By Tim Sharp, Hottinger Investment Management
If we look back to the end of 2019, it was clear to us and our advisers then that the fundamentals underlying the financial markets were fragile and potentially vulnerable to an unknown shock that questioned the market’s expectation of future growth. We were advocating for caution due to the potential for a global recession as a result of tight monetary policy and a lack of the central bank stimulus necessary to maintain positive global growth.
The contagion of the coronavirus outbreak may have laid bare the over-valuation of financial markets and drastically altered the macroeconomic outlook for this year. As we see it at present, there are four main unknowns: [i]
It is unknown how far coronavirus cases will spread – both in terms of number and geography – before the global peak is reached. Statistics from 12th March Absolute Strategy Research (ASR) would suggest that China is the only country, out of the 110 globally with registered cases, that has seen a levelling off of new cases. Asia (excluding China) is still seeing the number of cases increasing, as are Europe and North America, which means that the virus is not contained at this time. The best-case scenario based on the collated data is that the virus is brought under control during the month of April, when the economic fallout of the outbreak can be assessed.
At this time, the second unknown is consumer behavior, whether it is stockpiling during the epidemic or the willingness to return to normal consumption after the virus has been contained. Evidence would suggest that it took consumers 6 to 9 months to return to normal behavior after SARS, which calls into question the likelihood of a V-shaped recovery in the second half of the year.
The third unknown relates to the extent of the supply-side chain damage that is being sustained during the outbreak. For a company to change its parts supplier temporarily during a period of difficulty is one thing, but to have to implement such a supply chain adjustment permanently has more long-term consequences for the global economy. The impact could be similar to that of the US on-shoring that took place following the tax breaks in 2017.
The final unknown is the effectiveness of the central banks’ and governments’ policy response that has so far seen significant monetary policy easing from the US, Canada, UK and Australia, as well as an increase in QE from the European Central Bank (ECB). We have previously documented our belief that the strength of the dollar is fundamental to the growth of the global economy, and we feel that it may require a coordinated fiscal response outside of the US to stimulate the wider global economy. The strength of the Euro vs. USD, for example, will only be overcome in the long-run by employing a policy response that is wider-ranging than cutting rates and increasing TLTRO (targeted longer-term refinancing options) spending. At this time, however, the countries of the eurozone are not in agreement as to the best way forward for policy coordination.
The breakdown of the OPEC+ discussions has laid the foundations for a possible oil price war instigated by Saudi Arabia and largely influenced by the actions of Russia. The immediate fallout of a 35% depreciation in the price of Brent Crude from $51.60 to $33.30 is an indication of the likely result of there being no supply quotas in place for the major oil producing countries. The result of a prolonged oversupply of oil, other than a potential $20 per barrel handle, could have a more significant effect on the global economy than even the coronavirus.[ii]
The fiscal breakeven Brent crude oil price for major oil suppliers provided by Absolute Strategy Research (ASR) makes for interesting reading and there is potential for two effects to unfold[iii]. Firstly, Saudi Arabia has a fiscal breakeven of $84, despite having one of the lowest costs of supply. In previous periods of low oil prices, markets have seen sovereign wealth funds selling down liquid assets such as equities in order to maintain the domestic agenda. We have seen no evidence that this type of action has happened as yet, but we remain alive to such a scenario of forced selling. Secondly, the figures show that Russia’s fiscal breakeven is $42, while alternative providers such as US shale and Canadian oil sands having breakeven prices of around $50. This clearly leaves Russia with a margin to put pressure on the new oil producers in countries that have been thriving on high oil prices arguably created due to the US policy of imposing sanctions on Russia and Iran. It will be interesting to see how this unfolds, particularly if the oil price stays at a low enough level to lead to the shuttering of US wells.[iv]
China is seeing the beginnings of a return to normal activities, with reports calculating that the economy has returned to 50% of its pre-lunar new year capacity when the rest of the world is yet to see the peak impact of the virus.i Assuming that other countries have to follow a similar or even longer timeline to China, it is likely that estimations that the outbreak will persist well into the second quarter may prove to be accurate.
Most developed market equity indices have moved into bear market territory (i.e. fallen more than 20% from the February 2020 record high) suggesting that the financial markets are beginning to price in the possibility of a global recession in 2020. The core view that we have seen is that the 1st half of this year will see a technical recession and a peak in the epidemic, leaving the global economy to recover during the second half of the year. The downside risk to this scenario is that the virus containment is not as successful as currently expected and affects activity in the third quarter as well. This may then start to have a significant effect on the supply-side, impairing the ability of the global economy to bounce back quite so successfully and pushing the global economy into a deeper recession.i We are not so sure that this scenario is priced into equity markets, so we still remain cautious of calling the bottom of the market here.
The upside scenario is that the containment timeline could be correct and coordinated stimulus from major countries including China and the US may be effective enough to generate a strong recovery, however, at this time we do not have enough information to make informed decisions.
Any economic statistics that have been released recently relating to pre-virus contagion are largely irrelevant, so markets will remain volatile until fundamentals can be evaluated properly and we expect to see further earnings revisions.
[i] Absolute Strategy Research – Contagion Effects, 12 March 2020
[ii] Capital Economics – Oil price slump not a positive for global economy, 9 March 2020
[iii] Absolute Strategy Research – Investment Implications of possible Covid-19 Scenarios, 10 March 2020
[iv] Absolute Strategy Research – Oil shock adds to Coronavirus crisis, 10 March 2020
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