Friday, 17 April 2020

Delusional: Investors are underestimating the economic shock the world is facing

OPINION

Delusional: Investors are underestimating the economic shock the world is facing

By Ambrose Evans-Pritchard
April 16, 2020


Investors are repeating the mistake they made all through February and early March. They are again underestimating the immense economic shock of COVID-19.

Can there be any parallel in market history to the surreal clash of narratives we saw this week?
Global bourses soared even as the International Monetary Fund painted a series of scenarios ranging from dire - the most violent slump since the Great Depression - to catastrophic, with all the potential chain-reactions spelt out in its Global Financial Stability Report.

Markets should not be counting on a swift recovery.

Yet Goldman Sachs tells us that COVID-19 is under control and the worst is over. "The number of new active cases looks to be peaking globally, projections of cumulative fatalities and peak healthcare usage are coming down," it says.

From this breathtaking premise, Wall Street's fashion leader argues that we should "look through" the Great Lockdown to sunlit uplands ahead, anticipating a further 8 per cent rise in the S&P 500 index by the end of the year.

We can disregard normal bear market rules. This time we will avoid the textbook sequence of events in recessions: a swift crash followed by a torrid buy-the-dip rebound, and then a slow downward grind over months as reality hits home, ending only in capitulation at far lower levels.

Authorities have spared us such a fate by rescuing everything immediately. "The Fed and Congress have precluded the prospect of a complete economic collapse," it says.

I agree that $US5 trillion ($7.9 trillion) of central bank QE, vast fiscal packages (10 per cent of GDP in the US), and blanket guarantees, have averted disaster. They have - in a disjointed way - bought time and given us a chance of emerging from this global sudden stop without irreparable damage to the productive system.

What is surely wrong is to imagine that this pandemic is a one-off shock lasting three months or so, followed by an early release from lockdowns and a swift return to near normality. The first glimpses of antibody data - such as Denmark's test on blood donors - show that we are nowhere near the safe threshold of herd immunity.

They confirm fears that the mortality rate is at least 1 per cent of infections and that therefore no democracies can let the virus run its course without overwhelming their health services and destroying their political legitimacy. The supposed trade-off between lives and the economy is an illusion. The most certain way to turn this crisis into a depression is to give up too soon, as Spain is already doing, and Donald Trump is itching to do.

We would end up in the worst of all worlds, with multiple waves, and another forced closure of the economy to avert a winter tsunami, requiring trillions more in fiscal relief.

The only viable path is to contain the virus - to drive the R0 transmission rate (the reproduction number that describes the intensity of an outbreak) below 1 - and hold it down by East Asian means of "testing, tracing, and isolating" as we shift from an acute phase to a chronic phase. We are not close to achieving this. We lack the testing infrastructure at scale - even in Germany - and little is being done to prepare the public for tracking surveillance.

"We need a vaccine. Until we get one, the stock markets are in cloud-cuckoo land," says professor Anthony Costello from University College London.

The IMF's most extreme scenario is all too plausible. It assumes the pandemic drags on, with a second outbreak in 2021. This would cause output to contract by almost a tenth and set in motion a "non-linear response of financial markets" - fund parlance for defaults and panic.

Public debt ratios would jump by 20 percentage points of GDP. The shock would push Italy's debt above 175 per cent of GDP. Ratios would rise to 155 per cent in Portugal, and to 135 per cent in Spain and France. In my view, such debt spirals among sub-sovereign borrowers would render monetary union dangerously unstable unless the EU faced up to its "Hamiltonian" moment and agreed to fiscal union. The evidence is that Europe is not about to do any such thing.

Markets are assuming that Germany and its northern allies may grumble but will always allow the ECB to keep covering Club Med fiscal deficits. But assumptions are treacherous.

The IMF prefers to dodge this minefield, but its Stability Report lists plenty of other weak links. For starters, "emerging and frontier markets are facing the perfect storm". Currencies have buckled. Foreign funding has been cut off. Outflows are running at twice the pace of 2008. Median debt is almost 100 per cent of GDP, much higher before the Lehman crisis. Most lack the fiscal firepower to backstop their corporate systems and to cover lost wages.

Global banks were supposed to be bullet-proof after boosting capital ratios but the regulatory buffers were never stress-tested for such a shock. They risk becoming the "amplifier" of the downturn as rising bad loans force them to pull back, starving the real economy of credit.

Even if the worst is avoided and there is no secondary financial crisis, there will not be a swift return to normal. Mohamed El-Erian from Allianz said the rescue measures offer liquidity but cannot prevent the slow burn of defaults. Nor can they kick start the economy when companies refuse to invest because they have no idea what is going to happen.

The market has yet to grasp that "we don't come out of this where we went in". Earnings are structurally damaged for years to come. Equities are not worth the same. Some 17 million Americans have lost their jobs in three weeks and the Great Purge has yet to run its course. Global unemployment rates will explode to politically dangerous levels if the pandemic is not properly contained.

The idea of a V-shaped recovery was overly hopeful three weeks ago. Clinging to that position today borders on delusional.

Telegraph, London

https://www.smh.com.au/business/markets/delusional-investors-are-underestimating-the-economic-shock-the-world-is-facing-20200416-p54kc3.html?fbclid=IwAR1OUYlAPihyMCNOtNqFj9Bud_V3_BgtsluU3mHjzhiy7If-B7ip2Hvkoro

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