Neutral risk positioning confirmed

At an extraordinary meeting held on 9 March 2020, the Union Investment Committee (UIC) discussed the latest developments regarding coronavirus and confirmed the neutral risk positioning (RoRo meter at level 3). No changes were made to the model portfolio. The UIC continues to believe that the markets will remain very turbulent in the short term but that the outlook remains positive in the medium to long term. Consequently, the more conservative spread segments of European periphery bonds and investment-grade corporate bonds remain slightly overweighted.

The main points at a glance:

  • Curbs to growth are pushing up credit risk and solvency risk and could spill over to the financial sector going Forward

  • Possible paradigm shift in the oil market is compounding the effect

  • Targeted monetary and fiscal policy measures are needed and probable

  • The UIC continues to anticipate short-term turmoil but believes the long-term outlook for the capital markets is promising

The reason for today’s UIC meeting was the increasing spread of the novel virus outside China, the ever more substantial countermeasures being taken by governments and the tumultuous reactions to these measures in the markets. Growing risk aversion was compounded by the failure of the OPEC+ summit. This latest set of news caused risk assets to fall significantly in value. The DAX, which is a particularly sensitive barometer, dropped below the 11,000 points mark. Brent crude oil reacted even more vehemently to the combination of the failure to restrict supply and the expected decrease in demand. Today, it experienced its sharpest price fall since the first Gulf War in 1991.

UIC remains neutral but acknowledges the increased risks

In the UIC’s view, the capital market environment has deteriorated even further in recent days. Economic prospects and sentiment have continued to decline, even though the number of new coronavirus cases is already going down again in the hardest-hit countries of China and South Korea. However, bigger challenges have emerged in the financial sector as well. Credit risk is rising in the corporate sector owing to the huge outbreak of the virus in Europe and (probably) in the US, combined with the lower oil price (e.g. because of the highly leveraged US shale oil industry). Consequently, there is a growing risk that the banking sector will also be affected by this situation. This is uncharted territory for the capital markets and one of the key reasons for the current market turmoil.

Targeted monetary and fiscal policy measures are likely

Nevertheless, the UIC continues to hold the fundamental view that the situation does not warrant panic. The committee predicts that the aforementioned funding challenges will be recognised and dealt with in good time by those in charge of monetary and fiscal policy. There is no doubt that they have the means to do so.

The central banks have already underlined their willingness to take action. In the US, the Federal Reserve (Fed) has loosened the monetary policy reins with a first, and unexpected, interest-rate cut that could be quickly followed by further reductions. The UIC also expects that the European Central Bank (ECB) will introduce supporting measures at its meeting this Thursday. There is very little leeway for further interest-rate cuts in the euro area. However, the ECB is likely to contribute to fighting the fallout of the pandemic with instruments such as targeted injections of liquidity. What would be particularly helpful for companies and the capital markets would be for the ECB to take on more risk from the non-financial sector, for example by buying more securities.

National governments appear to have now recognised the seriousness of the situation. The German government, for example, decided on an initial package of measures during the first weekend of March. Rome and Paris are also discussing and providing assistance (including expanding compensation for short-time working and stepping up government investment). However, the UIC does not believe that the steps decided upon so far will be enough to overcome the effects of the coronavirus outbreak in the long term. The growing solvency risk for companies has not been sufficiently factored in so far. It is up to governments to protect the real economy against avoidable insolvencies (and thus against the curbing of growth in the economy as a whole), for example by issuing guarantees or sureties. The UIC believes that such steps are likely to be taken in the days and weeks ahead. The same applies, perhaps more so, to the US, where the upcoming presidential election campaign gives the incumbent a huge incentive to provide economic assistance.

Short-term curbs to growth stronger than expected

One of the triggers for the latest turmoil was the news of restrictions on travel within some areas of northern Italy. This changes the overall economic picture, because business in one of Europe’s strongest economic regions is being partly scaled back. A recession in Italy is therefore almost unavoidable. The economists at Union Investment predict a fall in economic output of 1.9 per cent. This will also serve to curb growth in the rest of the eurozone. After all, Italy is the third-largest economy in the euro area. As a result, gross domestic product is now likely to rise by only 0.4 per cent in 2020. Germany will be unable to escape these effects, especially in view of the close economic ties between southern Germany and northern Italy. The experts still predict growth of 0.3 per cent this year.

Return to original growth path in the medium to long term

At the same time, the UIC still holds the view that the slump in growth should largely be of a temporary nature. Catch-up effects further down the line should make up, at least in part, for disruptions to production and consumers holding back on spending. The steep fall in the oil price should provide additional support for consumer spending in western countries and should thus have a positive overall impact on the global economy. The government support mentioned above could provide additional stimulus.

Signs of a paradigm shift in the oil market

Events in the oil sector were another key trigger factor in the latest wave of volatility and sent a second shock wave through the capital markets. On the first weekend in March, the OPEC+ countries held a meeting in Vienna. But against all expectations, they were unable to reach agreement regarding further production cuts. The scheduled press conference was cancelled and the meeting ended without even the publication of a communiqué. According to statements from individual delegates, the status quo is that current commitments to limit production to 2.1 million barrels per day will expire at the end of March and that all countries will then be able to freely determine their own production volume going forward. This would see OPEC abandoning its price-supporting approach and returning to a focus on market share, as last seen between 2014 and 2016. At that time, prices fell from more than US$ 100 per barrel to less than US$ 30 per barrel before eventually bottoming out.

Saudi Arabia resumes the fight for market share

On the weekend, Saudi Arabia responded by announcing that it would increase its production significantly to more than 10 million barrels per day and lower its official sales price substantially in order to boost its export volumes at the expense of other countries. The main objective behind this approach is to render Russian oil exports to Europe and US oil exports to Asia unprofitable. At present, Russia’s fiscal position is fairly stable and the government in Moscow should thus be able to withstand a price war for a time. But the course has been set: Saudi Arabia wants to expand its market share and is turning up the pressure on other players in the oil market to respond.

US shale oil particularly vulnerable

The US shale oil sector is the weakest link in the (production) chain and likely to react first. Against this backdrop, private US oil companies will cut back investment even further, because many oil fields cannot be operated profitably at these lower price levels. As a result, banks’ funding operations in this sector will probably experience a rise in defaults among shale oil companies. In the past, the US economy typically benefited from falling oil prices. But over recent years, the US has become the world’s largest oil producer thanks to shale oil, so this latest price collapse is going to hurt the US economy.

Winners and losers of the failed OPEC negotiations

Unless the OPEC+ parties return to the negotiating table within the next few days, the fallout from the failed meeting will be huge and far-reaching. Oil-producing countries will be hit the hardest, while regions such as China – which normally imports 10 million barrels of oil per day – should benefit from falling prices. In terms of investments in the emerging markets, it is therefore impossible to make blanket predictions regarding the impact of the latest developments.

Outlook

The current turmoil should not distort our view of the medium and long-term picture. After all, the coronavirus hit the global economy at a time when growth was just starting to regain momentum. Tensions in the global trade environment have eased significantly in the wake of the phase-one deal between China and the US. This should stimulate growth. In addition, we expect to see targeted monetary and fiscal policy measures to alleviate the downward pressure on economic growth. The fundamental picture – which by and large remains constructive – should thus regain its influence on the markets in the second half of the year once the coronavirus epidemic starts to abate. Six to twelve months ahead, the outlook thus remains promising.

 

As at 9 March 2020