Peak Infection rates in US and Europe
Markets staged a risk-on rally following comments from President Trump yesterday that the US outbreak is beginning to stabilize, citing a reduction in the daily number of deaths in New York, the epicenter of the virus outbreak in the US.
Global equities rallied 5.5%, US high yield spreads tightened 18 basis points to 923 bp, while the 10-year US Treasury yield rose 7 basis points to 0.67%.
We believe that containment measures in the US and Europe are taking effect, and several epidemiologic studies (including IHME) are broadly forecasting that the daily rate of new cases would peak in the month of April.
Exhibit 1: The Institute for Health Metrics and Evaluation (IHME) COVID-19 projections for the United States assuming full social distancing through May 2020
The peaking of infection rates is critical in helping investors estimate how long containment measures would remain in place, which now seems to be at least all of April and likely until the end of May. It is also necessary before getting more clarity on the timing, scope and pace of the relaxation of containment measures.
After a sharp plunge in risk asset prices, including a 34% peak to trough correction in equities and a surge in high yield spreads to post-GFC records, the scenario of an extremely sharp recession in the first and second quarter of 2020, followed by a gradual recovery path starting sometime in the third quarter, broadly characterizes current consensus economic forecasts.
This base case of a very deep but short-lived recession is largely priced into markets. When a record initial unemployment claims figure of 3.3 million was reported on March 26, global equity markets were not caught wrong-footed and in fact rallied. This happened again on April 2 after a far worse 6.6 million figure was reported.
An analysis of market data (Exhibit 2) over the last seven decades shows that US recessions lasting for less than a year tend to result in an average S&P 500 correction of 20% with a range between 13% to 37% – which is generally in line with the trading range of the equity correction during this crisis so far.
Exhibit 2: Historical corrections in the S&P500 index during US recessions (1948 to current)
Source: Bank of Singapore, Bloomberg
* Start of recession pending confirmation by the US NBER
Risk of virus resurgence
This base case rests on the general premise that containment measures would be lifted by summer, and that wide-ranging monetary and fiscal stimulus measures would protect for a time against long-term economic damage, which would allow a gradual return to economic normality starting sometime in the third quarter of 2020.
Importantly, this scenario can only happen if we see, in addition to the peaking of the infection rates ahead, that the risk of second and subsequent waves of infections are being successfully managed by policymakers.
Despite various surveys showing that subsequent infection waves are not near the top of lists of investor concerns, medical experts caution that resurgence of infections are likely to happen. The World Health Organization has recently warned that resurgent infections could lead to an economically destructive cycle of repeated lockdowns if restrictions are lifted too soon.
And we already see warning signs of this. A county in central China was put under lockdown again after a resurgence in cases. In Japan, a recent surge in cases after a period of having controlled the pace of infections have resulted in policymakers declaring a state of emergency in seven prefectures, including Tokyo and Osaka. Similarly, a new wave of infections in Singapore has resulted in an escalation of containment measures.
Although there are grounds to hope that increased testing, greater awareness and more experience would help curtail the harm from subsequent waves of infection, this downside risk needs to be monitored carefully.
An increase in the risk of a prolonged recession would have severe market implications. History shows that prolonged recessions lasting more than a year tend to lead to a far sharper average equity correction of 38% with a range between 21% to 57% (Exhibit 2).
In the event that the risk of a prolonged recession – which is more onerous than current base case expectations – increases significantly, we could see markets testing and breaking below their recent March lows.
More stimulus buffers
The stimulus measures announced so far would help offset the effects of the sharp shocks to businesses and the labor market for a few months, but a longer-than-expected slump would result in a downward spiral of falling corporate earnings, surging unemployment and collapsing consumer demand.
As incoming economic data worsens ahead, we will be watching out for more stimulus from policy makers which would help build up additional buffers for businesses and consumers. Even after recently approving a US$2 trillion stimulus package, we see good odds that the US government would work on and pass another significant fiscal package, while the Fed is rapidly moving into its next phase to provide “Main Street” support to prop up small and mid-sized businesses and their employees.
In addition to the Fed’s US$349 million Paycheck Protection Program to provide no-collateral loans to small businesses, we expect to see a Temporary Corporate and Small Business Liquidity Facility (TCLF) financed by a portion of the Fed’s newly replenished US$454 billion arsenal from the US Treasury’s Exchange Stabilization Fund.
In the Eurozone, we expect to see a fiscal stimulus package with a sizeable headline number underwritten by an EUR870 billion expansion of the European Central Bank’s balance sheet, which is made available by the new Pandemic Emergency Purchase Program (PEPP) and the existing Asset Purchase Program (APP).
What should investors do?
We believe this volatile environment calls for careful capital management and a long-term mindset. Those who are leveraged should make use of rallies to de-risk and build up liquidity buffers. Remember the adage that the market can stay irrational longer than you can stay solvent.
For non-leveraged investors who are neutral-weight or underweight in terms of their risk exposure, attempting to time the market bottom is not practical. We recommend trading up in quality and patiently edging into solid assets that are oversold in terms of fundamental valuations.
Investors need to be careful and selective as not everything that has been sold off is cheap. Many companies will be permanently impaired by the sharp recessionary shock, and some will not survive. It is critical to focus on high quality assets with resilient balance sheets and growth.
We are overweight the Chinese, Hong Kong and Singapore equity markets as we believe that sufficiently attractive long-term risk-reward has emerged.
We are underweight developed markets high yield bonds, where we see significant vulnerability to downgrades and defaults given the exposure to US shale oil and the lower quality CCC and below credit names.
We take an overweight view on emerging market high yield bonds. While some near- to medium-term downside is possible, we do not expect spreads to revisit the levels achieved during the GFC. We maintain a preference for Asian high yield, in particular Chinese property, prefer Turkey within CEEMEA and stay defensively positioned in Latin America.
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Version: March 2020