As many of you will have seen, the Saudi/Russia disagreement about how to react to falling global demand post-Covid-19 has led to a sharp fall of 25–30% in oil prices, bringing the YTD fall to over 50%. A re-run of the high yield energy distress looks very likely in the short term, in addition to stresses in other markets. Further, markets are trying to digest the less negative story emerging from China alongside the worsening of Europe. As steps are taken to delay Covid-19, analysts will struggle to keep up with the real-time earnings story in all but the most obvious cases such as airlines.
In the next few weeks, we are likely to experience many repetitions of the same basic weakening global economy story; we will see it through estimate revisions, PMIs and, with a little delay, the hard economic data. Some analysts will focus more on the new cases or deaths from Covid-19 – not an especially useful indicator except as a guide to further restrictions by government. Our quantitative modelling team has evaluated the risks of being whipsawed during periods where prices lead estimate revisions but changing our value weighting too much runs the risk of avoiding opportunity as new trends emerge. As I write this note, sovereign yields are trading at extremes and are not helpful to value, unless or until a huge stimulus boosts nominal growth.
It is tempting to suggest that markets have parted company from fundamentals, and this must surely be true of bond yields. The same cannot be said of the equity markets. In our Dividend Discount Models, the risk premium is being sharply revised up at the same time the earnings growth estimate is being sharply revised down. Falling risk-free rates of even 100 basis points are not enough to offset the rising risk premium.
The key question in my view is not what the world looks like in March through June — likely to be pretty awful — but what the world looks like in September. We expect many governments to restart economies with a coordinated fiscal stimulus after the peak of the epidemic has passed and quarantines have been lifted.
Markets will be looking forward to calendar 2021 and 2022 earnings, and it is a racing certainty that the tone amongst central banks will remain super-dovish. Could there be inflationary pressures during the Covid-19 outbreak? In an environment with sharp changes in demand this is likely to be a feature, but perhaps not widespread enough to move core away from deflationary bias.
Another key question is how quickly we see some currencies re-set towards fair value — a common feature of currencies we have found through our research in our extensive Dynamic Strategic Hedging strategy. We have already seen this in the yen which has rallied almost 8% in the last few weeks. Overnight we saw a flash crash in AUD/NZD with recovery afterwards, providing clear evidence of the risks inherent in heightened risk sensitivity at banks, and their use of electronic market-making.
The trading desks are providing regular feedback on trading liquidity, which now looks variable but not dire. We traded Asia Pacific emerging market bonds this morning and all markets have traded acceptably. All credit markets are trading wider and especially risk-sensitive UK financials, Italy and airlines. ETFs continue to trade well in secondary markets with further evidence that they are an important independent source of liquidity to markets.
We will of course keep you well informed of developments.