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Market review – vicious cycle of negative sentiment leading where?

5 April 2020

Amine Chaieb, partner at Spearvest, provides a markets review in the midst of the Covid-19 crisis

The global economy was still in a fragile state when the COVID19 global crisis hit. With corporate balance sheets stretched and high leverage widely used by private and institutional investors, markets were especially vulnerable given the excessive valuation levels of risk assets at the beginning of the year.

The COVID19 shock is disrupting both supply and demand and if governments do not break a vicious cycle of negative sentiment reducing demand, therefore reducing prices leading to further supply reductions and massive layoffs, we could be in a self-reinforcing deflationary spiral that would be harder to break the longer it is allowed to take place.

In financial markets, the last few weeks around Mid-March resembled a massive global margin call where anything and everything was sold for cash. The evaporation of liquidity was evident across many asset classes, including treasuries on certain days when we witnessed wild inexplicable moves across safe havens.

The fastest equity drop on record since 1929 has done some long term damage to investor confidence and will potentially lead to a sustained de-rating of equities. This shift historically occurs at the end of each bull market as witnessed in 1970s and 2000s.

Brief rally

Meanwhile, global equities staged a brief rally towards the end of the month as investors speculated that the USD 2 trillion rescue package will mitigate the pandemic’s damage on companies, banks and households. Fresh rounds of monetary easing from central banks across Europe and North America also boosted risk assets, with European markets especially buoyed by the ECB’s decision to remove restrictions in its QE program, allowing it to focus its support on countries that need it the most.

A recurrence of a Eurozone sovereign debt crisis seemed a real possibility at several points in the past few weeks; now it looks like the ECB has finally got its act together and eliminated such a scenario. Although people won’t forget that it was largely thanks to some dreadful communication by the ECB that European sovereign bonds came under pressure in the first place.

Central Banks and governments are much more alert and aware of consequences than in previous crises. This is in contrast to 2008 when they took meaningful action only after banks had collapsed and credit froze for several months. Interest rates are the lowest ever, so government debt, especially when domestically financed, is not an urgent problem. Banks today are much stronger than in 2008 with deeper capital buffers and better regulation.

Finally, the success of China, Korea, Hong Kong and Taiwan in containing the pandemic provides a blueprint for other countries while manufacturers mobilize in order to provide more medical supplies, ventilators and testing instruments.

Two critical conditions

In addition to the unprecedented monetary and fiscal support, two critical conditions must be fulfilled by global policymakers to help establish a bottoming process in financial markets: the virus fades this spring and social distancing and lockdowns end; and that there is no second wave of contagion once individuals resume circulation domestically and globally.

For perspective, the TARP bank bailout was passed in October 2008 and the Fed’s QE1 came in November 2008, a year after the equity market’s peak and with the U.S. economy already a year into recession. Markets continued to fall as the economic damage proved deeper and more persistent than initially hoped. An additional fiscal package came in February 2009, a month before stocks bottomed.

With liquidity improving in the FX markets, zero US interest rates and less panic selling across risk assets, the US dollar has started to give back some of the excessive strength gained during the past few weeks of market turmoil. The biggest alarm of recent weeks was US dollar shortage, it now appears to have abated. However, as we learned in 2008, it may take several months before conditions fully normalize in credit markets despite central banks’ best efforts. One powerful indicator is the spread between Libor (at which banks lend to each other) over the equivalent T-bill rate, which remains at excessively high levels today, highlighting significant stress in global money markets and potential US Dollar funding difficulties for banks.

US job data 

Just when the markets regained a glimmer of optimism with an impressive rally over the past few days, the US job market provided an alarming reality check to investors. Last week we witnessed the worst jump in US jobless claims in history. With more than 6.6 million US workers seeking unemployment benefits, it is more than double the previous week’s figure. The 10 million combined jump over the past two weeks is equivalent to the cumulative increase in unemployment over the first seven months of the previous global recession in 2008.

The recession is just starting, and will certainly be a deep one, but how quickly can the global economy recover? All hopes hinge on strong coordinated action by governments, central banks and health authorities, which will be closely and meticulously watched by investors in the coming weeks. Clearly, we are not out of the woods yet.

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