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A crisis with lasting consequences
The COVID-19 pandemic has left societies, economies and markets reeling and 2020 has seen great global human, financial and economic damage. So what can we expect from a rather uncertain future?
The beginnings of an economic healing process
At Lombard Odier, we believe the economic healing process has begun. Simply put, we expect to succeed in containing the virus in the first half of this year which should allow us to recover in the coming quarters.
Why do we believe our base case?
Using Asia as a reference point, we have been monitoring the spread and containment of the virus and the reopening of Asia’s economies, especially in China. China has gingerly reopened itself up six weeks ahead of the other economies to a degree of success and has, up until now, avoided a second wave. This strengthens our base case. Economically speaking, we must try to keep the duration of the shock as short as possible and this stresses the importance of lifting lockdowns. Caution is the order of the day as societies must keep their guard up. Fortunately, many countries are finding ways to deal with current cases and mitigate a second wave using improved hospital capacity, testing ability and tracing technology to control the spread of new cases.
Furthermore, discipline when it comes to social distancing and masks will help to avoid another lockdown and continue to enable us to gradually open up more.
But is the worst yet to come?
There are risks of darker scenario. As economies open up, there is certainly the threat of rising coronavirus cases due to a lack of herd immunity. In the worst case, we may reopen and see second or even third waves of the contagion. Economies would continue to suffer from lockdowns and if we fail to contain outbreaks, the deep shock will extend well into 2021 and globally we would suffer from a prolonged cycle of recessions. However, given the tools we have at our disposal and the indicative data, we see this scenario as less likely at this point in time.
The road to recovery
Just as a patient recovers, there are ups and downs to economic recovery and it will not be linear nor homogenous. Just a mere few weeks ago, the sole preoccupation was our ability to contain the virus but now talks of safely reopening economies dominate the news agenda showing a shift in narrative. Now, as we go into the second half of the year, we can focus on recovery. It is already encouraging that certain countries such as Germany and Switzerland gradually began easing their confinement situations in April. We have seen that certain segments recover relatively quickly. As seen in China, the supply side leads the way and then demand follows.
This is evident in the fast rebound in real estate transactions (figure 1 above) and in coal consumption (figure 2 below) in recent weeks. And we should see the same in Europe. Germany has seen mobility rebound very quickly, according to Google data.
Although, we do not expect to fully recover pre COVID-19 supply and demand trends until 2021, we do believe that 80% of these trends should recover by the end of the year and the remaining 20% next year, providing another wave does not cause another worldwide shutdown.
Consumer spending in the doldrums?
Consumption capacity has been called into question as billions of people stay home. Has it been lost? Or just put on pause? Traditional consumption patterns have been thrown into disarray as demand has plummeted and oil prices have collapsed. If economies could open up with the same activity pre-coronavirus, then the deflation risk would be negligible. Yet that appears unlikely.
Those consumers who remain gainfully employed are able to spend on essentials and non-essentials but those who are out of work are less fortunate. Much of the data points to transitory employment trends as most of the unemployment in the European Union is technical and in the US, temporary workers have been hit hardest. In light of this, we do not expect consumption capacity to remain at current levels – it has the capacity to bounce back albeit to low levels of inflation and low interest rates.
A brave new post-COVID19 world…
The coronavirus is not necessarily a trend transformer…but it certainly exacerbates existing trends. Prior to the outbreak, economic growth characteristics were simply slow: low growth, slow trade, zero inflation and extremely low or even negative interest rates. A post-COVID world will only see that reality exacerbated. Our belief is that we will be constrained economically with the continued threat of a US trade war with China, very low energy prices and low inflation. Why? We see a monetary phenomenon. The consequences of the coronavirus have seen the Federal Reserve, for example, extending balance sheets and buying assets to prop up liquidity…but this liquidity isn’t reaching the economy. Normally, liquidity needs are met from commercial banks and loans but this is not the case and will result in sustained, low inflation.
The question of debt is in focus again. But we believe the relevant question is not the size of the debt but how sustainable it is. Debt is traditionally looked at in relation to GDP and its size. For us, the important factor is the debt cost and the payment as a share of GDP. As we do not anticipate rising inflation and interest rates, debt can be considered sustainable. Japan makes for a good case study as its debt stands at 200% of GDP but they invest their debt by investing in infrastructure, technology, education and healthcare. This is the model that Europe should follow in the wake of the coronavirus.
Protecting portfolios
In these troubling times, we maintain certain priorities for portfolios. Remaining agile and continually monitoring economic indicators has been our portfolio approach. We are ensuring they are liquid and have reduced less liquid asset classes such as emerging market debt and high-yield bonds. Anticipating weakness in oil prices and continued volatility, we had reduced portfolio exposure to oil-sensitive assets before the historic fall in oil benchmarks. Finally, we have strengthened downside protection in our slightly underweight equity exposure by using put options and increased our holdings of gold and the yen.
Important information
This document is issued by Bank Lombard Odier & Co Ltd or an entity of the Group (hereinafter “Lombard Odier”). It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a document. This document was not prepared by the Financial Research Department of Lombard Odier.
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