Conditions for reducing deep tail risks now.
Simplistically, for asset markets to recover sustainably from the current crisis, we think the market will need to be able to put limits on the tail risks that are currently centre-stage and for new tail risks not to surface. The broad challenge is that this crisis is unique in its source and speed – rather than starting in the financial system and emanating out to the real economy, it begins with a sudden stop in the real economy and works its way into financial markets – and it is still possible to imagine scenarios where the stop is longer and leads to much larger economic losses than in our own central case. At a high level, we see six conditions that we think would allow the market to define limits to that uncertainty on some key dimension of the problem.
1. A stabilization or flattening out of the infection rate curve in the US and Europe.
After a period of reluctance, the major DM economies have now moved towards much more stringent quarantine and social distancing restrictions. The outperformance of Chinese equities in February suggests that even without clear signs of an end to economic damage, markets may respond to signs that containment measures are beginning to work. Until we see durable progress on that front, it will be hard to anticipate that recent restrictions — and the hit to economies that they bring — might be lifted, which we think is a minimum condition for understanding the depth of the shock. At this point, infection rates are still rising rapidly in large parts of the US and Europe, and there are some worrying signs of renewed infections in parts of Asia.
2. Visibility on the depth and duration of disruptions on the economy.
As many of the major economies now move to more dramatic disruptions, the precise extent and timing of the economic damage is also highly uncertain. The hit to activity in China’s January/February data was extremely large. Will Western economies experience declines of similar depth? We would emphasize that duration is critical in this current episode. If disruptions are as large as we expect them to be, the difference between a 2 month and a 6 month period where they are in force is highly material in economic terms. Our current forecasts assume that the peak impact on US activity from the latest round of disruptions will be in April, with monthly GDP around 10% below where it would otherwise have been and a gradual recovery thereafter. But it will be hard to be confident in either the depth or duration of that trough without seeing signs that we are reaching one, particularly since there may be multipliers to the initial shock. It may be that enough progress on the infection rate or a sufficiently aggressive policy response is enough for the market to move ahead of this point. But we doubt that it will be able to sustain moves without validation from the macro data. With the data not yet reflecting the disruptions themselves, this point may be some way off.
3. Sufficiently large global stimulus.
Market troughs are characterised by both a stabilization in data but also a strong policy response that finally gets ahead of the deterioration in the data. In the GFC, for instance, the dramatic under-writing of credit risk by the Fed, a path towards strengthening bank capital, alongside monetary and fiscal stimulus (importantly from China, not just the US) were enough to stabilize parts of the risky asset complex in late 2008 (three months ahead of the equity bottom). The current policy response is also beginning to become more urgent and more broad-based. DM central banks have cut rates pre-emptively, initiated or expanded asset purchases and started or restarted lending programs to aid the flow of funding and credit. But the role of central banks as lenders of last resort will likely need to be broader and more unconditional. And while fiscal responses are now focusing, appropriately, on income replacement, business disruption and credit risks, with the overall US package now likely worth 5% of GDP, they still generally assume a relatively short period of disruptions to the economy. These are all moves in the right direction, but we doubt that they yet cover all that will be needed. More comprehensive backstops to business lending and perhaps to state and local finances are likely to be needed. In the process, we may find that not all governments can easily expand the public sector balance sheets if the size of the needed bailouts increases sharply.
4. A mitigation of funding and liquidity stresses.
Beyond the economic shock, funding stresses and liquidity problems have also taken centre stage, adding to the economic risks. The two problems are distinct. The funding issues, such as front-end Dollar funding shortages, are reminiscent of those from the GFC and central banks are quickly moving to reinstitute the programs and swap lines that stemmed that damage then. Market dysfunction has been as much about liquidity as funding, however. With post-crisis regulations reducing the ability of financial institutions to intermediate, many fixed income markets are struggling to process the large risk transfers that are required as investors adjust portfolios. In corporate credit, munis and parts of the Treasury market, market illiquidity has become a major issue. ETFs that provide daily liquidity against these markets have also traded at large discounts, reflecting the underlying difficulties of transacting. The Fed’s decision to resume Treasury purchases was aimed in part at alleviating some of these stresses at the heart of the bond market. And the BoE and ECB have resumed or expanded their corporate purchase programs. But unless central banks expand their role as “purchaser of last resort”, as our Credit team has termed it, many fixed income markets may remain dislocated.
5. Deep undervaluation across major assets and position reduction.
Everything has a price. Even without clear signs that the damage is coming to an end, if valuations come close to – or overshoot – plausible worst case scenarios, the risk-reward may be appealing even with high uncertainty. We have seen significant cheapening across assets over the past couple of weeks and pockets of deep value may now be emerging. But on a broad basis, we are not at Global Financial Crisis or overshooting levels yet. For example, in the case of EM FX, the median currency is now through ‘moderate’ levels of undervaluation (corresponding to early 2016 or autumn 2018) but we estimate a further 3% depreciation would be required to reach GFC-type ‘severe’ undervaluation. Similar benchmarking exercises for EUR sovereign spreads suggest that we are not yet in overshooting territory. Our Portfolio Strategy teams draw similar conclusions about equities. Valuations are rarely a sufficient condition for markets to recover. But an unusually large risk premium would allow investors greater comfort in terms of stepping back in if other conditions are fulfilled. The current crisis is forcing a transfer of risk on a number of dimensions, as investors cope not just with rising volatility and credit risk but with the failure of many traditional diversifying assets to offer real protection. Alongside economic conditions, market bottoms often occur only once assets have been transferred from weak to strong holders. That transfer creates the conditions for deep undervaluation, particularly where liquidity is a challenge. So positioning indicators that suggest that this process is nearing completion are also likely to be helpful.
6. No intensification of other tail risks.
The longer this crisis lasts, the higher the probability that other tails risks intensify further. A pandemic induced contraction in economic activity is different from typical economic recessions. For instance, the recovery from the GFC was slow and halting, in part because there was a large overhang of housing investment to work through, balance sheets needed re-building and the credit transmission system needed healing from the trauma of the banking crisis. In theory at least, the recovery from the Covid-19 shock should be more rapid given the absence of these factors – unless the contraction and market reactions causes other things to break. That’s what investors (and policymakers) need to be focussed on – both in order to evaluate the eventual recovery prospects, but also in thinking of the places where market dislocations can extend further and deepen the negative impacts across the economy. We would highlight the following areas, some of which are already in train:
(i) A further Dollar spike: a rush for safe haven assets, dollar funding shortages and reserve recycling have already caused a Dollar surge. An intensification of this move, with the CNY participating as well will cause a new round of tightening financial conditions across the world.
(ii) Even lower oil prices and their implications in EM. The outbreak of the Saudi-Russia price war has already put severe pressure on asset markets across oil exporters. However, in the event of a move to and through $20/bbl oil, especially if it is prolonged, we can expect to see more non-linear price action in EM credit, further market pressure on oil exporting countries, and the eventual adjustments in exchange rate arrangements in places like Nigeria.
(iii) Politics and its spillovers into sovereign spreads and funding. A public health crisis and a prolonged economic shock are likely to put governments under severe pressure, and where there are already pre-existing fragilities, this could create political crises that can exacerbate the already negative price action. This is a key risk in the context of Italy, Spain and peripheral Europe, especially if there are new migration crises; it could complicate the Brexit process further; cause a renewed worsening in US-China relations; and put pressure on EM governments where there are institutional weaknesses. In the US, state and municipal governments may also face stresses if support from federal institutions is viewed as insufficient to contain balance sheet pressures.
Is that all?
FYI, we think that the US is on the path becoming a gigantic Italy.