The capital markets will remain in "risk-off plus" mode - until the second derivation becomes negative!

03/16/2020 - Dr. Peter Oertmann
Market Insights

In the last two weeks our lives have changed fundamentally. The measures taken by the government to slow down the spread of the Covid-19 virus have resulted in an unparalleled slowdown and almost a standstill in our lives. Business trips are being cancelled, and wherever possible, teams are being split and moved to home offices. People buy food - sometimes in huge quantities - and otherwise practically stop consuming. Private trips are cancelled, and all plans are put on hold for the time being. The cities are deserted, and in some places, there are already explicit curfews. The borders are closed, freedom of movement is increasingly restricted. The news and social media are full of reports on the spread of the virus, infection rates and the measures taken in the regions and countries.

All this depresses the mood, and most - even those who cannot remember the model of exponential growth from their mathematics classes - have now understood: These limitations must now happen! As a society, we must now manage, in a show of solidarity, to contain the speed at which the virus spreads, so that our health systems remain functional. We must do everything in our power to suppress the growth curve of infections; growth must flatten out. Mathematically speaking, the second derivation of this curve must become negative. Not until we see this the dynamics of infections among the people will become weaker. The world community must concentrate on one issue: Flatten the curve!

Against the backdrop of this dramatic development the stock markets have plummeted massively in the last three weeks. The MSCI World has lost about a quarter of its value since mid-February, while investors worldwide have fled to safe havens, such as US government bonds (up about 8 %) and gold. The CBOE volatility index for the S&P 500 (VIX) has risen from relaxed levels by about 15 % since mid-February to levels of 60 % and more. The capital markets are in an alarming state. The current daily movements in major stock indices such as the Dow Jones Index are at historic record levels. The actions of market participants reflect a high degree of uncertainty about the future global economic order and the coexistence of people in this world.

The fears and measures taken in connection with the corona virus are already leaving deep scars on the business operations of companies. Due to massive declines in sales, a large number of companies are already on the brink of collapse. The medium-term outlook is darkening for almost all industries, with only a few exceptions. All of this is presumably already largely reflected in the pricing. The daily ups and downs are currently determined by new information on the spread of the virus and the assessments and measures taken by global institutions, governments and central banks. The current oil price war between Saudi Arabia and Russia is almost becoming an anecdote against the backdrop of the Covid-19 threat.

The first reactive interest rate cuts by the central banks have evaporated rather quickly on the markets. When has there ever been a time when the FED cut the key interest rate by an extraordinary 0.5 % and the markets just batted an eyelid? Market participants understood very quickly that the monetary policy can no longer help much. The ECB in particular lacks the necessary resources that could be used to stabilize economic growth. Nevertheless, a few days ago the ECB once again massively improved financing conditions in the euro zone by purchasing additional bonds and lending to banks. At the same time, President Christine Lagarde very clearly called on governments to take the lead in tackling the crisis with fiscal means. The finger is pointing in the right direction. Nevertheless, the central banks must continue to take care of the hygiene factor of liquidity, which they will do without limit. Yesterday, Sunday, in a second emergency meeting, the FED lowered the key interest rate again by 1.0 %, anchoring it close to zero. Unfortunately, there is only one interpretation for this: the dynamics of the virus spread in the USA and the economy seem to be in a very poor state at the moment.

The massive economic shock can and must be tackled by the states. Many states have already reacted with enormous aid commitments to companies. The German government has announced that it will do "everything necessary" to support companies in this situation. Measures amounting to half a trillion euros are under consideration. Aid packages worth billions have been made available worldwide. Presumably it was these latest pledges by the heads of state that saved the stock markets from even bigger crashes. Now it is important that the stabilizing effect of these aid packages and funds actually materializes.

The economic risks of the pandemic are immense. China has just published catastrophic growth figures for January and February: industrial production fell by 13.5 % and consumption by 20 %. Have there ever been such figures from China? A global recession is very likely. The economic development in the USA appears extremely critical, as the yield curve in America has been pointing to considerable recessionary risks for some time.

The mix of market movements, relative valuations and the unfolding set of economic data is complex. The currently dominant factor in the markets is the risk appetite of the participants. This is reflected in their portfolio decisions and is derived primarily from their assessments of the economic and social consequences of the corona pandemic. At present, one could speak of "risk-off plus". Classical fundamental valuation and selection processes are outshone by this. In order to regain confidence in the capital market, good news is needed in the following three areas:

1. Dynamics of the expansion: The considerable actions taken by governments to achieve social distancing must have a measurable impact. The exponential growth curve for the spread of the virus must change into a logistic curve - as explained above: the second derivation of the curve must become negative! This must be evident in many countries; global progress must be visible. Good news about the curve should make investors more confident and willing to take risks.

2. Understanding of the virus: The virus must become more transparent for us humans. If medical research and practice gains further knowledge about the properties of Covid-19, it will make us safer in dealing with the virus, this will have a positive effect on market sentiment. Any kind of hope on the horizon in the medical field can lead to enormous price corrections - upwards.

3. The companies' health: It must be noticeable that the numerous fiscal aid packages are actually sufficient in volume and are distributed boldly and without excessive bureaucracy. If companies can actually stabilize with this aid and we receive positive news from the badly affected sectors, this will increase the willingness to take risks on the capital market.

We are all responsible for topic 1. Issue 2 is in the hands of doctors and medical researchers, and issue 3 is now in the hands of politicians.

There will definitely be life after the crisis. The virus will then still be in the world, but it will have become part of our reality. Then people will live together again, work, consume, fulfil their dreams and make plans. The vast majority of business models will still be viable after the crisis. There will of course be deep marks on companies' balance sheets, and some production and supply chains will change. But it will continue. The courageous actions of states and institutions and the solidarity and discipline of the people will lead us through the crisis.

Of course, there are also extraordinary opportunities on the capital market at present. As a result of the distortions, risk premiums have risen massively, especially in the stock markets and for corporate bonds, i. e. the expected returns are particularly high. Even those who are currently prepared to buy illiquid investments can expect higher risk premiums than usual. Speculative funds could be invested accordingly if the risk-bearing capacity is sufficient. In this environment, there is only one formula for investment: diversification. Only consistent diversification across stock and bond markets, across regions, countries and currency areas, as well as across different investment styles and risk premiums, is able to bring assets over the ravages of this global catastrophe.