Trade war, impeachment proceedings and Brexit debates. As main risk scenarios, these three seem today to be from a different era and almost ridiculously harmless. They have nearly been forgotten in a few turbulent weeks. The unhappy transformation has been brought about by a pandemic: the new coronavirus, Covid-19, which originated in China and has spread surprisingly rapidly abroad. The full extent of this spread did not become apparent until the end of February, after DWS' regular strategy meeting. The contagion's impact on capital markets in just the following three weeks can be quickly illustrated. The number of new cases outside China quickly approached China’s total. On March 9, Italy effectively quarantined the entire country. Big cultural and sport events were cancelled in many parts of the world. In the markets, the S&P 500 slumped at record speed by almost 20% from its record high and European indices have lost more than a quarter of their value. Stock-market volatility has reached levels last seen in 2008. To make matters worse, key oil producers Saudi Arabia and Russia embarked on a full-blown price war, sending oil down to 20 dollar per barrel. All U.S. government-bond maturities yielded less than 1% for the first time in history, while the risk premiums on euro high-yield bonds doubled virtually overnight. The virus has also arrived in most people's daily lives. At DWS too, we have taken extensive precautions to ensure smooth business operations. These dramatic developments suffice to explain why our forecasts made in mid-February were no longer relevant.
Another tectonic shift occurred on March 12: the day on which almost the whole of Europe switched to crisis mode and it became obvious that the United States would soon have to follow suit. Stock markets suffered historic falls and most bond markets froze. Central banks began to intervene with large liquidity packages, and both the U.S. Federal Reserve (the Fed) and the Bank of England cut interest rates radically. At 0.1%, the benchmark British bank rate is at its lowest level on record, going back to 1689. The European Central Bank (ECB) followed suit with numerous easing measures to stimulate bank lending and a 750 billion euro purchase program, to improve liquidity in the bond markets. The high proportion of traders and fund managers currently working from home has exacerbated the lack of market liquidity. This is evident in the fact that even on days of massive collapses in the riskier markets (such as equities and corporate bonds), the supposed safe havens, gold and government bonds, have lost value. They become a source of liquidity for many companies and also institutional investors when the overarching rule is: cash is king.
Economic life is collapsing before everyone's eyes. Extensive border closures have led to 60 kilometer long traffic jams for trucks on the Polish-German border. Air traffic has been largely suspended. The closure of shops, cultural and sports facilities, and the imposition of curfews, are leaving city centers in Europe and the U.S. empty. China's economic data for January and February showed the likely economic consequences: capital investment fell by 24.5% compared to a year earlier and retail sales by 20.5%. The figures were significantly worse than analysts had expected.
Events are moving now at extraordinary speed. A Lenin once stated: "there are decades where nothing happens and weeks where decades happen." The range of possible growth rates for the current year is correspondingly broad. It depends primarily on how long and to what extent the preventative measures already taken will last. This is anything but predictable at present. Even the second- and third-round effects of the abrupt economic slump will only become fully visible over time. The uncertainty is further increased by the feedback loops between economies. China, for example, despite its own success in restraining the coronavirus, is now suffering from the weakness in its export markets.
The greatest uncertainty, however, remains the future trajectory of the virus and the burdens health-care systems have to cope with. While it might be difficult to explain all differences in the speed of infection and mortality rates between various countries, one thing has been clarified by all doctors dealing with the pandemic so far: the mortality rate increases dramatically once local health-care systems are overwhelmed and lack beds and ventilators.
In general, medical issues will occupy us more than anything else in the coming weeks. Of course, the aid packages provided by central banks and governments are also extremely important in preserving "business as usual" as far as possible, providing security for small businesses and the self-employed and ensuring that markets continue to function properly. But of equal importance will be the continuing development of virus itself, and how state authorities deal with it.
We too have more questions than answers, and a certain unpredictability is also part of the nature of a virus and the pandemic it causes. However, we believe that three months of experience with the virus have greatly improved our judgement. First of all, we continue to assume that the pandemic will remain a temporary phenomenon whose worst phase will be behind us by the beginning of summer, at least in the regions that are already severely affected. The number of new infections in key economic regions should stabilize clearly in the first half of the year, and the pandemic’s worst impact from an economic perspective should be over by year-end. To get to this point three things must happen: First, the virus will have to have been brought largely under control by then. Essential for this is the provision of a large number of test kits, whose use must be simplified. Second, disease-relieving medicines would need to be approved, long before an effective vaccine is available. Third, as odd as this may sound at first society will need to get used to dealing with the virus, just as it has become accustomed to dealing with other viral diseases.
As at the end of March, it looks as if the further spread in the West is following the example of Italy rather than China, although Italy might have suffered from an amalgamation of negative factors. At the time of writing, the U.S. is recording more new cases than any other country and is likely soon to have the highest number of infected people in absolute terms. In parts of the U.S., especially in some large cities, the health-care system is already overwhelmed. In Europe the methods being used by most states – social lockdowns and curfews – are already having an effect on the number of new infections. We assume that such closures, and more generally what might be called a "shock freeze" of large parts of the economy, cannot be maintained for more than six to eight weeks before being gradually eased. This unfreezing, however, could lead to a second wave of infections. This is why we do not expect a quick recovery but rather a more prolonged one.
In view of the above we arrive at the following. We expect a short-lived global recession. In the U.S. and the Eurozone we expect the economy to shrink by around four percent this year, while China should manage to grow slightly.
Asset prices (as well as economic activity) should continue to be bolstered by central banks that have to a large extent already delivered what we expected, and in some cases more. Key interest rates are close to zero almost everywhere in the developed world, and numerous liquidity support measures have already been announced. Bond purchases are again among them (the ECB announced a750-billion-euro package and on March 23 the Fed announced that it would buy as many bonds as necessary, including corporate bonds). We have adjusted our bond yield forecasts accordingly: we expect 10-year U.S. government bonds to yield 0.9% in twelve months, and corresponding German government bonds to yield -0.5%. However, given the sheer size of the current fiscal and central-bank packages, we will soon have to address the possible longer-term effects of these measures on inflation and interest rates.
With regard to equities, after an extremely weak first half of 2020 and stabilization in the second half, we expect a drop in earnings of 20% for the full year 2020. The recovery in 2021 should lead to slightly better figures for the next 12-month period. Without wanting to place too much emphasis on concrete price forecasts now, our core scenario sees most stock indices trading significantly above their current level in twelve months' time. However, this does not rule out the possibility of new lows being tested along the way. Now that the large monetary and fiscal packages have largely evaporated in the stock markets, we believe currently the two important parameters for investors are news on the coronavirus, relating to containment or progress on treatments, and stock valuations. The Dax, for example, is trading close to its book value (8200 points), which in our opinion leaves little further downside risk. The S&P 500, on the other hand, is still trading at a price-to-book ratio of 2.75. Despite the structural superiority of the S&P 500, one could conclude that the potential for setbacks is higher than for the Dax. All in all, we currently have no regional stock-market preferences on a 12-month horizon. At the sector level, we think the natural losers from this crisis, even in the longer term, will be tourism, airlines, the oil sector and parts of the financial sector. The winners should be sectors we liked anyway: highly profitable stocks with strong balance sheets in the technology and communications and health-care sectors.
What else will shape the markets to 2021 and beyond? It is almost certain that Joe Biden, who is considered a moderate, will be the Democrat challenging President Trump. For investors Biden is probably a more reassuring candidate than his chief rival for the nomination, Bernie Sanders, whom Trump would probably have preferred to face. For the time being, however, Trump has other worries. The weak stock market, the incipient economic slump, and his volatile management of the coronavirus crisis could cost him votes. In other countries, too, the handling of the coronavirus could cause difficulties for those in power. Aside from that, the fiscal response to the virus is likely to remain an important issue for politicians worldwide, and also for capital markets.
Inflation and interest rates will most probably still preoccupy capital markets. We had assumed that monetary policy would remain loose in 2020 but rates have fallen still lower. That the U.S. is now also likely to be trapped in a low-interest world for some time changes or reinforces some of our premises. In addition to U.S. Treasuries themselves, some of which no longer even compensate for inflation, the dollar is losing its fundamental appeal. Its current strength is a by-product of the big emergency moves in capital markets. At the same time, There Is No Alternative is gaining weight: investors are being forced into corporate bonds and equities because government-bond yields are so low, or even negative. Other investments that we believe should benefit from the low interest-rate environment are in real estate and infrastructure. Whether inflation will remain as invisible as it has since 2009 will be another big question for markets. Ultimately, however, stronger inflation would again speak in favor of equities.
To conclude, we are dealing with the most severe economic standstill and capital-market reversal in the post-war period. The damage done and distortions created will only become clear in the coming months. The pandemic itself will probably get a lot worse in most countries before it gets any better. The virus is extremely insidious and has been underestimated by the developed world for too long. But what should not be underestimated is the adaptability and inventiveness of humanity when so directly confronted with a crisis. This is not the time to capitulate, not even as investors. The markets are likely to remain volatile for the time being and some added security, such as gold, and a higher cash balance certainly seem reasonable. But one should not completely close one's eyes to the opportunities. We believe the expected further negative headlines about the virus will be accompanied by more positive news over time. As capital markets anticipate future developments we can expect them to move on even when the situation on the ground still seems to be worsening. Our core scenario would need to be very much mistaken for most share prices not to be higher in twelve months' time. In times like these, though, this almost seems like a secondary consideration. Stay healthy and take care of yourself and each other.
1. By March 24, most big equity indices have lost a third from their highs on average.
2. For example, as measured by the VIX for the S&P 500 and the Euro Stoxx 50.
3. Such as the lower number of intensive care units and ventilators, an older population and one of the most polluted air in Europe.
4. In our opinion, this is evident in the fact that Trump's numerous direct hostilities against Biden have not been matched by attacks against Bernie Sanders. On the contrary, Trump worried in his tweets that the Democrats might prevent Sanders from winning the candidacy. See for example his tweet from March 10 and February 29.
5. "There is no alternative": low interest rates are pushing investors into higher-yielding and thus more risky investments, such as equities, despite sometimes high valuation levels.