilities and potential consequences for the economy and ultimately the markets, without forgetting the positive ones.

The transition from main street to wall street
The world economy has just suffered an external shock that has given it a heart attack. The measures taken to contain this coronavirus pandemic are leading to a contraction  or even an outright cessation of all activities in the sectors that are affected the most, such as tourism, transport or cultural and sporting events. Even if the pandemic peters out within a few weeks’ time, the damage has already been done. Some businesses are facing cash flow difficulties. Cancelled or delayed payments cause a drop in the speed of circulation of money.

We have always feared such a phenomenon: in a context where asset prices and debt levels leave little room for error and manoeuvre for governments and central banks in developed countries, a mistake in monetary or fiscal policy has far-reaching consequences.

We know that a cyber-attack, which would paralyse the Internet for an extended period of time, could inflict such a damage to the economy. We had not considered the possibility that a virus initially similar to a butterfly’s wing flapping on the other side of the world could lead to the closure of the borders of one of the largest countries in the European Union. Developed economies are therefore potentially at risk of a deflationary spiral resulting from the forced liquidation of debts and loans through a forced interruption of activity for major health reasons. Moreover, the impact on the financial markets is set to cause a negative wealth shock to affluent households, with additional consequences on consumption in Europe and especially  in the United States.

There is a feedback loop effect between the economy and the markets these days that we have repeatedly described as ‘the tail is wagging the dog’. As a result, the governments concerned must urgently compensate the loss of income for the most affected private agents by monetising the required amounts and ensuring the functioning of the financial system by avoiding additional systemic stress. This is a tall order.

Austrian school of economics treatment is not recommended for this patient
This crisis already seems to have political consequences in the short, medium and even longer term. It starts with the upcoming US presidential election. Never before have Donald Trump’s re-election chances been affected to such an extent, neither by the trade war nor by the hopeless attempt by the Democrats to impeach the President.

Looking at Europe, some governments might be tempted to let ‘unnecessary’ defaults happen in the fatalistic sense that the private agents most affected should have been more cautious and should have had more reserves to weather such a crisis. This Darwinistic view of the world is intellectually interesting except that in the real world democracy does not necessarily survive the ensuing monetary disorder, hyper-inflation or hyper-deflation. It is important that the theses of supporters of the Austrian school of economics are left in their place, i.e. on the shelves of university libraries.

The market is right but the situation very fluid
As a starting point, we should note that the market correctly assesses the risks to which we are exposed as described above. The uncertainty is immense. The historical market movements we have just witnessed, for example between the long US bonds and the S&P 500 Index, are not an aberration. They reflect the current risks and  uncertainties.

First, the pandemic will subside, but when and after what damage to the economy is unclear. Second, when and how policymakers will respond with measures to counter this shock remains to be seen. Conventional monetary policy is known to be only marginally effective given close to zero interest rates. Moreover, lowering rates does not solve anything when people are losing income. The Federal reserve and the European Central Bank urgently need to monetise. Quantitative easing (asset purchases) is a must. Third, measures to support distressed borrowers and the banks that lend to them are imperative to enable households and businesses concerned to avoid a mechanical default. 

The situation is therefore extremely fluid and the markets could shift for better or worse depending on the evolution of these biological, economic and political parameters. We are sitting on the brink between an increase in deflationary pressures that would benefit US Treasury bonds and gold (preferably in physical form) or a normalisation in a context of massive stimulus that would abruptly revert the stock market trends of recent weeks.

The worst is not certain
What we know is that, while the worst case scenario is not yet priced in, the risk premia and relative valuations of  the main asset classes reflect the current uncertainties. The price of security, represented by 10-year US Treasury yields, hit a low of 0.31% on 9 March and is now very high. The same applies to the price of insurance, with the VIX index hitting 60%, the highest level since the collapse of Lehman Brothers at the beginning of the last financial crisis. The prospective risk premium for US equities exceeds 5% compared to a historical average of 3%. Today, the cost of sleeping well is not only expensive long-term, but potentially also for the not so distant future.

That said, we are hostage to policymakers who should make the right choices and fast. If they fail, risk assets can suffer another de-rating, but the floor should not be too distant, price- and time-wise, as democracy is at stake.