Markets scenarios & risks - May 2020

Where do we stand on Covid-19

The potential easing of lockdown measures bring some light at the end of the tunnel. This is particularly the case in Europe where several countries are opening back shops, manufacturing capabilities or services. Data show that the worse is probably over in Italy and France for instance, but in the US, many states such as New York remain in an acute phase of the outbreak. Moreover, emerging countries are still at the beginning of the pandemic. Although it is too early to draw a conclusion, the low level of death toll registered so far in Africa gives hope for a more benign impact than feared. On one hand, these countries’ infrastructures will make the disease more difficult to fight but on the other hand, EM demographics are more favourable. Going forward, the lack of tests make the statistics less and less reliable.
The total number of deaths directly linked to the virus are significantly underestimated according to recent studies. Therefore, we still ignore the magnitude of the outbreak at the global level. The situation seems to be stable in China where feared of a second wave remain. As constraints measures starts to unfold, many questions remain unanswered: Is the collective immunity sufficient to avoid a sharp pick up in cases once we reduce confinement measures? Are we going to see a second wave? If so, will it be smaller or bigger than the first? It is reasonable to assume that Covid-19 will not disappear anytime soon, and will remain a source of risk until a medical treatment appears.

Methodology

• Scenarios

The probabilities reflect the likelihood of financial regimes (central, downside and upside scenario) which are conditioned and defined by our macro-financial forecasts. We use the k-means clustering algorithm to our enlarged macroeconomic dataset, splitting the observations into the K cluster, where K represents most of the variability in the dataset. Observations belong to one cluster or another based on their similarities. The grouping of the observations into the k clusters is obtained by minimizing the sum of squared Euclidean distances between observations and clusters centroids i.e. the reference values for each cluster. The greater the distance, the lower the probability to belong to a given regime. The GIC qualitative overlay is finally applied.

• Risks

The probabilities of risks are the outcome of an internal survey. Risks to monitor are clustered in three categories: Economic, Financial and (Geo)politics. While the three categories are interconnected, they have specific epicentres related to their three drivers. The weights (percentages) are the composition of highest impact scenarios derived by the quarterly survey run on the investment floor.

1. The big picture: The pandemic outbreak has altered the financial regime cycle we had in mind at the end of 2019. We now expect a contraction (central bank and government support, a recession, and rising unemployment), followed by a recovery later in 2021 (economic activity retracing back but below 2019 levels, rising labour costs, and cooling down of monetary and government actions), which would eventually land in a late cycle in 2022 (or potentially an asset reflation regime, should central banks remain ultra-supportive). The first phase is characterized by a preference for cash, govies, IG under the CB umbrellas, and gold. The following step will be to move to EM equity (first-in, first-out), base metals and HY as soon as the profit cycle bounces back while the last stage will be a broad repositioning in DM equities and the full credit spectrum.

2. Economic backdrop: a global reession with sequencing drawdown and diverging recovery path. The length of the weakness and the extent of permanent output loss and demand destruction will dependc on how long the lockdowns last, only partially compensated by central bank and government actions. The recovery will lead to de-synchronized paths in three blocks: China/South Asia, US/Europe and developing countries, each producing specific investment opportunities.

- Labour markets will be key to assessing the final shock to domestic demand. Unemployment is expected to rise to levels not seen in the past 50 years, if policies and schemes to support reduced hours workers fail to produce their intended effects. Most vulnerable are Italy and Spain, whose labour markets are more exposed to temp workers, sectors at risk (tourism-related), and those that still have not fully recovered from 2012 crisis. Among EMs, the larger the informal sector, the more pronounced the shock.

- China first-in-first-out. Policy has tilted towards further easing to cope with downside (exacerbated by weakening global demand).

- Covid-19 is exacerbating EM fragilities on rising debt, increasing external vulnerability and oil dependency. Fiscal and reserves buffers are favouring Russia, South Korea, the Philippines and Peru.

3. Global liquidity started to increase in Q2 2019, with the Fed back on a rate-cut course and eventually entered crossborder banking circuits. However, liquidity as perceived by market participants remains tepid. In fact, global financial conditions, while far from GFC levels, have bottomed out in 2020 and corrected only marginally, notwithstanding the massive monetary policy efforts.

4. Italy: Covid-19 and lockdowns will be a drag on GDP that we expect to revert back to pre-crisis levels in 2022 in our base case. The debt/GDP path will depend on growth, the average cost of debt and the primary balance. PEPP (flexibility on capital key and no issuer limit) will support short-term financing needs. The ECB has around €100-120bn of firepower for buying BTPs and will absorb the €55bn of new net issuance for 2020 very easily (including €25bn of new fiscal measures). In the medium term, Italy will take more than 10 years to revert back to its 2019 debt/GDP level. Rating agency actions will depend on the policy response.

The large fiscal packages announced by governments to counter the virus crisis aim, so far, at stabilizing more than stimulate economies. In addition to funding emergency response to the virus situation itself, these packages intend to prevent a worsening of the crisis through the financial and household income channels. Only part of the amounts recently announced by governments are budget easing measures under a strict definition. On these, there is a larger push in the US and Japan than in Europe so far. Other amounts are advances meant to be reimbursed, or (for the largest amounts) government guarantees to corporate debt.
 Regarding guarantees, the European push is, at this stage, much larger than the US one. Within the specific architecture of the Euro area, European institutions have also played a major part, by lifting restrictions so that member states can deploy their national program. A European-level mutualized response is also under way, with a number of programs already decided and larger ones currently being negotiated.
The combined effect of the recession and the whole array of above-mentioned measures on deficits and debt could be, very roughly for large advanced economies given the many unknowns, a 7% to 15% of GDP deficit increase and a 15% to 25% of GDP public debt increase in 2020. However, the public debt sustainability of large advanced economies may not be that damaged by the crisis, due to the large QE programs announced by central banks that will monetize the additional debt. Yet, the recently announced stabilization-aiming fiscal measures are not the end of the fiscal easing chapter opened by the crisis. Indeed, they will probably give way to further measures, this time stimulus-oriented, once the confinement measures are gradually lifted. It is also very probable that some of the crisis-fighting fiscal measures, currently presented as temporary will become more or less permanent due to demands of a stronger government role in the economy, and stronger social safety nets. If not matched by offsetting revenue-raising measures, they may lead to permanently higher structural primary deficits.

* See forthcoming Thematic Paper by Tristan Perrier