Financial markets stay fragile

• We believe it is still too early to reenter risk assets in any significant manner because the sell-off is likely not over given the evolution of the COVID-19 pandemic and its economic consequences.
• The next two to four weeks will be crucial to determine whether lockdowns are effective to contain the virus, and how financial markets assess the massive combined stimulus measures so far.

Most of the world’s failure to heed the warnings of epidemiologists has led to what German Chancellor Angela Merkel – herself now in quarantine – has described as the most serious crisis since WWII. It now unfortunately appears that the coronavirus disease (COVID-19) pandemic will escalate further in coming weeks in much of Europe, the USA and many developing countries. Whether the infection rates, and sadly, the death toll reaches the dimensions of Italy will depend on how effectively lockdown and social-distancing measures are implemented and followed, and how robust the various healthcare systems prove to be. The shutdown of significant parts of the economy imply that the world is heading for a global recession, with a historical hit to economic activity especially in Q2 of this year. Our conclusion remains that it is too early to reenter risk assets in any significant manner because a further sell-off cannot be excluded given the evolution of the pandemic and its economic consequences. Valuations of risk assets have become more attractive, but given the difficulty of estimating future earnings, it is not clear that they are already outright cheap.

Flattening the curve

The next few weeks will prove whether the lockdown and self-distancing measures that have, or are, being implemented in Europe as well as in the USA succeed in flattening the current exponential path of infections. Only if this can be achieved, will health care systems withstand the pressure of rising infections. Italy will remain one of the key focus countries, as the number of infections there is still rising sharply despite increasingly harsh measures that have now been in effect for about one month. There will also be a focus on Germany, where there is hope that the rate of infection will be lower than in Italy. In the USA, New York City, California and some other areas that are experiencing heavy outbreaks will be watched carefully as well. Finally, some countries in Asia including Hong Kong appear to be seeing a second albeit more modest wave of infections. It will be important to obtain evidence that these indeed remain moderate, and that they can be brought under control without imposing yet again harsh measures.

Efficacy of lockdowns

As regards the economy, it is now clear that Europe as well as the USA are heading into a sharp downturn in Q2, similar to what China experienced a couple months earlier, largely because of the lockdown measures. Our economists at Credit Suisse expect setbacks of 10%-15% in second quarter gross domestic product (GDP), with leading indicators such as Purchasing Managers’ Indices dropping to historical lows of 30 or even below. However, our base case remains that we will see a stabilization and gradual recovery beginning in Q3, as lockdowns are carefully relaxed and the policy measures that are currently being implemented support aggregate demand. Yet a relaxation of the lockdown measures depends crucially on a flattening of the curve of infections. The current lockdown measures have a limited time horizon, and if they are extended for several months, they will have very negative implications for the real economy around the world.

Liquidity injections are working

The massive liquidity injections by the US Federal Reserve (Fed) as well as the measures adopted by the European Central Bank (ECB) should, in our view, suffice to stabilize for now the financial system, which seemed to be heading toward severe stress last week, similar to what we experienced in the great financial crisis in 2008. We are watching carefully for new signs of market dislocations, not least in the US Treasury market. There are signs still that the stress is not over yet and that more relief may be needed. To see the VIX in the 60%-70% range is a clear sign of stress, as are high yield spreads at levels above 800 basis points. In response, fiscal policy has now also been ramped up significantly in Europe, for instance with the German government approving funds to the order of 10% of GDP. The US Congress is also in the process of approving a massive fiscal program, but it will be critical that this process is not used for political posturing, otherwise markets will be further unsettled. Such measures are aimed at preventing widespread defaults of companies and supporting workers who are being laid off. More specifically, measures to support health care expenditures at the state or individual level are being boosted as well. This will hopefully also help reduce current shortages of medical equipment.

Two to four crucial weeks ahead

That said, we still believe it is premature to move overweight into equities vs strategic allocations. Investors should only add to risk where their cash positions are very high, have an equity allocation well below the strategic target, and can tolerate the elevated volatility. Equity markets and other risk assets are still reacting to the evolution of the coronavirus (COVID-19) pandemic and the effect on underlying fundamental value continues to be highly uncertain. This is why it is crucial for financial markets to see meaningful information that containment and social distancing measures are effective in flattening the curve of infections. We are hoping that positive signs will emerge in this regard over the next two to four weeks. For now, we recommend to watch and wait.