Over the past few months, we have seen the world change beyond recognition. We have faced fatalities which are comparable to wartime figures or conflicts which have changed history dramatically for generations. It seems that Covid-19 will be another turning point in history even if we don’t know how this will affect us yet.
The coronavirus has influenced many aspects of life, including human existence, economics, politics, and social affairs. We can all see some life changes now and some are yet to come. It is very hard, at this moment, to predict what will happen in the future, because the nature of the crisis is completely different to the previous ones, regarding geographical range but also the range of life areas. This crisis seems to be different due to substantial uncertainty, impact on people lives and livelihood.
The global lockdown around the world, with the intention of protecting human lives, has severe consequences in many areas. It is impossible to list them all, however the impact on individual economies can become a chain reaction that strikes various aspects of our lives.
The International Monetary Fund sees “the great lockdown recession” as the worst since the Great Depression and estimates that global gross domestic product will shrink 3% this year. It could be the deepest dive since the Great Depression. IMF chief economist Gita Gopinath believes that the cumulative loss in global GDP this year and next could be about 9 trillion of USD – bigger than the economies of Japan and Germany combined.
Before the coronavirus pandemic, the US federal budget deficit was expected to hit a record high $1 trillion. Now, it is on track for more than $4 trillion. The US national debt could rise and exceed levels which have not seen since the World War II.
The April 2020 the unemployment rate hit 14.7%, which is the highest record since 1930, as employers have cut an unprecedented 20.5 million jobs. According to McKinsey, the virus pandemic might hurt 57 million of US workers. Consumer spending declined at the fastest pace since 1980. Blue chips or potentate companies such as British Airways, Ryanair or AIRBNB may cut thousands of jobs, measured in double digit ratio numbers. Toyota warned that their profit for the year will tumble 80%. Some others may file for bankruptcy or bailout.
Most central banks have cut interest rates to around or below zero to blunt effects of the coronavirus with only FED lunching an unprecedented range of emergency stimulus to support as much as 2.3 trillion US Dollars Loans. Fiscal packages have varied even more. The US provides around 10% of GDP in support, Germany around 4.5% of GDP and Japan stimulus package can be worth around 20% of GDP, according to Bloomberg.
Oil markets collapsed in April, trading at the lowest levels in data going back to 1946, driving WTI futures below zero for the first time in the history of unprecedented wipe-outs. The reason for the sinking prices was the limited capacity of oil storage, responding to the enormous supply from crude oil producers and the minimal demand generated by the freeze of global transportation and industry. The tiny price of crude oil could break the budgets of many economies and the American shale drillers industry.
The situation seems quite difficult and unpredictable, but the world is not over yet.
We also have some positive news on the horizon, due to the flattening of the disease curve we have seen planned easing of lockdowns in countries such as the USA, Italy, Germany and Spain. Stock markets rebounded in May, based on scale of monetary and fiscal stimulation. Oil markets have partially recovered after it turned out that there is still some capacity in oil storage facilities and oil drillers cut the output.
What will happen next? Good question … The crisis does not seem to be only a financial crisis, just oil, exclusively sub-primes but … the ubiquitous crisis, based on demand and supply disorder.
It is difficult to predict what is going to be hit the worst or benefit the most, but it is worth paying attention to several factors that may be an impulse for markets.
1 - Federal Reserve (FED) and central banks
It is difficult to predict what is going to be hit the worst or benefit the most, but it is worth paying attention to several factors that may be an impulse for markets.
No one questions that the stimulation announced by the FED and other central banks promises another “security buffer” for financial markets, due to risk reduction of credit collapse. Security buffers in short-term categories, are understood as dismissal of company defaults. It does not mean it will cure the economy as the scale of money print can create serious, further consequences related to “asset bubbles” and unprecedented increase of debt.
However, the price of major asset classes such as stocks, bonds and commodities will largely depend on the further actions of central banks. Besides the rhetoric of Federal Reserve, ECB, Bank of Japan and other central banks, it is crucial to monitor interest rates, new ideas of policy makers, the size of central bank balance-sheets and the level of public debt.
For the time being, market investors will speculate if FED will cut rates again, turning them negative. As FED declared it will not, investors are not that sure. It can have a gigantic influence on markets, especially treasury bonds, bank’s profits, credit markets and economy. Even the credibility of Federal Reserve.
2 - Labour market
Indirectly an important indicator of supply and demand. For the last couple of years, the economic growth was driven in the large part by consumption, supported mostly by basic job income and loans. In the simplest terms, losing jobs should mean less money to spend and harder to get a bank loan, which can limit the demand. Except that, it also means savings rate increase. From the other side, less employees should mean less production and services. That hits supply.
From the perspective of microeconomics, less demand and less supply means less income for companies and corporations. It can have a major influence for stocks and corporate debt.
Looking at macroeconomic terms that means less government income from taxes and customs which affects the country’s economy and prices dynamic. The macro impact may affect treasury and municipal bonds also.
The most important data that should be monitored are unemployment and new jobless claims.
3 - Trade-war
The tensions between the United States and China are beginning to rise again, mainly because of the ongoing trade war. But for now, the motives are different. The rhetoric has changed. Now the major concern is who is responsible for the covid-19 crisis. It is called a “blame game”. However, this is just a smokescreen for the fight for dominance in the global economy. For instance, Donald Trump orders federal retirement money invested in Chinese equities to be pulled, that equals around $4billion assets. Europe and the rest of the world are slowly joining the war, seeing how dependent they are on supplies from China. The European politics argue that diversification of supply is necessary and considering prohibiting investment from outside of Europe. But the news flow fluctuates. China is stepping up the purchase of soybean from US and declares intention to buy more this year. Donald Trump suggest they have very good communication with the Chinese president Xi Jinping.
In this environment, there is a concern that US or international companies who are dependent upon China for essential parts for their businesses to move production out of China or stay in China? It could be a serious concern if people in the financial markets try to figure out, how much exposure they should have to the Chinese economy?!
Political headlines, Donald Trump and Chinese ministers’ tweets (“new form of communication with markets”), may have direct impact for financial markets yet. It is very unpredictable and one of the most crucial means of information.
4 - Inflation
As described earlier, the current crisis is not only financial, but above all it is of a supply-demand nature. Supply and demand are strongly reflected in price levels of assets and goods, services. The previous crisis of 2007–2009 and measures to prevent global collapse have caused inflation, but mainly asset price inflation. This is why financial assets are appreciated, while inflation in consumer goods and consumer prices are not so clearly visible.
At the moment, this can change, because lockdown not only causes a disturbance of supply chains, but also a decrease in production or the number of services. A smaller number of employees has a direct impact on the number of goods and services produced. Despite the decline in demand, the predominance of the production process, the change in the global allocation of goods, can have a large impact on supply disruption, which will have a bearing on market prices. And this, in turn, may hit the prices of fixed-coupon bonds and the commodities markets.
5 - US Dollar and EURUSD (Eurodollar)
US Dollar is the world currency of which most economies depend. Many countries make settlements in the real economy, using US Dollar. Many countries value their assets against the dollar. This is why the currency's importance is irrevocable. But there is one more important feature of the dollar for financial markets. The barometer of risk appetite and risk aversion. And these lead to knowledge of global asset allocation.
The easiest way to look at this feature is to look at eurusd. Eurusd is one of the most important currency pairs in the world. The exchange rate depends on many factors in the short term, but the behaviour of the Eurodollar, due to its importance, liquidity, impact on the real economy, allows you to find out what the sentiment might be among investors around the world.
This is one of the main indicators is risk aversion and risk appetite. Changes in this major currency pair could signal the moments when the world is escaping to "safe" assets, buying the dollar and US Treasury Bonds, or getting rid of the dollar and returning to home countries or emerging markets showing greater propensity for risk.
As eurusd imitates global sentiment, it allows you to quickly figure out how participants in the global financial market interpret market events, macro data, and political news. It should be remembered that the market may act irrationally, and thus irrationally interpret the market events. Anyway, eurusd reflect market sentiment and global asset allocation well.
6 - US treasury bonds – 2 and 10 year benchmarks (2y, 10y)
US Treasury bonds are one of the most important markets in the world. This is the main asset class that counterbalances equity markets. Treasury bonds are a benchmark for many other instruments. The 10-year (also 30-year) yield is used as a proxy for mortgage rates, and other measures; it can be also an indicator of investor sentiment about the economy. Since they are backed by US government, they are seen as one of the safest assets around the world, often used in valuations as a risk-free rate. It is called by investors as a “safe heaven” or when they want to run away from equity markets into the safe spot, it is called “flight to quality”.
Treasury yield often reflects the credit quality of the country. When yields are rising it can mean 2 things: investors want to put money into more risky assets like stocks or the credit quality of the country is getting worse. It is an asset which is often first to react to geopolitical issues. But also, it is first to react for monetary policy changes. As US treasury bonds are being traded by investors from the smallest to the biggest and both from US and rest of the world, it is a good leading indicator of the market perception and bets for economy.
Short term bonds like 2 years are the quickest reacting for monetary policy changes, which is related to interest rate risk as long term , like a 10 years, are more related to a country credit quality. If we look at spread between 2y and 10-year bonds, in normal circumstances the curve should be steep, which means that 2y yields are lower than 10y yields. But we can have a situation when the curve inverts, which in the past has predicted a recession.
During the current coronavirus crisis, 10y yields dropped to the lowest levels in history 0,55%, as investors were running into “safe heaven”. However, it might not be over yet. If the economy worsens and FED will have to use extraordinary tools, like i.e. negative rates, it can go even further to zero and over-perform stock markets, like last year.
7 - S&P500
Is the stock market index that measures the performance of 500 the biggest companies listed on the stock exchange in the United States. It is one of the best known and the most followed equity indices, which can represent US stock market. Investors use it as the benchmark of the overall market, to which all other investments are compared. The makeup of the S&P 500 industries reflects that of the economy. We can use S&P500 as a leading indicator for the US economy. If investors are confident that economy is doing well or improving, they can buy stocks. By the size of the market capitalisation it can drive other, big, and smaller equity markets, reflecting equity investors sentiment. As the index is being tracked by the biggest funds and asset managers, it reflects the equity market by the descent flow going into and from the stock exchange. But it is also being used by many individual investors for their individual portfolios as a benchmark.
Before the pandemic, we had more than 10 years of bull market, and stock market valuations reached dizzying levels. During the bull market, the S&P500 achieved a historic record of 3316 points. The Buffet indicator, popular among investors, has historically reached record levels close to 140%. The indicator is market capitalization in relation to GDP. It is called a Buffet Indicator as the legendary investor uses it to evaluate stock market valuation. Looking at one, it is possible to assess how much the prices on the stock exchange differ from the size of the economy. The level above 100% can be understood as overvalued stock market. But level 140% can be very dangerous. But does it mean that S&P500 will stop rallying? This is not known. However, this should be considered when deciding to buy stocks.
As the coronavirus pandemic hit the world and world economy, as well as United States, S&P500 lost more than 33% of value in March 2020 and rebounded by almost 31% over next month. The U.S. Securities and Exchange Commission mandated the creation of market-wide circuit-breakers to prevent a repeat of the Oct. 19, 1987 market crash, in which the Dow plunged 22.6%. Since then, they have only been triggered once in 1997 before the four times in March 2020. Trading on S&P500 in March 2020 was halted as the index triggered level 1 market wide circuit breakers, during the opening hours, 4 times: on March 9, 12 and 16, 18, based on drops of 7% from the previous close. As the market cap is huge and a lot of investors trade on S&P500, many of them lost and earned a lot of money, during these dramatic market moves.
Investors who want to make investment decisions regarding equities should closely watch and monitor the index changes as many markets can follow the trend and performance of S&P500.
8 - Oil markets
Coronavirus epidemic and lockdown countermeasures, directly and mostly hit widely understood transportation, starting from individual car transport, through commercial transport, shipping, air, water and sea transport. That hit transport companies, the car industry, airlines, refineries, and others. In addition, fewer employees, and hence smaller demand for goods, hit the petrochemical industry and industry in general, which has an insane effect on the use of fuels as energy carriers and production prefabricates.
In addition, it turned out that oil production cannot be stopped for technical and economic reasons. Many shafts cannot suddenly stop drilling because it involves high costs of stopping and reopening. Some shafts cannot be open again. On the other hand, the local oil industry maintains many countries such as Saudi Arabia, Russia or Nigeria. Since production cannot be stopped at once, the produced oil, which cannot be sold, due to the lack of demand, must be stored. The problem is that the amount of space in oil storage facilities decreases day by day. And cutting production does not solve the problem at all.
All of the above have a serious impact on the valuation of oil and related financial assets. Recently, the price of crude oil has fallen to unprecedented levels, which has triggered a wave of cash that has flowed into investment funds investing in oil.
Many investors know the sell-off was enormous and they see great potential for rising prices. However, it should be remembered that oil markets will remain under great volatility and uncertainty about the recovery of the oil industry over the next years. Nevertheless, interest in investing in the oil market will remain for a long time from now. Therefore, investors looking for investment ideas should closely watch this sector of the market. Also, for forecasting achievements in other industries.
Investors should pay attention to data from the oil market such as: oil production dynamic globally and in the largest centres of oil production like US, Saudi Arabia, Russia; oil implied demand, but also inventories, reserves of oil gasoline, distillate and refinery utilization.
9 - Volatility (asset prices)
The current crisis does not cover only one area of the market and of the economy, but covers many aspects of the economy and industries. Starting from the tourist industry, through transport, logistics, the housing market, the market of commercial real estates, to medical services, sports, hairdressers, etc. This means that the investor may get lost in the thickening of information, market events, industry news, having a direct impact on asset prices. The multifaceted aspect of the global market can have a colossal impact on price volatility in financial markets. Volatility might have a descent impact on the investment by rapid changes in asset valuations. This is why the preservation of the capital may be reflected in a diversification of assets.
Highly diversified products, such as investment funds and ETFs, can help to protect against volatility of individual assets and asset classes. Otherwise the risk of stop loss, the risk that the investor will not catch up with the market is serious. ETFs and diversified portfolios may solve the problem.
Investors might look at and monitor the Volatility index, called VIX index, created by Chicago Board Options Exchange (CBOE), a real-time market index that represents market’s expectations of 30-day forward-looking volatility. It is also called “Fear index” or “Fear Gauge”. It is another indicator of investors sentiment, which measures market risk and reflects market fear and stress.
10 - ETF flows
Exchange traded funds (ETFs) are a type of security that involves a collection of underlying securities, such as stocks, bonds, commodities, and many others. They are investment funds, very often reflecting market indices, constructed as one instrument. ETFs are becoming more and more popular among investors and outstanding of ETFs becomes bigger and bigger in the financial markets
As ETFs reflects market changes among different asset classes and markets, they are becoming a barometer of global investment fund asset allocation. As the asset flow rules the markets, it is a very important to figure out where the money flows goes, and into which asset classes. It helps to estimate the position and sentiment of the market investors. When we realize that within a few weeks much more cash flowed into equity funds, and the debt flowed away from bond funds at the time, it may mean that investors are more willing to take risks and give up safe assets for more risky investments. Market asset allocation is changing then. It can mean that buyers are entering equity markets and sellers are entering bond markets.
It can be a nice leading indicator for financial markets. For instance, if macro data from the economy come out weak and we expect it to hit stock markets, it is the market that determines the prices of assets, in which direction they will go. It should be remembered that the market does not operate rationally and makes its own decisions based on its assessment criteria. When we look at labour market and jobless data come out weak, it can but it does not mean that traders will sell stocks. On the other side there is Federal Reserve which will stimulate the labour market and traders can expect that the situation will improve. Thus, the market decides when the prices will go.
ETFs reflects the most important markets, like a US Treasury yield curve, S&P500, European corporate bond market, commodity markets and some others. It can help a lot to estimate and foresee the market asset allocation and position.
The bottom line
Notice: Golden Sand Bank ("Bank") exercised due diligence to ensure that the information contained in this publication was not incorrect or untrue as at the date of publication. All Investment products are at risk, as their value can go down as well as up. The tax treatment of your investment will depend on your individual circumstances and may change in the future. If you are unsure about whether investing is right for you, please seek financial advice. This publication is not an investment recommendation or investment advice in connection with any services provided by the Bank to the Client.