Financial Markets Flash 23-03-2020

The Corona virus outbreak is hitting a globalized economy that was on the road to recovery. It has also revealed a lack of preparedness in the way large health crises are managed (although there are some differences between countries). Its consequences will be very serious, even though this crisis does have an end date: it will end when the spread of the virus is contained and/or when a vaccine is found. The problem is that we don't know when that will be and it is difficult to estimate the economic damage it will cause.

In the long term, the ways in which our societies think and organize themselves will most certainly be reviewed. In the shorter term, the economic and financial consequences will be very significant.

More and more observers now consider that the current stock market movement will exceed the scale of the 2008 crisis, which was the worst since the 1929 debacle. It should be remembered that in 2008, the major equity indexes lost approximately half of their value. Currently, since January's highs, the S&P 500 index is down 32% and the Eurostoxx index is down 35%.

Initial growth estimates are impressive and were unimaginable even two months ago.

China, the first country to be affected, is in recession with GDP contraction of almost 6% estimated in the first quarter. In the Eurozone, there is no real reliable estimate yet as it is too recent, but a decline of around 15% in Q2 GDP at an annualized basis is becoming a consensus figure. In Germany, a 5% decline in GDP this year has been suggested. In the United States, estimates are very disparate and are also in the process of adjustment, but some expectations are striking: the President of the Saint Louis Fed, James Bullard, expects the unemployment rate to reach 3% in the United States in Q2 due to the many company closures that will take place. He is also expecting a 50% drop in GDP in snapshot terms. JP Morgan and Goldman Sachs anticipate a 14% and 24% drop respectively in Q2 on an annualized basis.

The problem is that this sudden contraction in the economy is likely to create chain reactions. They are easy to imagine, and they are worrying: the stoppage of activity due to generalized containment will inevitably lead to business failures, which may lead to a banking crisis due to the multiplication of defaults, and thus a halt in the granting of loans to the economy, etc.

A massive response from Central Banks and governments is therefore needed. Some concrete progress has already been made and there is likely to be more to come.

Central Banks were the first to act. The Federal Reserve very quickly lowered its key interest rates, bringing the range for monetary interest rates to its lowest level since 2009, to 0%/0.25%, which brings them closer to rates in the eurozone, where the ECB no longer had much room for maneuver for easing key interest rates given that they were already in negative territory, which poses other problems.

They also announced a series of measures to support the bond markets, with complete packages for the purchase of government and corporate securities amounting to roughly the same amount of USD 750 bn and EUR 750 bn respectively.

What is important and encouraging in the eurozone is first and foremost a consensual awareness of the scale of the challenge (which has not always been the case). Similarly, the broadening of eligible assets to short-term corporate securities (commercial paper) and a change - temporary for the time being - in the key for subscription have been rather well received by the markets. This means that the ECB has the possibility to buy Italian bonds, for example, without having to buy the corresponding German securities. This measure has already borne some fruit, as peripheral spreads have since halved after a sharp tightening the previous week.

It should also be noted that the two major Central Banks are ready to go further and have declared that their resources are unlimited.

Governments took over fairly quickly in the end, with a series of measures such as a direct increase in public spending to distribute it in purchasing power or investments, and also numerous payment facilities or loan guarantees for both individuals and businesses.

Going into all of the details would be tedious, but the amounts are likely to be quite large, and ultimately increase debt levels in relation to GDP, by around 10-15%. For example, France's debt-to-GDP ratio could rise from 100% to 115% at the end of this crisis, Italy's from 135% to nearly 150%, Germany's from 60% to 70/80%. The German finance minister has just announced a EUR 350 bn plan, or nearly 10% of the country's GDP.

In the United States, an emergency plan for medical research worth nearly $100 bn was quickly decided. A fiscal stimulus package that could reach $2,000 bn (almost 9% of GDP) is under discussion in the Senate between the Republicans and the Democrats, which includes nearly $500 bn in direct distribution to Americans and tax reductions, credit facilities for businesses, public investment, etc.

For the record, we note that we are getting closer to the concept of "universal income" and "Helicopter Money", i.e. the direct financing of projects by the Central Bank without going through the banking channel.

How to invest in this unprecedented situation with very low visibility?

The question of the duration of the crisis and the speed of the recovery are essential, and from this point of view anything is possible. If the peak of the epidemic is reached in two months and if government measures succeed in avoiding a cascade of bankruptcies, then the rebound could be rapid and current prices are attractive. If not, the stock market correction may continue.

It is difficult to say which of these scenarios is likely to occur, but we believe that it is advisable to reinvest gradually, with a long-term view, and with a careful assessment of the overall risks that this entails in portfolios, so as to avoid being forced to sell if necessary.

Equity valuations are starting to appear acceptable: P/E ratio on the known results for 2019 "before the virus" of 13.5 on the S&P 500 index and nearly 10 on the Eurostoxx index. Admittedly, the estimates for 2020 will be revised downwards significantly, with "Top Down" estimates that are now in the region of -30%, which would result in "bottom of the cycle" 2020 P/E ratios of 19 and 15 respectively.

Document completed on 23/03/2020

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