Aggressive monetary and fiscal support, along with signs of a flattening in the COVID-19 count, have stabilized risk assets
Global equity markets continued on a slightly downward trend in the past week, ending Q1:2020 deep in the red. Specifically, the S&P500 contracted by 20%, its largest quarterly decline on record. Corporate bond spreads widened significantly both in the Investment spectrum (by 200 bps), as well as in the Speculative Grade spectrum (by 520 bps) on both sides of the Atlantic, as the undergoing global economic recession will inevitably led to increasing debt-repayment delays and/or defaults despite the massive policy response (see below). Core Government bond yields declined (US) or revisited all-time lows (Germany), as central banks took unprecedented support measures, while euro area periphery bond spreads widened (Italy: +40 bps to 200 bps). Gold gained ground modestly (by 4% to $1577/ounce), while oil prices fell by 68% to $22/barrel as OPEC+ did not find common ground to cut supply.
Aggressive monetary policy measures, combined with sizeable fiscal spending announcements, have prevented equity prices to decline further, in our view. The S&P500 bottomed on March 23 (2237) following a -27% 12-month forward Price-to-Earnings decline to 13.9x (15.3 as of April 6th and a peak of 19x mid-February). The Federal Reserve has expanded its balance sheet by over $1 trillion in the past two weeks via purchases of US Treasuries and agency MBS, as well as due to the expansion of cross-currency swaps. In addition, it is expected to initiate Investment Grade corporate bond purchases and loans in the primary, as well the secondary, market of up to $200 billion by mid-April. The ECB has committed to purchase new assets (mainly Government and corporate bonds) at a pace of at least €100 billion per month in the course of 2020 with a total envelope of above €1 trillion.
On the fiscal side, spending has increased across the board, with the US being more aggressive. According to our estimates, the US CARES Act will have a total cost of c. $2 trillion or 9% of GDP, with European fiscal measures ranging between 2%-4% of GDP (loan guarantees amount to more than 10% of GDP). A coordinated approach at euro area level is also imminent, most probably by using existing instruments of the European Commission, the European Investment Bank and the ESM, albeit with slightly more favorable terms and conditions. In that context, the Eurogroup meeting on Tuesday 7th April is important, with circulating non-papers pointing towards a “solidarity-fund” SPV (highly optimistic).
As signs of a flattening in the COVID-19 count are indicating (excluding Japan), risk appetite has revived in recent days. Assuming the current rate of deceleration continues, epidemic curves in most developed economies could flatten by end-April (see graphs below). This yardstick, if achieved, could gradually lead countries to, gradually and slowly, relaxing containment measures in the coming months, thus alleviating the duration of the ongoing recession. Indeed, the S&P500 rose by 7% on Monday 6th, with equity futures pointing to further gains on Tuesday, while euro area equity indices have recorded gains of c. 7% in the past two trading sessions. Corporate bond spreads narrowed modestly (5 bps to 15bps) as “fallen angel” (Investment Grade) and default rate (Speculative Grade) uncertainty remains elevated.
All in all, the retracement in each asset class as a percentage of its maximum drawdown year-to-date due to COVID-19 remains below 50%, with the exception of the Italian-German spread (see graph page 3). Thus, on the one hand, risk premia are still high, suggesting buying opportunities based solely on valuations. On the other hand, uncertainty related to the coronavirus crisis and its implications on the global economy has been, and remains, very high compared with previous pandemics according to Ahir et al (World Pandemic Uncertainty Index – see graph page 3). As a result, high volatility is expected to continue this week, albeit with a less bearish tone compared with the previous two weeks.