March 2020

In a surprise move, the Fed cuts US interest rates by half a percent. The coronavirus will hit world economic growth.

The market for catastrophe bonds is predicting a coronavirus pandemic which is at odds with the opinion of the World Health Organization. Nevertheless, the virus has the potential near-term to push the world economy into recession. The Fed surprised markets with its move to cut US interest rates by 50 basis points.

 

Catastrophe bonds predict a pandemic

The International Bank for Reconstruction and Development (World Bank), issued two catastrophe bonds in July 2017, structured precisely to pay off in the event of a severe outbreak of an infectious disease. Pay-outs are triggered by factors such as the number of reported cases and deaths. The payout mechanism is complex, relating also to metrics such as the duration of the disease, the speed at which it spreads and the geographical spread of infections and deaths. Riskier tranches of these bonds now trade at discounts over 50%, clearly signaling a market view that a pandemic is upon us.

 

Further severe travel restrictions and the cancellation of mass events likely

As long as no vaccine is available, controlling the virus would probably require massive travel restrictions even as one accepts that the travel restrictions introduced thus far have failed to stop its spread.

 

The impact on transport, tourism and hotels…..

…is clear for all to see. In the most vulnerable areas, investors may have to prepare for a wave of bankruptcies, a wave of bailouts and at the very least for widespread capital raises and shareholder dilution. The scale of potential risk is indicated by Macao’s casino industry where February revenues have fallen 90%, or in Como where 50% of hotel bookings have been cancelled. Firms such as Nestle, Facebook and Google have implemented wide-reaching business travel bans and the Global Business Travel Association estimates the virus is costing its industry some $47bn a month.

 

Oil demand has fallen substantially

Travel restrictions have led to a collapse in demand for all types of fuel and oil producers with production costs below selling prices now face increased credit problems. The financial threat to the tourism and energy sectors is obvious as are the likely secondary effects on the bank sector, which now faces increasing write-offs on loan assets. For investors, capital increases and renewed dilution are in prospect.

 

The Fed surprised with a 50 basis point rate cut

The Fed surprised markets with its unanimous decision to cut US interest rates by 50 basis points on March 3rd. The next FOMC policy meeting is scheduled for March 17-18. The market now expects this meeting to deliver a further 25 basis point rate cut. This is also our expectation. Further measures of stimulus from the ECB are likely in coming weeks and we believe the Eurozone’s central bank is considering the provision of direct emergency lines of credit. We see ECB President Mme. Lagarde backing such a move given her previous record as head of the IMF.

 

Monetary policy can’t really combat supply shocks such as a further spread of the coronavirus

Monetary policy can’t combat the spread of the coronavirus, but it can help offset the associated credit risks. Expect a global race towards zero interest rates.

 

How bad is the real economic impact likely to be?

Looking at pollution and traffic volume data, one might conclude that Chinese GDP has plummeted by 30-50%. But official Chinese statistics will never reveal the true scale of the collapse. Investors should underweight Chinese stocks and bonds. Their pricing is very opaque due to the authorities’ manipulation of Chinese markets. If China were a real market economy with a bankruptcy law comparable to those in Western countries, there would now be a wave of bankruptcies. However, under China’s mixed economy system, in which the Chinese Communist party has an overarching role, creditworthiness is “dictated from above”, so there are unlikely to be mass bankruptcies. According to official statistics, the number of new infections in China is now falling sharply. This information could actually be correct given the extreme measures of disease isolation that China has enforced in recent weeks.

Chinese Purchasing Manager indices crash

The Caixin General Composite Purchasing Managers’ index (PMI) plummeted from 51.9 in January to a record low of 27.5 in February, while the services PMI dropped to 26.5. The Jibun Bank PMI for services in Japan fell from 51 to 46.8 in February

 

For now, European Purchasing Manager indices have been able to match expectations

Purchasing Managers’ indices in Europe have so far matched analyst estimates. The Markit Eurozone Composite index reported 51.6 for February (as expected). However, the paralysis of economic activity due to the spread of the virus in Europe in more recent weeks is not properly reflected in this figure. It now looks almost certain that March data will show a significant deterioration.

 

The coronavirus could cause a recession

The chances of a recession have increased. The coronavirus represents a massive shock for the entire global economy. This is clear from the reaction in bond markets. For the first time in 150 years, the yield on the 10-year US government bonds has fallen below 1%. The sharp drop in the oil price also signals a (short-term) substantially increased risk of recession. But, if the virus can be contained soon, there should be a strong upswing.

 

Containment in the West is difficult

Western governments, unlike authoritarian China, cannot except in dire circumstances implement “extreme curfews and restrictions on freedom of movement”. So, chances of containment in the western world are unfortunately much lower than in China. For now, it is likely that the virus will continue to spread on a global basis.

The authorities face a very difficult balancing act

Absent a vaccine, the virus can only be combatted through tight restrictions on the movement of persons and extreme isolation measures. However, such measures would “stall” the economy. Given that extreme measures of restriction and control are only being implemented in isolated cases in the Western world, we are pessimistic as to the virus being contained.

 

Financial markets celebrate Joe Biden

On so-called Super Tuesday, Joe Biden won 9 of the 14 states holding elections for delegates to the Democrat party convention later in the year. Joe Biden is viewed as a moderate and his success was welcomed by the market as was the ongoing poor showing of the radical, Elizabeth Warren.

The news flow on the coronavirus is likely to be very volatile in the next few days. The virus represents a significant demand and supply shock that is difficult to combat with monetary and fiscal policies. It is not possible to predict the further development of this pandemic. For example, tomorrow could bring good news of the rapid development of an effective vaccine. But equally, the day afterwards could see reports circulating that the virus has mutated into a much more dangerous disease, with significantly higher mortality rates.

 

We continue to recommend that investors remain tactically underweight in equities and overweight in gold. We see the convertible bond market as offering an attractive balance of risk and reward.

 

 


Contact: Thomas Härter, CIO, Investment Office
Telephone: +41 58 680 60 44


Disclaimer: The information and opinions in this document come from sources that are considered to be reliable. Nevertheless, we cannot guarantee the reliability, completeness or accuracy of these sources. The information and opinions in this document do not constitute and shall not be construed as a solicitation, offer or recommendation to purchase or sell any investment or to engage in any other transaction. We urgently recommend that interested investors consult their personal investment advisor before making any decisions based on the document so that personal investment objectives, financial situation, individu-al needs, risk profile and other relevant information can be duly taken into account in conjunction.