Markets scenarios & risks - June 2020

Where do we stand on Covid-19

China has declared it won the battle against Covid-19 and its economy seems to be back on track. Though a second wave is still possible, China, Japan and other Asian countries have successfully managed new clusters so far. Lockdown measures are gradually lifted across Europe and the US while the rate of daily deaths of patients diagnosed with the virus continues to ease.

As we are writing, around 5,5 million people have been infected and 350 thousand died according to official numbers with a third coming from the US. Brazil where hospital are overwhelmed and Russia account for more than 350 thousand cases each with a relatively low death rate. However, statistics are getting less and less reliable as the virus is spreading across emerging countries.

Although the chance of finding an appropriate drug or a vaccine is rising, since several medical studies are showing encouraging results, there is still no treatment to the disease. Therefore, social distancing, partial or complete confinement, and availability of masks, tests and hand sanitizer are the main factors to contain the outbreak. Frontiers remain shut for the most part including within the E.U. Schengen area, and advanced countries are competing for medical equipment, drugs and a potential vaccine. Inequality of access to a vaccine will probably be a source of geopolitical tensions going forward.

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. China-US tensions escalate: China-US tensions escalated on the ramping rhetoric on China’s role in handling the pandemic. Tensions involving tariffs and extra tariffs measures (such as against Huawei) will lead to retaliations from China, rendering previous efforts futile. One Chinese reaction could play out in the FX space: we envisaged a risk scenario with the USD/CNY peaking higher at 7.30 from a base case of 7.15. On a broader perspective, Covid-19 might exacerbate current trade tensions into a more structural conflict, leading to a “cold war”. 

2. Labour market 

• US: In this first round job losses were concentrated in front-line sectors (i.e., service- and hospitality-related), among small/ medium enterprises, lower-pay sectors and employees. There has been a shift in the composition of the pool and computation of average hourly earnings, which have increased significantly. Some unemployed persons were reported as temporary layoffs. Currently, the 14.7% unemployment rate could be underestimating the full extent of the damage, which will become visible in next few months (second-round effects on deeper economic damages). We estimate that about 30 million jobs are at risk, that unemployment could rise to about 22% and then recede gradually (after peaking in Q2-Q3). Keep an eye on: continuing claims (if and how they decline in states that are opening back up) and labor force participation rate trends (if it remains weak or not – i.e., people coming back to look for a job).
• China‘s economy is recovering (based on macro and micro evidence), showing that the worst is likely behind for the services sector while pressures in manufacturing employment are building up. Balancing these two factors, the unemployment rate is likely to hover at just below 6% in the near term. The worst reading was 6.2% in February.

3. German Constitutional Court ruling: The German Constitutional Court ruling challenges the EU legal architecture. Political ramifications are bigger threats than a short term impact on monetary policy and the economy. The best strategy is for the ECB not to react, but to acknowledge the ruling and continue business as usual. If not, it would likely pave the way to other national courts to challenge the legal EU framework legitimacy.

4. Increased funding needs: Increased funding needs to create market dislocations and rates pressures. There is limited scope for higher rates, as central banks will monetize additional debt supply and short- and long-dated bonds (Fed to buy unlimited supply of Treasuries and MBS, ECB to increase the size of PEPP). The base case is for the curve to flatten on gloomy economic and inflation expectations.

5. Equity markets: Equity markets are pricing in a reality closer to the upside scenario amid a depressed environment for EPS growth. Valuations had been lifted on central banks’ “whatever it takes” and easing of financial conditions. Based on policy responses and lockdowns, we are maintaining our strategic preference for risky assets but the valuation boost does not provide the best upside today. We recommend not chasing equities while preferring the relative safety of IG.

As the third round of negotiation between the UK and the EU has failed to show significant progress, both parties are facing the mounting risk of a no-deal Brexit. Indeed, we are only a few weeks away from the end of June deadline where the UK can still ask for an extension of talks, which it refused to do so far. The Covid-19 crisis caused some delays but talks restarted via videoconference. The latest round closed with an exchange of bitter words between the E.U. negotiator Michel Barnier and David Frost representing the UK, highlighting a disagreement on key points including common governance, social and environmental standards, so called “level playing field”. Other topics are still unclear such as the solution to avoid a hard border in Ireland or immigration rules.

The roots of misunderstanding are deep. In fact, the EU is still trying to forge a deal, which would allow the UK an extensive access to the Single Market with the obligations that comes with it, while the UK is basically asking for a trade deal-based relationship with light obligations and no oversight from the EU.

The clock is ticking. The European Council scheduled on 18-19th June is supposed to discuss the new treaty with the UK, and seven months look extremely short to finalise a deal and get it approved by 27 member states. Unless both side amend their position and the UK asks for an extension, it becomes more and more likely, the British, which have left the E.U. on 30th January, will not have a trade agreement with its main economic partner on 31th December 2020. Nonetheless, last year after very tense negotiations, both sides finally showed pragmatism and signed the EU-UK Withdrawal agreement.