Ives Bonzon (Julius Baer) | When the circumstances we face become extreme, the temptation to panic is great. As Daniel Kahne-man, the great psychologist and Nobel Prize – winning economist for his work on choices and decisions, explained, the human brain is subdivided between a fast brain focused on the risks to our survival and a slow brain useful for grasping complex problems. The pandemic scenario touches us emotionally at the heart of our most precious asset, our survival. Nevertheless, more than ever, it is crucial to apprehend the situation with our slow brain. Un-certainty has rarely been so extreme. To sum up, we can imagine that this is the time when panic is salutary, but most probably a calm approach is the most effective one to protect our wealth in the me-dium-term. So let’s use our slow brain and review what we know, what we don’t know, and what the markets discount at current prices.
Since the last week of February, trading volumes have approximately doubled in the markets. To date, markets have functioned normally, providing investors with the ability to transfer risk and adjust their positions to developments in a rapidly chang-ing environment. The market impact of investment pools trading large sizes seems moderate so far. From this point of view, evidence confirms that we do not have a systemic risk problem, at least not yet.
IS ITALY TRYING TO BREAK ITS FISCAL STRAIGHTJACKET?
In Italy, faced with a rapid rise in coronavirus deaths, the government has decided to quarantine nearly 16 million citizens. Milan, the economic lung of Italy, is also threatened with suffocation. The de-cision is obviously unprecedented in peacetime. As we discussed last week, governments face a di-lemma between the measures needed to contain the spread of the virus as quickly and effectively as possible and the risk of killing the economy. No one can answer this question even in a vague manner, as the biological phenomenon is so unpredictable. The measures decided this weekend by the Conti government are so radical that one wonders whether Rome is not trying to kill two birds with one stone. Indeed, Italy could both contain the epi-demic and break the fiscal straitjacket imposed by the European Union, as exceptional circumstances require massive support from macroeconomic poli-cies. This covid-19 crisis will not be without political consequences in the near future. It could, as already mentioned, accelerate the transition to non-orthodox macroeconomic policies such as neg-ative taxes. However, these political consequences will not be discernible either quickly or easily, which will maintain volatility in the markets for an ex-tended period of time. Please brace yourself for more ups and downs (ups as well, no typo).
OIL-PRODUCING NATIONS INFLICT A SECOND SHOCK TO THE WORLD ECONOMY
The weekend news of Saudi Arabia’s oil price war could not have come at a worse time. It constitutes an additional external shock at a time when the capital structures of oil companies are already un-der significant pressure. In any case, the shock to the economy worsens in the short-term as the credit crunch intensifies and, with it, deflationary pressures. The unprecedented collapse in oil prices is a kind of anti-oil crisis. Demand for oil has been reduced while supply will increase as a result of the Saudi reaction. The situation is similar to the 1973 oil crisis, but in reverse! Given the damage it will in-flict on the US shale oil industry, Washington’s re-action may be interesting. The energy sector was already under stress before the latest events and a collapse in the oil price below USD 30 a barrel will lead to many credit defaults, if it does not recover quickly. In turn, the high-yield bond sector will suf-fer from the fund and ETF redemptions that can be expected. In the medium-term, however, the econ-omies of oil-importing countries will benefit from lower energy prices, which will support household disposable income. Not everything is negative.
THE (NEGATIVE) WEALTH EFFECT WILL START TO PLAY OUT
Added to the list of problems that the coronavirus has triggered is the negative wealth effect. Devel-oped economies, especially the United States, have indeed become sensitive to changes in wealth caused by sharp rises or falls in the prices of finan-cial assets. Between 2006 and 2010, the US housing crisis represented a wealth shock of around minus USD 7’000 billion spread across US households. At recent highs, the US equity market alone accounted for around USD 30’000 billion in market capitalisa-tion. Each 10% drop in the market therefore repre-sents a loss of wealth of USD 3’000 billion. The ef-fect on the economy and in particular on consump-tion cannot be underestimated from a certain level onwards. We reiterate our view that the Federal Re-serve will be forced to intervene decisively, includ-ing by buying shares, if we reach levels below 2,400 points on the S&P500 index.
NO EASY FIX TO THE CREDIT CRUNCH
As already mentioned in these columns, the unique nature of the problem is that a pandemic confronts the global economy, which makes fiscal or mone-tary intervention ineffective, as long as the spread of the virus is not under control. The more damage is inflicted on the economy in the short-term, the faster the epidemic will be contained, but the higher the risk premiums in the markets will be in the immediate future. At most, policymakers can ensure relative stability in the markets in order to prevent the negative wealth effect and the fall in the speed of money circulation in the financial sys-tem from worsening. They should show determina-tion to ensure a swift recovery by the time the virus goes dormant again.
EXTRAORDINARY CIRCUMSTANCES REQUIRE A VERY ORDINARY APPROACH
Everyone realises, I think, the exceptional but above all unprecedented nature of the current health crisis and the risks it poses to the world economy and even to the world order. Faced with such a situation, the temptation to believe the Cas-sandras is immense. In reality, the only certainty is that market visibility has rarely been so low. We are fundamentally hostage to the time it will take to contain this coronavirus, allowing a return to nor-mal. At the time of writing, the situation has gone beyond the simple context of a temporary adjust-ment of risk premiums. Some assets in the oil sec-tor or in tourism, transport or events industries are definitely impaired.
Unlike the financial crisis in 2008 where the main uncertainty was when the policymakers would make the required decisions, which happened in March 2009, in the current case nobody knows how the epidemic will develop. Moreover, no one knows what the political consequences of current events will be. While the virus may continue to spread, re-quiring more measures damaging the economy, markets have significantly discounted this scenario in record time. The spring is getting compressed and it is important to remember that it can get re-leased violently at the first signs of a downturn in the epidemic.
We have two key recommendations to share in the present circumstances:
1. Pay particular attention to distinguish be-tween assets that are or will be durably or definitively impaired by this crisis and those only experiencing a temporary change of valuation
2. In the face of this maximum uncertainty, the fall-back position is the strategic asset allocation of a portfolio, not cash
3. Gold is not an effective hedge as long as counterparty risk does not rise, US Treasur-ies are a better hedge