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The long and the short of the Coronavirus

Pascal Blackburne, CIO 2020-03-01

With the coronavirus having now spread well beyond the borders of China, governments across the globe are taking drastic action – under intense media pressure – to contain the epidemic. Scientists warn that these measures might not succeed, but also provide reassurance as to the potency of this new form of flu. One thing is certain, though: from an economic standpoint, the worst is yet to come. Which explains why stock markets have gone into panic mode.

Cher Client,

Comme vous le savez, nous affrontons actuellement en Europe une crise sanitaire de grande ampleur. Ce contexte est totalement inédit. Nous devons, en tant qu'acteur économique responsable, être à la hauteur de la crise profonde que nous sommes en train de traverser. Dans ce moment fondamental pour la relation client, nous restons à vos côtés.

Nous devons continuer à agir et à prendre nos décisions en veillant à préserver la santé de nos collaborateurs et à assurer la continuité de notre activité. Nous nous y étions préparés, et aujourd’hui nous sommes organisés et totalement mobilisés pour vous assurer la poursuite de nos services.

Ainsi, nous avons activé en début de semaine notre plan de continuité d’activité, réparti nos équipes et mis en œuvre le télétravail. Tous nos collaborateurs disposent des moyens techniques adéquats pour poursuivre leurs activités et répondre aux attentes qui sont les vôtres.

Au cours des prochaines semaines, nous allons devoir être collectivement flexibles et agiles, afin d’agir au mieux de l’intérêt des clients.

Vos contacts habituels se tiennent à votre disposition pour toute information complémentaire.

Let us begin with a brief discussion of the virus itself, understandably scary but ultimately probably not that different from the usual seasonal flu. Although it is still early days in compiling data, scientists suggest that the COVID-19 mortality rate is “only” around 1%, with a large share of patients presenting mild – if any – symptoms. Just like in the case of the regular flu which, it is worth reminding, causes some 40’000 deaths every winter in Europe, elderly persons and those with chronic health conditions are most at risk. Of note also is the fact that new infections are now receding in China, although a second wave is not impossible as travel restrictions are lifted.

Now to the economic consequences. The shortage of inputs faced by Western factories (container exports from China continue to be very difficult), potential worker quarantines (should it come to that in our countries too) and lower consumption due to overall anxiety/uncertainty make further profit warnings very likely during the next weeks. First half 2020 GDP figures will undoubtedly be hit, with a recession (aka two consecutive quarters of contraction) even possible.

In an attempt to mitigate the impact, alongside sanitary decisions, some governments are implementing almost war-like stimulus measures. In Hong-Kong for instance, where the coronavirus follows months of political unrest, all adult permanent residents will be given USD 1,200 in cash. In China, road, bridge and tunnels tolls have been removed to favour workforce “repatriation”, banks have been granted extra funding to support small businesses, electric car subsidies have been extended, and so on. In the US, extraordinary measures were taken by the Fed, implementing an emergency rate cut of 50 basis points. Closer to us, Germany’s finance ministry is allegedly looking into how to loosen constitutional budget deficit limitations and, with Italy hit particularly hard by the coronavirus, the EU will no doubt take a much more lenient stance on public deficits.

Meanwhile, and unsurprisingly, stock markets have experienced their worst plunge since the 2008 financial crisis. What does the immediate future hold in store for investors and how should they react? While these are obviously very difficult questions, our best guess would be that market sentiment remains negative for several weeks as the bad news (on both the virus and corporate fronts) continues. That said, selling now is not warranted in our view, particularly given our bias towards “value” stocks/sectors. Rather, we are gearing up to switch our gold exposure (that is fulfilling its intended hedge function but starting to become a very crowded space) into equities – US rather than European ones should we add, to the extent that Boris Johnson’s July deadline for a deal with the EU is paving the way for a hard Brexit. As always though, timing the move will be key. Also, we intend to look for opportunities in the high yield bond space, where spreads were at extreme lows just weeks ago but have since undergone a very sharp upmove. They remain however well below their December 2018 levels.

The Longer-Term Enemy: Inflation

The coronavirus crisis has made the world’s dependence on the “Chinese factory” very clear, notably to the many policymakers who had fallen asleep at the wheel for years. A return to basics is thus to be expected, with governments and private companies reflecting on how they can insource back part of the (previously outsourced) production, i.e. move away from the “global supply chain” model embraced during the past two decades. Is it not somewhat strange that authorities protected domestic food producers with subsidies and import constraints, but not other basic consumption goods? This is likely to change going forward, albeit over a multi-year timeframe, gradually pushing the cost of production upward – particularly given the tight labour markets and ageing demographics across the developed world.

The COVID-19 scare could also serve as the trigger for the boost in government spending that the IMF has been advocating for some time already. Countries that have the fiscal leeway to do so (for instance the aforementioned Germany) may well launch into large infrastructure projects, adding to supply-side pressures.

What all this means is that inflation will likely be the central banks’ next enemy, and one that they will have trouble fighting given their reduced independence, as well as the ballooning overall debt. Odds are that monetary authorities will have little choice but to allow inflation to run its own course which, in turn, does not make for a bright long-term picture for investors.

Indeed, the combination of low interest rates and high inflation will make it very difficult to protect purchasing power.

US: FED in “Panic” Mode and Fast-unravelling Democratic Primaries

For the first time since the depths of the Great Financial Crisis, the US Federal Reserve (Fed) decided – unanimously – on 3 March to implement an emergency 50 basis point rate cut, bringing the Fed funds rate to the 1% - 1.25% range. Echoing this, the US 10-year Treasury bond yield fell below the 1% mark for the first time ever. Jerome Powell, the Fed Chairman, described the rate cut as a pre-emptive move to limit the economic fallout from the coronavirus and resulting public health measures. He also signalled that further action is possible, “depending on the flow of events”. Indeed, the market is now betting on a 25 basis point cut at the Fed’s next scheduled meeting, on 18 March, and possibly again in April.

In our view – and that of many market participants judging by how short-lived the Fed-induced rally proved – using so much of the limited potential for rate cuts, this early in the crisis as far as the US economy is concerned, was unwarranted. Not to mention, as per Chairman Powell’s own admission, that “a rate cut cannot reduce the rate of infection, it won’t fix a broken supply chain”. Worse, the Fed’s decision to act so forcefully in between regular meetings may actually add to overall corporate and consumer anxiety.

More fundamentally, this cut in interest rates even as US inflation stands well above the Fed’s 2% target illustrates the central bank’s reduced independence that we alluded to earlier. Can one really believe that the decision did “never (…) consider any political considerations whatsoever”?

Talking about politics, the Democratic primaries are now well underway, with the Super Tuesday (accounting for one-third of the total delegates) results being released as we write. And the picture is fast becoming clearer – as well as less risky dare we say. Indeed, Pete Buttigieg and Amy Klobuchar’s decision to quit the race just ahead of the Super Tuesday, followed by Michael Bloomberg’s withdrawal upon disappointing results, all serve to strengthen Joe Biden’s chances of becoming the 2020 Democratic presidential nominee. As we have argued previously, beating Donald Trump next November will be no easy task, but a more centrally positioned Democratic contender does stand a better chance than, say, Bernie Sanders or Elisabeth Warren. Moreover, it reduces the tail risk for investors of seeing Senator Sanders and his market hostile political program, reaching to the White House.

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