The fund managers, researchers, and economists of Erste Asset Management have compiled and answered the most frequently asked questions about the coronavirus and its effects on the markets.
What is currently happening on the stock exchanges?
Investors have been regrouping their assets in recent weeks towards save havens. Equities are being sold while government bonds are being bought. This means that the focus of investors is not on the return potential of equities but on the comparatively lower risk of government bonds.
Such developments tend to occur when the economic outlook is deteriorating. Indeed, the measures taken to contain the coronavirus from spreading have a clearly negative impact on the economy. These developments cause share prices to fall and government bond prices to rise.
What does the current situation mean for the global economy?
The status quo does not provide much historical data to rely on. This of course produces uncertainty, which we currently feel on the stock exchanges. That being said, it is still possible to assess the effects on the global economy thoroughly.
The scientific studies that are available on pandemics and the economy are either based on models, which means assumed data about the effects of a pandemic are put into a model (e.g. retail sales, labour force supply etc), and the model yields a resulting scenario.
The other method is to use past crises as basis to predict a scenario. This is, for example, done with MERS, SARS, Ebola, or earlier influenza pandemics such as the Spanish flu.
Both of these methods come with downsides, given that the scenarios do not fit the current situation.
- The interest rates today are much lower than in any scenario established ten years ago. This means that the stimulus effect of interest rate cuts by the central bank is overweighted.
- Supply chains are far more integrated than 5, 10, or 20 years ago. This means that disruptions in global commerce have significantly stronger and more far-reaching effects than only a few years ago.
- China now accounts for a far bigger share of the global economy than five or ten years ago. This means that the impact of the Covid-19 epidemic in China has much wore weight in global terms than SARS had.
What conclusions can we draw from the studies?
Pandemics tend to set off a quick and V-shaped economic development. As long as the number of new infections is on the rise and, in particular, as long as public institutions and individuals continue to try to contain them by decreed or voluntary social isolation, the economy is going to stagnate.
Only the bare necessities will be bought, and production falls significantly. But as soon as the crisis has peaked, the economy will be picking up speed again fairly quickly. The result is the return to the pre-crisis status quo.
The literature suggests about one to two quarters for this sequence of economic slump and subsequent recovery. Pre-crisis levels should be reached after one year. The situation in China, where the number of new infections outside of Hubei has been reported at zero as of 9 March 2020, has been following this script. The question now is how strongly and fast the recovery will kick in.
The effects of such a development on growth are definitely negative. The studies only differ in terms of the extent to which the economy is affected. Here, the numbers range from (in our opinion, overly moderate) 0.3% of global GDP growth to (from our perspective, exaggerated) consequences that would be comparable to a financial crisis. The most recent estimates predict that growth rates will be cut in half in 2020.
Are we facing a recession?
As mentioned earlier, we expect a short but sharp decline in economic activities for the regions affected by Covid-19. In countries such as China, this is likely to cause growth to turn negative for at least one quarter. In countries where growth was not particularly high to start with even before the crisis (e.g. Italy), the economy is not only likely to shrink, but there is also the risk of this situation lasting for a prolonged period of time, given that the pre-crisis growth rate was only slightly above zero.
However, we believe that in this situation the markets will be more interested in news about the Covid-19 virus and measures taken to contain it than economic data. It is clear that the measures will eat into economic growth. At this point, this is about getting the virus under control. As soon as that is done, the markets will be entering a calmer phase as well. If we were to see a situation like in China (ex-Hubei) in Europe, a rebound on the markets would be likely.
What measures have governments and institutions like the Fed or the ECB taken?
Governments have various alternatives of acting in, or reacting to, the current situation.
- Governments can take measures to impede the spreading of the virus. Of course, many of those measures such as the quarantine in China or Italy are extremely disruptive for social interaction and the economy. But that is the lesser of two evils at this point.
- In addition, governments can also ensure that those whose health is at risk are taken care of. This also contributes to the reduction of the direct economic consequences of the crisis.
- An important task of governments these days is of course also to inform the public transparently about the risks and dangers of Covid-19. Among them is the swift forwarding of information across national borders. This is the only way for countries to prepare for the virus in a timely fashion and to take suitable measures. In this context, the exchange of research results is also crucial for the development of an effective protocol to contain the virus as quickly as possible. In the best case, this could also lead to the development of a vaccine.
On top of these directly Covid-19-related measures, the governments and central banks also have their traditional arsenal of fiscal and monetary measures readily available.
- It will be the job of the central banks to provide the economy with sufficient volumes of liquidity so as to prevent avoidable insolvencies from occurring. This strategy makes sense especially if the aforementioned economic assumptions turn out to be correct.
- It will be challenging to pursue a route of traditional fiscal policy in this situation. Planned construction projects that need years to complete are unlikely to move ahead in the coming weeks. Measures such as reduced work hours that support a return to the growth path may help – in addition, of course, to anything that helps fight the health-related consequences of the Covid-19 virus.
- Both governments and central banks have realised the severity of the situation and will leave nothing undone to support with suitable measures.
What exactly is going on with the oil price?
The oil price fell by almost 35% at the beginning of the week. This was the strongest fluctuation since 1991. Back then, the fall had been triggered by the outbreak of the second Gulf War.
On 5 and 6 March, OPEC – headquartered in Vienna since 1965 – held an extraordinary meeting at its HQ. The goal of the meeting was to keep the oil price stable amid the demand shock caused by the coronavirus. This would have only been possible by cutting production further, i.e. by reducing supply. In the past, OPEC and Russia as non-member state had agreed to and implemented such production curtailment.
However, this time Russia refused to agree to a further reduction of supply, which led to an escalation between Saudi Arabia and Russia.
The current environment now generates a production surplus; the previously reduced production of 2.1mn barrels per day makes it onto the market, looking for buyers. – At a time when demand is already subdued due to the weak economy and the coronavirus. A swift solution of the affront is unlikely, because neither Russia nor Saudi Arabia wants to back down. Both can still produce profitably at USD 30, but they cannot balance their budget at lower oil prices.
What companies and countries will be negatively affected by the low oil price, and which ones will benefit from it?
Among the biggest losers of the oil price slump is the USA. While the country has increased production significantly in recent years on the back of shale gas, the production costs of many producers are higher than the current sales price. If the price remained at its current level for a while, it would cause some oil producers to become insolvent.
Among the beneficiaries is primarily the consumer, because the lower oil price will be passed on to them at the petrol station. The central banks also have more wiggle room in terms of rate cuts, because a lower oil price basically has a deflationary effect.
What’s in store for us, and how does one construct a portfolio in such a situation?
Amid falling prices, it is always important for investors to keep the eye on the long-term perspective. Also, the portfolio should be diversified by asset class or country/region in order to absorb the risks. This can be done by investing in actively managed equity, bond, or multi-asset funds. Recent weeks have clearly highlighted the upsides of this form of diversification:
- Diversification by asset class: whereas equities are down, multi-asset funds have benefited from the rising prices of credit-safe government bonds from the USA and Europe. Gold is part of our multi-asset funds and asset management accounts and has contributed positively as well.
What is the current positioning of Erste AM?
In our multi-asset funds and asset management accounts we pursue a broadly diversified investment strategy. In addition, we shifted our positioning towards a more defensive strategy at the end of February. This means we reduced the equity ratio and, by contrast, increased government bonds from Europe and the USA.
In our equity funds, the focus is on quality and growth. Generally speaking, in the developed markets we are keeping lower weightings in the sectors that are particularly badly affected, and in the emerging markets funds we have for example reallocated assets to pharmaceutical companies or producers of medical aid.
For our dossier on the coronavirus, please visit: https://blog.de.erste-am.com/dossier/coronavirus/
Important legal disclaimer:
Forecasts are no reliable indicator of future developments.