Markets endure their worst week since 1987
- Monday, March 16, 2020
Back in November 2019, when I was conducting my research for the 32nd Edition of our investment portfolios, the outbreak of Coronavirus in Wuhan province and the impact it was starting to have upon the health of China was one of the articles I wrote about. I felt at the time that this could be serious to the world economy but did not realise how true that was soon to become. The view at the time was that it was containable. I was feeling more positive about the Federal Reserve being more supportive of a slowing global economy and in hindsight, I should have taken a more defensive position over the potential that Coronavirus could have on portfolio values.
The world’s institutions, governments and central banks have been slow to grasp early enough the true impact that Coronavirus would have. If anyone was not convinced, they are now.
A key challenge now is to provide funding to businesses whose cash flow will be badly hit by the massive reduction in movement and economic activity. Demand has collapsed in sectors such as transport, hotels, restaurants and service providers. The dangers are that this temporary shock will have a more permanent effect as businesses fail and close due to the crisis engulfing us. An early example was Flybe. Such developments will impact on the supply side of the economy and limit our ability to recover.
Central Banks have now reacted to the ever growing and evolving crisis. The US Federal Reserve was the first to cut interest rates by 0.5% on 3rd March. The Fed also announced plans to inject US$1.5tr into short term money markets to preserve market stability and to also purchase US$60bn of US treasury bonds. The Fed today cut rates again to 0% and expanded its quantitative easing (QE) programme by US$700 bn to include direct purchases of US corporate bonds giving a direct boost to business.
On the morning of Wednesday 11th March, The Bank of England also cut UK interest rates by 0.5% to 0.25% and introduced a range of measures to help business with cash flow as economic inactivity hits turnover. Cheaper money will itself not overcome Coronavirus but will help companies through what will be a very tough trading few months. In the afternoon, Chancellor Rishi Sunak’s first budget laid out the government’s plans to support British business, employers and tradespeople.
Interest rates have also been cut in Australia, Canada and China. In Japan, The Bank of Japan spent Y100bn (US$950bn) buying Japanese company stock.
The ECB relaunched its QE programme on 13th March. The ECB intends to purchase E120bn of Eurozone bonds and launch a package to support business and boost lending to SME business. The ECB did not however reduce interest rates as they are already negative. Overall markets were underwhelmed with the ECB announcements. The ECB’s new Chair, Christine Lagarde stated that ‘the ECB was not there to close spreads’. Her statement compounded the damage and saw borrowing costs for Eurozone countries soar within seconds as the Eurobond market sold off. Ms Lagarde challenged European governments to share in the responsibility to support the economy. This is in contrast to the position of Mario Draghi, the last Chair of the ECB, who did so much to support the Euro.
This does illustrate that the ECB is at the end of its capability and that Eurozone governments must also step in. The ECB relative inaction contrasts with that of the Bank of England who through its multi-pronged credit boost offered 13% of UK GDP to support the economy.
Governments will be under pressure to bail out the airline sector. For example, Norwegian Airways have pleaded for an immediate hand out after warning that it is within weeks of collapse. Lufthansa is seeking liquidity as it grounded 600 planes.
In addition to the Coronavirus pandemic , the breakdown in the long standing agreement between oil producers OPEC and Russia, known as OPEC + could not have come at a worse time for global markets. The coronavirus demand slump resulted in OPEC suggesting a 1.5 million barrels a day cut in global oil production in order to stabilise oil prices. This was rejected by Moscow as they feel that the current pricing deal only aids the US shale oil industry. Saudi did not compromise but instead cut prices to steal market share.
Oil prices fell from US$50pb to US$33.85pb within a week, a fall of 32%. The resulting price war is now expected to result in 3.2 million barrels over production per day leading to further price falls.
As oil companies amount for over 10% of the UK FTSE 100 index, this news saw the FTSE 100 fall by 7.7%. There are wider implications as long term both Saudi Arabia and Russia cannot sustain an oil price of US$33pb but especially nor can US shale oil producers.
The combination of the ever growing Coronavirus pandemic across Western Europe and the USA as well as the oil price war sent global stock markets into panic selling last week. The big falls occurred on Thursday; the day after Donal Trump announced the closure of all European travel into the USA. This announcement was made without any consultation and resulted in falls of 10% in one day. One day falls of this magnitude have not been seen since 1987. Donald Trump’s announcement has been dubbed ‘the most expensive speech in history’. It is evident that the President has come late to any significant containment action as he had previously denied the danger and potential of the Coronavirus risk. The USA is yet the witness the full impact of the Coronavirus as their health service only serves the wealthy or insured. Millions of Americans will not have access to testing or treatment and this will be a major theme of Novembers Presidential elections. ‘Sleepy’ Joe may get his revenge.
The panic selling of last week did ease on Friday as the S&P 500 rebounded 9.29%. Money has left equities and moved to safe havens like cash, gilts, US treasuries and gold. Gold rallied above US$1,700 per ounce and bond yields fell as capital values rose on demand. The 5 year UK gilt yield fell below zero for the first time ever, while the whole of the US treasury yield curve fell below 1%.
The combination of a falling stock markets and emergency interest rate cuts remind us of the events of 2008. 2008 was a financial crash that took a long time to recover from as banks, companies and households had to rebuild their balance sheets. Due to Bank of England stress testing the UK banking system in the years following 2008, we know that the UK banking system is robust and secure against the shock that Coronavirus is throwing at it. Our banks are perfectly solvent. The real challenge will be for consumer facing businesses such as pubs, restaurants, airlines and travel agents entering a state of distress as cash flow falls on reduced demand. This is where our banks need to support good businesses that are challenged by the impact that Coronavirus is having.
We have been living through a period where QE has inflated the value of equities, bonds and property. These heavy market falls has brought the loose money policy benefit to a sharp end.
Long standing low interest and low inflation rates have in some ways masked the underlying debt levels and fragility of the world economy and Coronavirus has exposed this. The shock comes at a time when global debt to GDP stands at a near record 242% as compared to 211% in 2007 prior to the financial crisis. If companies are starved of cash flow or access to lending this will become an issue of debt defaults. Any break in the supply chains can easily become a break in the payment chain.
It was very pleasing to hear that Morrison’s said that it would pay its small suppliers immediately to help their cash flow. Morrison’s has about 3000 small suppliers including 1750 farmers. I hope that this very positive move is repeated and other businesses follow suit as the whole country is in this together.
We need the coordinated efforts of government and central bank to keep our businesses and health services well supported and then see evidence of reduced rates of new infections in the western world. At that point markets will be very cheap and investors will return. We are now expecting recessionary pressures but if avoided then a sharp recovery in values will be on the cards as we have witnessed after previous world pandemics.
In China and other areas of Asia where numbers of new Coronavirus cases are significantly falling, the economy is now gradually returning to normal. Factories are restocking supply chains. The signs that the virus is coming under control in Asia reinforces the view that the world will get over this crisis and recover. The economic impact looks likely to be a very ‘sharp shock’ but that activity should rebound as soon as the virus fades.
Stock markets are quite good at discounting disaster and there is a lot of disaster currently priced into current equity valuations. It is still hard to know if we have hit the bottom but my instincts say not quite yet as the USA is yet to experience the worst of the pandemic.
It is expected that the Coronavirus pandemic and resultant contraction of economic activity will push the world into recession, but the extent and length will in many ways depend upon the scale of impact on the USA. The situation in Europe will soon get worse, but the US is the biggest swing factor given its size and role in driving global demand. A US recession will mean a world recession. However, the strong support provided by governments and central banks may be sufficient for a recovery later in 2020.
Chris DaviesChartered Financial Adviser
Chris is a Chartered Independent Financial Adviser and leads the investment team.