Financial Markets’ Red Wedding

Last week was to financial markets what the Red Wedding was to Game of Thrones – meaning pretty much everybody got slaughtered.

Let’s start with equities. They have had their worst week since the financial crisis with global markets being down some 10 to 14% as the Corona virus spreads rapidly around the globe. In total, more than 6 trillion USD in wealth have already been wiped out, and there is surely more to come. US equities have decreased by more than 12% over the last week, and Asian and European equities have not fared much better on average. Commodities are plunging as well with the oil price being down 12.6%.

Interestingly enough, even asset classes that have been declared “safe havens” by some cranks, like Bitcoin and gold, have not fared too well either. Gold initially appreciated, but all the gains were subsequently reversed, and the gold price has now declined some 3%. Bitcoin got absolutely wiped out and declined even more than most global equity markets, some 13% as of right now.

Financial uncertainty and market volatility are also at all-time highs as. The VIX is approaching levels one could observe during the financial crisis of 2008. The S&P 500 is now trading well below both the 100- and 200-day moving averages, two indicators frequently used by technical traders, and other global equity indices have fallen by a similar amount, and therefore also breached these key support levels.

While COVID-19 can initially be seen as a supply shock, leading to work stops and interrupting global supply chains with China being the initial epicenter as well as the world’s manufacturing bench, it is quite clear that the negative demand effect is now substantial, and also more disruptive than the original shock to supply. This can be easily seen by looking at market inflation expectations. A supply shock disrupts production and is thus inflationary while a demand shock is deflationary. As one can see from the TIPS spread, inflation expectations have been falling rapidly within just a couple of weeks. The assertion that the Corona virus is simply a supply shock and that more expansionary monetary or fiscal policy cannot help does not hold up under a little scrutiny. Just the wealth effect of wiping out more than half a dozen trillion US dollars from global equity markets should negatively affect consumer spending as well as investment. Add to this the global uncertainty over how the virus will spread and how bad the pandemic will be, and you get a further detrimental impact on consumption and investment.

The fact that global commodity prices are plunging also speaks to the fact that we are dealing with a global demand shock. Furthermore, the price decline will negatively affect commodity exporters and therefore potentially aggravate the current global economic downturn.

Finally, as we have repeatedly learned over the last decade, central banks as well as fiscal policy makers usually find themselves behind the curve when it comes to large global macroeconomic shocks. And I am afraid that this time will be no different, especially since there is a lot of policy inertia. While this applies more to fiscal policy, one can also observe it for central bankers who for some reason are engaging in interest rate smoothing and are hesitant to cut rates by more than 50 bps, even when it is warranted.

To me, it is therefore quite clear that the negative demand effect of the pandemic and the financial contagion already substantially outweigh the disruptive supply effect. It is not only inflation expectations that have tumbled. The entire US yield curve has shifted down rapidly, by almost 40 bps compared to one month ago and 15-20 bps compared to one week ago and is now completely inverted. This, of course, has historically been a precursor to an oncoming recession.   

Macrobond Moment: It is very easy to create a dynamic version of the yield curve with the Macrobond Yield Curve analysis that always updates with the latest data and allows you to compare the current curve to the one from 5 days ago and a month ago in this specific example. 

Financial markets have therefore rapidly shifted their outlook and now expect much lower nominal and real GDP growth and even lower interest rates in the years to come, compared to just a couple of weeks ago. US monetary policy is becoming tighter by the minute as all government maturities now have lower yields than the federal funds rate.   

The Fed funds futures market now suggests that the probability of rate cut in the end of April has increased to close to 50% (up from 20% a couple of weeks ago) while the probability of a 50 bps rate cut has surged from as little as 3% several weeks ago to almost 40% last Friday. This is both good and bad news. Market participants now expect that the Fed will react relatively quickly to the ongoing economic downturn. However, this also leaves ample room for the Fed to disappoint and therefore aggravate financial markets even further. If one or two rate cuts are priced in but the Fed stands still, then monetary policy is actively becoming tighter and the Fed will only aggravate the current negative demand shock by acting too timidly.

Note: The straight line is the current policy rate (left axis) while the other time series are the future-based probabilities for the Fed Funds to be within a certain range by the FOMC meeting on the 29th of April, 2020 (right axis).

What is of great concern is that as of today, there is little indication of central banks taking the current financial and demand shock seriously enough. I therefore expect the US to be in a mild recession by mid-summer, conditional on the Fed not cutting interest rate by more than 25 bps over the next two months. What the Fed really ought to do, though, is shock markets in the opposite direction with a rate cut of at least 75 bps, and maybe even more. As Ubide has outlined in his book The Paradox of risk, central banks have acted far too timidly post-2008. As a result, they often ended up having to do more later on because they were too risk-averse initially. A positive shock and awe-moment by the Fed right now could still prevent a downturn and provide some recession insurance.

The outlook for Europe is even more concerning, since parts of the Eurozone might already be in a recession as last quarter’s growth has been negative in several key euro area economies. Furthermore, the ECB’s policy rate is already negative, and they are doing QE. Therefore, any monetary accommodation can only come via an increase in asset purchases, which seems rather unlikely at the moment. Moreover, fiscal policy is also too tight in the Eurozone, but the one country with ample fiscal space that is large enough to give euro area GDP a boost, is unwilling to employ it. (I speak of Germany, of course).

So, here is what to expect for the rest of 2020: A severe recession in China as parts of the country are completely shut down and suffer from the spread of the virus. The Chinese PMI just tumbled more than it did during the global financial crisis in 2008, not a good outlook. Given China’s share of world GDP, this will weigh down substantially on the global economy.

The current decline is completely unprecedented and even more severe than during the Great Recession. Given this new data point, the country is most likely already in a deep recession. Expect global equity markets to decline further this week, and then some more bar significant central bank easing.

Combine this with a recession in the Eurozone and a potential slowdown of the US economy as the ECB and Fed respond too timidly, and we have a very bleak 2020 ahead of us. Italy is already in a recession, the German economy has stalled for several quarters, and France had negative growth in Q4 of 2019 as well. The downside risks to the Eurozone have therefore increased substantially, which is a major concern as the ECB is unlikely to provide sufficient accommodation to prevent a major downturn.

I therefore expect global growth to be substantially lower this year, and indeed we should anticipate the worst year since the global financial crisis. Again, the latest data points seem to vindicate Larry Summers’ secular stagnation hypothesis as advanced economies cannot shake off the growth trap they have found themselves in post-2008.

However, the global economy will eventually recover from the current economic downturn. Now it’s just a question of how bad it will get, a lot will depend on central banks’ reaction function, and when to buy the dip. Stay tuned!

Written by Julius Probst

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