Financial Markets Flash 17-03-2020

As we emphasised in our Financial Markets Flash from last Friday, the current stock market crisis contains the same ingredients as the three most recent major downturns of 2000, 2008 and 2011... But it is also very different, and not only because of what has caused it.

Some of the same ingredients as in the three previous downturns...

As was the case in 2000, some sectors had in recent months shown signs of being overvalued, i.e. growth stocks in general and tech-related stocks more specifically. With interest rates so low it makes sense for growth stocks, which offer a certain degree of earnings visibility, to trade on higher multiples. But valuations had become rather excessive in recent years, hence our cautious stance on equities at the start of this year.

The downturn of 2008 was above all a financial crisis triggered by excessive debt in certain sectors (real estate along with real estate structured products). This degenerated into a major liquidity crisis. This is not the case today, but some segments have probably become overleveraged in recent years (private equity, corporate debt?). And now the credit markets are seizing up. There is no liquidity and we are beginning to see some forced sales by leveraged funds that are unwinding their positions...

The situation in 2011 was a crisis of confidence about the foundations underlying the euro: how can the same interest rates apply to countries with different deficit and debt levels? The concept was placed under protection by Mario Draghi’s ECB and his stimulus policy. But it could become an issue again now. This is going to be a costly crisis and governments will have to pay up, which will increase their debt levels further.

But they are not all on an equal footing: Italy’s debt already represents over 130% of its GDP and France’s 100%, whereas Germany and some Northern European countries are once again complying with the single currency’s founding principles with around 60%... These gaps could get wider and are beginning to affect the markets. Spreads have started to widen again in recent days (see chart YTD at 16/03/20).

Christine Lagarde’s ECB no longer has all that much headroom when it comes to interest rates. If necessary, she would have to get special permission to adjust her asset purchase policy, i.e. to increase volumes and change the ECB capital key (which determines the share of capital attributable to each state) in order to revive investor confidence and show that the euro is indestructible. To achieve this, she would need to convince the rather reluctant Germans. More generally, Christine Lagarde has not yet managed to restore confidence in the markets.

10Y govie yields in the Euro zone

... but the current crisis is also a very different one

The markets are correcting much more rapidly. The main indices have lost up to 30% / 40% in the space of 3 weeks. This is a full-blown stockmarket crash. The last three downturns were more gradual at the start and then worsened after a few months... (see chart comparing the current Eurostoxx 50 downturn vs. the periods 2011- 2013 / 2007-2009 / 2000-2002).

The very nature of the markets has changed: trading is now driven much more by automated tools and allocation models. Passive investment management now also plays a prominent role, requiring automatic adjustments to be made. In addition, there are fewer end investors as banks have been forced to scale back their positions and insurers face low interest rates so they need to raise more capital.

Central banks are no longer able to reassure the markets. In current circumstances, the markets are doubting the effectiveness of monetary measures. The markets did not react well to the interest rate cut decided by the Fed on Sunday night, and Wall Street had its worst trading session since the crash of 1987.

Fed Funds rates are back at their 2009 lows of 0%/0.25% and are thus converging with interest rates in the euro zone. But Jerome Powell said he would not push interest rates into negative territory, which means there is no longer any headroom as things stand today.

Nor will the Fed expand the asset purchase buying criteria applied under its QE policy. So it will not be purchasing equities or corporate bonds any time soon.

More generally, central banks have created the minimum conditions required to prevent a financial crisis. The ball is now in the political court, and governments must either give central banks the capacity to take action on a larger scale or prop up the economy directly.

It is true at this stage that interest rate measures will have no immediate impact on the economy as there is no demand; consumers are under lockdown on account of the epidemic. Companies will require concrete support to make up for lost revenues, particularly in the case of small companies operating in the service and tourism industries...

Govies are no longer an effective safe haven.

The fact that bond yields have risen recently raises questions. The yield on Germany’s Bund, the ultimate safe haven during previous crises, has seen its yield edge up in recent days from -0.85% to -0.42%.

Similarly, the yield on the Bund’s US counterpart has risen from a low of around 0.35% to 0.8%...

Are the markets in the process of pricing in a massive fiscal stimulus?

This is more of an economic than a financial crisis, so the solution will involve governments repairing the damage caused by this epidemic. This will add vast amounts to already lofty debt levels, but some governments such as France’s have made a commitment to support businesses "at all costs". Discussions within the euro zone look set to be complicated.

Growth will be hit very hard indeed this year, although not many forecasts have been made as yet.

A Goldman Sachs report suggests US growth will fall to 0% in Q1 and -5% in Q2, before bouncing back to +3% in Q3 and +4% in Q4. In this case we would be looking at a V-shaped recovery, which makes sense as the production apparatus has not sustained any damage, it is merely under "quarantine". So the question is when can we expect the recovery to begin, a forecast that is impossible to make at this stage.

In short, the current crisis will perhaps eventually prove constructive as it might trigger positive changes in behaviour (greater public spirit), methods (more remote working), better ways of organising production chains (less globalisation), etc. This could help us refocus on what matters and also pave the way to a greener and more virtuous economy. In the meantime, we are facing a severe economic crisis that will push public debt levels even higher. Nonetheless, our feeling is that the markets are over-panicking somewhat and have already factored in (at least partly) a very bearish scenario indeed. Those with long-term investment horizons ought to begin reinvesting, especially in equities and high yield bonds.

Document completed on 17/03/2020

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