Courtesy of ZeroHedge
Authored by Goldman economist Zach Pandl1. Virus transmission through reopening still a major source of two-sided risk.
In our view the most important risks to confidence in a reversal of economic damage are medical in nature. The key unknown, in our view, relates to the sensitivity of virus transmission to economic activity. On the one hand, it may be possible to restart significant amounts of business activity while keeping the public health risks manageable. As our economists point out, a number of behavioral changes, like mask wearing and more frequent cleaning of workplaces, should help lower transmission rates, all else equal. There is also potential upside risk from good news on treatments and vaccines, although the market has taken some credit already. On the other hand, we may find out that transmission rates pick up after restarting activity only in the “easier” sectors, like manufacturing and construction. At this point we simply do not know what will happen. Countries that have relaxed restrictions already, like China, never had the same widespread outbreak that Western countries experienced. Others that have tried to go without government-mandated social distancing, like Sweden, may experience a worsening outbreak over the next month. Given the reopening timeline for some US states and a few European countries, we should learn much more about these issues over the next 2-3 weeks, and there are risks on both sides. Continued incremental progress towards reopening without a meaningful increase in new infections is likely to allow markets to more finely calibrate the depth and duration of the cyclical hit and compress that source of risk premium further (although “second wave” risks for the coming Autumn would remain). For the same reason, a rise in “R0” above 1 early in the restart process would undercut some key supports that the market has been drawing comfort from.
2. Oil markets switching from headwind to potential tailwind.
Following a volatile rebalancing process in physical crude oil markets—with spot WTI prices briefly diving into negative territory—our commodity strategists have turned more constructive on the outlook. They caution that reducing the sizable inventory overhang will take time, but forecast that Brent prices will pick up moderately from current levels in H2 2020. A potential bottom in oil prices should affect all oil-sensitive assets, but the degree and duration of the impact will likely vary substantially. We find it helpful to think of oil-linked assets as akin to options on the path for prices—many all which are out-of-the-money (OTM) currently. Even OTM options have delta, however, so many oil-linked assets could benefit from a rapid rise in prices to some degree. For that reason, trades across assets that are implicitly short options on oil prices should be avoided for the time being, in our view. However, both the duration of the option and its “strike price” will also matter for the asset-specific response. If price increases need to be relatively quick or relatively large for the business or sovereign to remain solvent, the benefit from a moderate rise in prices may be fleeting. For example, listed Canadian oil producers require only a moderate rise in prices to cover cash costs, whereas Nigeria and Saudi Arabia may require a significant increase to prevent continued current account deterioration and further FX reserve use. These differences should start to show through after the initial rise in prices.
3. Europe will come together, but at what spread?
In contrast to commodity markets, risks from stress in European sovereign bond markets have worsened over the last month. At the ECB’s current purchase pace and with buying distributed according to the “capital key”, we estimate that Italy will need to tap public markets for €126bn before year-end, or €189bn at an annualized rate. This is well in excess of the previous annual high for Italy’s public borrowing. We expect that this substantial issuance will continue to put pressure on Italy’s borrowing costs (and potentially Spain’s as well). The ECB’s interventions – including last week’s PELTROs – should help anchor the front-end and may encourage some domestic carry-trading further out the curve. But we think there is a good chance that they will prove insufficient, and we are likely to move back and forth without greater clarity on the scope and legality of ECB interventions (an example is this morning's German constitutional court judgement). The question will then be: at what level of market pressure will EU institutions step in to provide more support? This could come in the form of much larger ECB purchases, a more explicit relaxation of the capital key, or an alternative EU-wide recovery effort with few strings attached, for example. Before policymakers take these steps, we think higher spreads may be needed for domestic political considerations to change. Although these risks are partly priced in some areas, we remain concerned about the risks to European economies and markets, as well as potential for spillovers to other major economies.
4. US-China tensions threaten a return to last year’s debates.
So far this year, Asia in general and China in particular have mostly been sources of stability for global markets, reflecting the relaxation of US-China trade tensions in January and the relatively quick mitigation of domestic coronavirus risks thereafter. The fallout from the global outbreak risks unsettling that stability. For example, the Washington Post reported last week that the White House was “beginning to explore proposals for punishing or demanding financial compensation from China for its handling of the coronavirus pandemic”. In our view, much of this rhetoric is designed for a domestic audience and should be considered in the context of the US election cycle. However, we cannot rule out a return to some of the issues that roiled markets last year, and will be watching closely for signs that US officials are considering taking specific actions. One example might include certain investment restrictions, like those proposed by Senator Rubio and others last year. Although these risks appear manageable for now, we worry that US officials may be willing to take more risk as the economy begins to recover and the US presidential election race heats up. As we saw last year, US-China tensions can be significant drivers of market trends, even if the direct impact of tariffs and other actions is relatively modest. Since the market has been more focused on other risks, relatively less of this risk appears to be priced in China-sensitive assets.
5. Taxes may rise, but other recession “scars” should be manageable.
In his press conference last week, Fed Chair Powell expressed concern about potential “longer run damage to the economy”, and spoke of the need for policy to remain focused on limiting that damage. Many investors seem to share the concern about “scars” from the coronavirus recession—long-lasting effects that will weigh on corporate earnings and markets for some time. We are sympathetic to the idea that high debt-to-GDP ratios across many economies will need to be addressed at some point, and this may result in significant tax increases, including on corporate income. We also see a risk that bankruptcies and credit losses prove a larger obstacle than in our central case, since it is hard to be certain of the net effects of an unusually sharp shock and the support that has been given. But our economists note that other recessionary fallout may actually be relatively small compared to the size of the downturn, due to the temporary nature of many job losses, the huge amount of fiscal policy support in place and easier US financial conditions. From a market standpoint we would also stress that longer-run costs will naturally develop over a longer period of time—so while some of these issues may be worrisome, they may not be sufficient reasons for markets to decline over the coming quarters. We will be watching the debate about corporate income taxes closely through the US election cycle, as large swings in expectations on that issue could affect broad markets. But otherwise we think investors should not be excessively pessimistic about the asset market outlook due to “scarring” risk.
6. Further progress on some tail risks.
In mid-March we set out a framework for assessing how the economic downturn might affect markets. We argued that financial market and economic crises involve a distinct set of tail risks, and that markets would recover in a sequential way as those risks were mitigated or at least better understood. By our mid-April update, a number of important risks had already turned around—including funding and liquidity stresses, an insufficient macro policy response, and a failure to control infection spread. As a result, the asset prices most geared to these risks have likely past their extremes, including money market spreads, implied vol, and significant parts of corporate credit and structured product markets. With crude oil markets now going through the necessary adjustments to balance supply and demand, our commodity strategists see an improved distribution for prices, and we would characterize oil markets as a source of upside risk to other assets, including assets linked to EM oil exporters that have been outside the “policy tent” and still embed significant risk premia. Separately, our analytical work on valuation has positively affected our views on the margin. Because markets seem to look at least two years ahead, we would expect most assets to be relatively insensitive to news on the depth of the contraction as long as it would reasonably be expected to reverse before too long.
7. A narrow path for upside.
Much now depends on a tricky balance of risks. There is a potential path higher in risky assets even after the rally, but it is narrower than before. Although broad equity indices have rebounded, the rally has been narrowly concentrated and cyclical sectors have underperformed. The performance of other assets—including developed market rates and EM currencies—also suggest markets have not priced in much more growth optimism. If we see the likely pickup in business activity and focus on the reopening process without clear evidence of renewed infections or an intensification of Europe/China risks, this would likely open up a path to more upside, particularly in cyclical parts of the market. Additional good news on the treatment/vaccine front would reinforce that. But this scenario may be possible in the near-term even if the broader medical risks do reappear, since the biggest source of uncertainty in the outlook—the degree of sensitivity of virus transmission to economic activity—will be difficult to observe over the coming 2-3 weeks, given the lags between loosening restrictions and reported transmission. For these reasons, upside options in equities probably still underprice the “upside tail”.
8. Broad cyclical risks remain; watch virus transmission rate.
More broadly, however, we are not ready to say that cyclical risks in general have passed or to embrace further upside from here as a central case. The public health outlook is still largely an unknown. Depending on how it evolves, the overall macroeconomic cost of the coronavirus recession could still be much larger than expected. If effective transmission rates for the virus remain below 1 through the month of May, we would feel more confident that we have seen the lows for risky assets and highs for safe havens, and could consider turning the risk dial up a bit further. Ahead of that, we would make a few general recommendations.
First, position portfolios such that a further squeeze higher in risky assets over the short-term could be tolerable—a smooth-ish reopening process is a realistic scenario which needs to be taken into account. One approach may be through longs in oil-linked assets, given the better distribution of risks in those markets.
Second, add hedges for the identifiable risks. We think currency markets are a good place to do this, and like Yen longs for broad macroeconomic risks, Swiss Franc longs for Europe-centric risks, and Dollar longs vs non-Japan Asia currencies for a possible further deterioration in US-China relations.
Third, continue leaning into macro differentiation trades, including DM vs EM, US vs Europe, and country-specific differentiation trades within those groups.