Bond markets: Aid from governments and central banks should prevent the sovereign debt crisis from returning
The coronavirus crisis had a significant impact on the European bond market in the first quarter. German government bonds were the only ones that were in demand as a safe haven, and they recorded a gain of 2.0% according to the JP Morgan Index. In contrast, the JP Morgan Index for government bonds from the euro zone achieved a return of only 0.2% because the price gains of northern European government bonds, which are considered a safe haven, were almost completely offset by the negative performance of southern European government bonds. Financial market players feared a return of the sovereign debt crisis due to massive increases in government spending and a virtual standstill of the economy in southern Europe. A EUR 750 billion Pandemic Emergency Purchasing Program (PEPP) launched by the European Central Bank (ECB) was the only thing preventing higher price losses for government bonds from southern Europe. Fears of a debt crisis also reached the market for corporate bonds. Due to widespread stagnation in many sectors, companies are now threatened by bankruptcy due to a lack of income and thus the means to pay interest and repay debts. However, the ECB and the national governments in Europe have worked hard to ensure that sufficient funds are available to help companies through the difficult times by providing liquidity support, government-guaranteed bridging loans and tax deferrals. Unfortunately, media reports indicate that government aid has not yet arrived everywhere. According to the BofA Merrill Lynch Index, euro-denominated corporate bonds with an investment grade rating lost around 6.1% in the first quarter and euro-denominated high-yield bonds even lost around 14.6%. A new EUR 120 billion quantitative easing program launched by the ECB with a focus on private sector securities prevented even greater price losses for corporate bonds.
There’s still a risk of the European sovereign debt crisis returning in the second quarter because debt ratios in southern European countries will rise massively, thus possibly jeopardizing debt sustainability. The member states of the European Monetary Union are currently working on a plan to secure financing for southern European countries, bearing in mind that a country’s financing costs are a decisive factor in calculating its debt sustainability. However, if efforts succeed, with the help of the ECB, the European Investment Bank and the European Stability Mechanism, in guaranteeing comprehensive state financing at low interest rates for southern European countries, worries about the stability of the European Monetary Union would certainly subside. Ironically, the euro zone could fail because the ECB has fewer options for action than the US Federal Reserve or the Bank of Japan. It’s also important to avoid major corporate failures in the next few weeks by supplying government support. In our base scenario, we expect sufficient government aid and an improving economic environment starting in June at the latest, which would cause the corporate bond market to stabilize again soon. In the meantime, however, we see a risk that the rating agencies could substantially downgrade the creditworthiness of many companies, which would lead to price losses for investors.
Equity markets: Volatile sideways movement is the most likely scenario
In February and March, US equities suffered the most sudden price drop in their long history. In just 16 trading days, they lost more than 20%, thus meeting the generally accepted definition of a bear market. Overall, the global equity markets recorded substantial price losses in the first quarter. The MSCI Europe stock index decreased 21.7%, the MSCI World lost around 20% and the MSCI Emerging Markets lost 19% – all in local currency. Interestingly, China's CSI 300 stock index was among the world's best performing equity markets in the first quarter with a loss of only 10%. As the quarter progressed, it became increasingly apparent that China was able to quickly bring the coronavirus pandemic under control and could thus loosen initial quarantine regulations towards the end of the quarter. In line with this, China's economic data already showed first signs of improvement in March.
The coronavirus crisis is likely to reinforce Asia's long-term economic growth trend and pave the way for Asia to achieve economic dominance in the world. As a result, global investors are likely to include Asia in their portfolios more and more. Furthermore, experience shows that equity markets often anticipate a recession early on and go into reverse gear beforehand. In contrast, market players seem to have difficulty foreseeing the end of a recession; thus, equity prices often do not bottom out until economic data has reached its lowest point. We currently assume that the extensive aid programs of the central banks and governments should prevent a wave of bankruptcies and thus a financial market crisis. We therefore believe there is a good chance the economy will recover slowly and in line with easing quarantine regulations. In our base scenario, we expect the economy will bottom out in June. Risks that could jeopardize this base scenario include a return of the sovereign debt crisis in Europe, a wave of corporate bankruptcies due to policy mistakes, and a pandemic in the US that spirals out of control. The second quarter is therefore likely to be difficult for the equity markets as well. In our base scenario, we assume volatile sideways movement; in our risk scenarios, we assume further major price losses.
Euro zone: Trend reversal is possible in the second quarter, but the impact of Covid-19 is likely to last a long time
The effects of the coronavirus are hitting Europe very hard. The first half of 2020 is expected to see the sharpest drop in GDP in the post-war period, and the slump in economic activity is expected to be in the double digits. At present, the chances are good that, due to extensive quarantine regulations, the number of infected persons in the euro zone member states will reach a peak at the beginning of April – and a downward trend could begin in the weeks after that. The initial regulations could then be eased towards the end of April, but in order to avoid a new wave of infections, this can only happen slowly and gradually. Furthermore, experience from Asia shows that testing for the coronavirus needs to be continuous and extensive and newly infected people must be isolated quickly. This is an important prerequisite for gradually relaxing quarantine regulations in line with a declining trend of new infections. There is therefore also a good chance that economic data will turn around in May or June. In March, the purchasing managers' indices in China showed that good management of the crisis enables an economy to recover quickly.
However, the impact of the corona crisis on the European Monetary Union are likely to last for a long time. Public debt in southern European countries will increase noticeably, and debt sustainability will be jeopardized in some countries. This poses the question of whether the euro can survive. Sufficient public financing for all member states could be ensured if the European Stability Mechanism (ESM) were to provide a new emergency credit line with less strict conditionality for which all member states would apply simultaneously in order to avoid negative stigma effects. The ECB could then activate the OMT program to ensure sufficient funding for all member states in need.
It is important for the euro zone to agree soon on a new financing structure, thus sending out a sign of solidarity. According to surveys, politicians in Germany and France are currently gaining public trust, but in Italy, the anti-EU party Fratelli d'Italia has already reached 13% and, together with the anti-EU party Lega, this figure stands at 42%. The current government made up of Social Democrats and the 5-star movement has only 36% approval. It would therefore be important for all member states of the European Monetary Union to come together in an effort to quickly reverse the political mood in Italy.
US economy: Economic recovery likely to be slower than in other developed countries
The USA reacted late to the corona crisis and is therefore lagging behind developments in Europe by about one to two weeks. Therefore, it’s possible the number of infected persons will not peak before the end of April. There’s also still some uncertainty as to whether the quarantine regulations will even be sufficient to achieve the turnaround we expect. On the other hand, economic policy measures seem to be enough for now to avoid a financial market crisis. The US Federal Reserve (Fed) has launched an extensive package of programs to ensure that the capital market can continue to meet the credit needs of the real economy. The Fed is also keeping government financing costs low via a QE program that is unlimited in terms of both volume and time. Should there be renewed turbulence on the sovereign bond markets, the Fed could switch to yield curve control and fix the yield on ten-year US Treasuries in a next step. Furthermore, economic policy is now focusing less on preserving jobs and more on securing private household incomes in the form of one-off payments and substantial increases in unemployment benefits. Should the corona crisis lead to structural changes, the American model would allow the labor market to adapt quickly to the changed economy while the European model of securing jobs that are then "old" would lead to slower structural change. However, the USA is still feeling the impact of an oil price shock that has hit the shale gas industry hard. In the course of the second quarter, we expect the number of infected persons to decline, quarantine regulations to be gradually relaxed, and economic recovery to begin. However, due to the oil price shock, this recovery could be slower than in other regions of the world.
Asian economy: Economic recovery is within eyeshot for Japan; Asia is playing a growing role in the global economy
The coronavirus crisis has hit Japan hard. Japan’s GDP is now expected to have fallen for three quarters in a row, and the country may not return to positive growth until the third quarter of 2020. This is despite the fact that Japan has hardly been directly affected by the coronavirus pandemic so far. As of the end of March, there were fewer than 2,000 infected people in Japan, although the number of newly infected people has recently risen somewhat. Therefore, it’s possible the government could tighten quarantine regulations. Overall, however, Japan should be spared a major outbreak of the pandemic due to the caution exercised by its population. Weak growth can therefore be attributed primarily to decreasing exports and a noticeable decline in tourism. Since the beginning of the year, the TOPIX has only lost about 15% with a volatility of 31% while the S&P 500 lost more than 20% with a volatility of 56%. The reasons for this could be the mild course of the pandemic in Japan and the fact that the Japanese central bank has purchased large volumes of equities, particularly on turbulent days. However, it’s questionable whether the Japanese central bank's share purchases will have a positive impact on the real economy beyond the direct impact on the equity market. At the end of March, the Japanese yen was trading against the US dollar at roughly the same level as at the beginning of the year. All in all, we see good chances for economic recovery from the third quarter onwards.
A study by the Federal Reserve Bank of New York on the effects of the 1918 Spanish flu in the USA shows that those US cities that quickly implemented extensive quarantine regulations suffered only a temporary slump in growth and were able to recover quickly economically. These results are likely transferable to countries like China, South Korea and Taiwan in the current crisis. In Asia, especially in China, it appears that the number of new infections has been reduced considerably in recent weeks and quarantine regulations have thus been gradually loosened. This has led to rapid normalization of Chinese exports, imports and industrial production. The service sector is still lagging behind, but it should recover in the next few months. The pandemic has been much less severe in Asia than in Europe and the USA. Therefore, Asia's economic role in the global economy is likely to continue to grow, and Asia will become increasingly important for international investors and their investment portfolios.
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