• First, there was a demand shock due to the global epidemic. Then, Saudi Arabia’s price war triggered a supply shock in oil. Hence, the odds of a global recession have risen.
• Policymakers are under heavy pressure. So far the response has not been tangible. Given the panic, traders are looking for entry points, while investors keep writing insurance.
The 9 March is the 11th birthday of the equity bull market. Yet investors do not have time to celebrate, let alone pop the cork. The week opened in major distress, as a deteriorating epidemic situation was exacerbated by a breakdown in oil prices. For oil producers, the worst of all nightmares has materialised lately. First, demand has collapsed due to fallout from the epidemic. Then, over the weekend, one of the top oil producers started a price war. The resulting breakdown in energy prices has sent shock waves to the financial system and made bourses reprice the recession odds to ‘more likely’.
When push comes to shove, the lenders – and spenders – of last resort come into play, i.e. central banks and governments. The US central bank delivered on time with a big rate cut last week, just to see this taken as a sign of panic. “What is the Federal Reserve seeing that we do not?” was the under-tone in markets. So the next shot has to be on target. Looking at currency markets, investors still have higher confidence in the US having more leeway to print money than Europe or Japan. That is why the euro was trading just shy of 1.15 in the early hours on Monday. The European Central Bank will give an update on Thursday at the latest. But the real proof of the pudding will be the response of European governments: how can they assure that the current epidemic will not sink small and medium-sized enterprises and trigger mass lay-offs? Again, confidence is higher that the White House will deliver just like Beijing has been doing for weeks now. Supporting troubled businesses via tax cuts and bridge financing is where Europe faces the biggest challenge.
“Be fearful when others are greedy and greedy when others are fearful” is the quote of the week. Warren Buffett’s wisdom is often taken as an excuse not to chase extended markets. Given the distress that markets are in now, there are a lot more followers in theory than in practice. All the more, traders should be looking for entry points while investors keep writing insurance.
Christian Gattiker, Head of Research, Julius Baer
ITALY: NO ‘TRICOLORE’ ANYMORE, ONLY RED
The whole country of Italy is under quarantine, as Italian Prime Minister Conte announced yesterday in a conference to the Italians. This is a drastic measure to protect the virus to spread further and will certainly have a substantial economic impact and political consequences. We remain Neutral but cautious on European peripheral government bonds.
The Prime Minister of Italy, Giuseppe Conte, decided to add up protection against the spread of the coronavirus and introduced drastic measures by extending the quarantine to the entire country. Public events are banned and Italians are only allowed to leave their homes for work, essential food purchases and emergency reasons until at least 3 April. Residents have to give account for being compliant with the new rules and explaining their movements; non-compliance will be sanctioned by fines or even imprisonment. These are drastic measures and will certainly leave their mark on the economy, which has been struggling already before. Italian banks are back in focus as they will be the weakest link and most vulnerable to a prolonged economic downturn in the country. Liquidity injections by the ECB will be of outmost importance. Political consequences are difficult to assess at this point but also pose further risks. We keep a Neutral rating on Italy and European peripheral government bonds more generally, but see more downside risks now.
-Dario Messi, Fixed Income Analyst, Julius Baer
Gold: Real yields matter most
• Due to a decline in inflation expectations and some forced selling, gold has not reacted to Monday’s equity market sell-off.
• Barring a global recession, we still feel that growth risks are well reflected in the gold market and maintain a Neutral view.
Gold is a safe haven and for most investors it seems like a simple asset. On a day like today, when a wave of risk aversion hits the markets, gold is supposed to perform well and alleviate some of the pain caused by plummeting equities. However, gold has not reacted to the sell-off in the equity markets and the related de-cline in US Treasury yields. How is that possible? One reason lies in sharply lower oil prices, which are dragging down inflation expectations and thus inflation-adjusted yields. For the past few years, inflation-adjusted yields, so-called real yields, have been one of the most important drivers of the gold price. A second rea-son is forced selling. Forced selling occurs in times of severe stress in financial markets and relates to the phenomenon that investors have no choice but to sell their gold in order to cover losses in credit-financed equities. A decline in the number of out-standing contracts in the gold futures market points in this direction, although the evidence is not very strong in our view as e.g. physically backed gold products are still recording inflows.
Independent of today’s reaction, we have to acknowledge that gold’s short-term fundamentals have strengthened rather than weakened since we recommended taking profits around two weeks ago. The risks of a slowdown in global growth as a result of the spreading of the coronavirus have risen and the US Federal Reserve has reacted with a surprising interest rate cut. However, as even more cuts are priced into the market today, we still feel comfortable with our assessment, that growth risks are already reflected well in the gold market – unless the global economy falls into recession. We maintain our Neutral view on gold but lift our 3-month price target to USD 1625 per ounce. At the same time, we leave our 12-month price target unchanged at USD 1600 per ounce as global growth should recover eventually. In the very short-term, price risks still remain skewed to the upside.