Market scenarios and risks - November 2020

Monthly update

Risks are clustered to ease the detection of hedging strategies, but they are obviously linked. We maintain the overall narrative and probabilities on the risk outlook with the pandemic exacerbating existing fragilities and vulnerabilities.

1. Adjusting our central scenario to the impact of the 2nd wave

• The Covid-19 2nd wave is much stronger than expected in many European countries while the situation has also recently deteriorated in the US. Latin America has become the epicentre of the pandemic.
• Authorities have to choose between public health i.e. lockdowns and economic wealth. In Europe, the priority is clearly to maintain public health.
• Despite medical advances and treatments, we are still in the grip of Covid-19 a year after it appeared in China and a vaccine is still not available.
• This changes the balance of risk in our scenario analysis. We increase the probability of the downside scenario from 20 to 25% (deep recession/ secular stagnation) and reduce the central scenario probability to 65%.

2. Q4 GDP growth may return in negative territory

• After the technical rebound, the global recovery is confirmed smoother. We expect weaker growth both in the US and in Europe. We do not rule out a mild double dip in our central scenario.
• High frequency indicators in aggregate show a flattening curve.
• The service sector continues to suffer with increasing divergences with manufacturing. Tourism, leisure and consumer-facing activities remain highly disrupted. The situation will mechanically deteriorate further in economies subject to new restrictions.

3. Emergency measures are back, with the blessing of CBs

• Emergency measures are back. The second wave will once again increase the pressure on policymakers to act. The major central banks (notably the Fed and ECB) are calling on governments to do more. This means that CBs will (when possible) continue to support their efforts, by increasing their asset purchase programmes.
• This postpones until a little later the need to implement stimulus plans (infrastructures in the US, Recovery fund in Europe).
• Execution of structural/medium term oriented /fiscal measures remain however key. In Europe, the EU recovery plan is in the national approbation phase which might be longer than expected. 4 years after the referendum, the uncertainty on the Brexit outcome remains.
• Bad news is no longer good news. The policy mix, however proactive it may be, is not able to offset all the effects of the Covid crisis.

4. The ECB inflation challenge

• What if the risk of deflation intensifies and the euro appreciates further? This could be a dangerous cocktail for the ECB.
• A rate cut is the only effective tool that the ECB has at its disposal to combat deflationary pressure exacerbated by the euro appreciation but it would have negative side effects hosted my some members in the Council.
• Negative deposit rate and yields could weaken the euro and alleviate the burden of sovereign debt. But are a tax on the banking system despite rates tiering and may not stimulate economy with positive `reversal rate while it could endanger financial stability and remain difficult to exit.
• The bar is high to cut rates (outright deflationary pressure coupled with a strong appreciation of the euro). We expect the ECB to extend its QE, in time and in volume.