Market comment - Q&A: Coronavirus in three scenarios

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As the coronavirus is spreading outside China, financial markets are facing severe turbulence. ABN AMRO has defined three possible scenarios for the virus, the economy and the markets.

Last week was one of the worst weeks in history for financial markets. What happened?

Last week, we saw equity markets plunging and bond yields dropping. Markets went into a sharp correction with a drop of more than 10% in just one week. The coronavirus is the main reason behind these developments. Initially, investors thought the outbreak would be contained to China, but this has proven to be too optimistic. The occurrence of new cases in other countries has led to a flight to safety as investors are unsure how far and quickly the virus is spreading and consequently, what the negative impact is going to be for the economy.

How is ABN AMRO looking at the recent developments for the investment strategy?

Clearly, it is difficult to predict how the virus is going to develop and how it will impact the global economy. It is not difficult to come up with all kinds of disaster scenarios. However, we believe the most important thing for now is not to panic. The World Health Organization (WHO) Director-General, who is in a much better position to make statements about how the virus is going to evolve, stated this weekend: “Global markets … should calm down and try to see the reality. We need to continue to be rational.” We agree with this statement. We recommend not to act with any buying or selling as long as markets remain this volatile. For any future repositioning, we are working with different scenarios from here on. These scenarios are based on the extent of the virus spreading and the consequent impact on the economy. Scenarios are useful for comparing the facts with the most likely outcome, by checking to see which scenario we are in and then translating this into investment decisions.

Which scenarios are you considering?

We have defined three scenarios, all with a different impact on the economy.

  1. The first scenario is labelled a transient shock. In this scenario, the virus will be ‘under control’ by the end of the first quarter. This means that the number of cases in China will continue to fall and there will be a limited spread to new major countries and regions. In this scenario, there will be a sharp fall in economic growth in the first quarter, but there will be a growth rebound in the second quarter. The rebound will be strongest in China, while other economies will show modest improvements. For the rest of the year, we would expect the Chinese growth slowing back to pre-virus levels and the global economy growing at moderate levels.
  2. The second scenario is a prolonged shock. We still expect the number of cases in China to come down and activity to go back to normal. However, the spreading outside China is significant and will lead to containment measures in these regions with a direct negative effect on the economy. Confidence will be hit and company earning will suffer more. In this scenario, the Chinese economy will rebound in the second quarter, but in other economies, growth will continue to slow until containment measures will start to have an effect. The central banks will ease monetary policy and there will be some fiscal stimulus.
  3. The third scenario is one of a severe shock that triggers a global recession. In this scenario, there is a major spread of the virus across different economic regions, leading to a large number of lockdowns of major economic hubs and widespread travel restrictions. Confidence numbers, both among companies and consumers, will be hit and a global recession will become inevitable. The

Chinese economy will recover much more modestly. Central banks will step in with monetary policy, and governments will respond with fiscal stimulus. Because of the time it takes before these measures have an effect on the real economy and the severity of the immediate damage, this economic downturn may continue for the rest of the year. In this scenario, we are not expecting any signs of improvement before the end of the year.

What will be the impact on financial markets for each scenario?

Under the circumstances, the scenario of a transient shock is clearly the most optimistic scenario. In this scenario, we expect equity markets to rebound as investors start to realise that this is a merely temporary problem. Markets are forward looking and the impact of a temporary shock is limited in the longer term. We will return to investor behaviour similar to what we have seen in 2019, when markets were rising driven by lower interest rates, a business environment that is still all right for companies to perform and the fact that there is no alternative for equities. This scenario will be good for equity markets and commodities. Bond markets, which have returned to absolute low yields, particularly safe government bonds, will struggle as investors switch back to risky assets.

In case the shock is to last longer, such as in our second scenario, uncertainty will also remain longer. In this scenario, we would expect markets to stabilise or perhaps slightly rise, as investors will be more familiar with the virus and the potential effects. Actions taken by central banks and governments need to be closely watched, as their policy response can make all the difference. In this scenario, we will also see opportunities for risky assets to do well, but more modestly, much more selectively and with much more volatility.

Finally, the scenario of a severe shock will not be positive at all for financial markets. With more regions in lockdown and with confidence numbers being hurt, investors will remain concerned and will continue to look for safety. In this scenario, it is likely that equity markets enter into bear market territory, meaning a further drop of at least another 10% may occur. Safe government bonds, even with in many cases negative yields, will do well.

Which scenario do you think is most likely?

As abovementioned, it is difficult to make high-conviction calls on how the virus is developing. Looking at the facts, we are leaning more towards the first two scenarios and less towards the last scenario. Going forward, we will continue to watch the spreading of the virus in the different regions and the containment measures taken. In addition, we will look closely at the response from governments and central banks. Note that the bond markets has started to price in significantly more action from central banks since last week, particularly from the US Federal Reserve.

What would you advise our clients?

Our main advice to clients is first of all to stay calm. When markets are this volatile, it is better to wait for more clarity and stabilisation. Therefore, we recommend to refrain from any large changes to the portfolio at this moment. If we are to end up with the first scenario, then this might prove a good buying opportunity. In the past, we have seen that these corrections can rebound quickly, but it is too soon to tell for now. And while the jury is still out, it could equally turn out that we are in scenario two, in which case we need to tread more carefully with our investments.

Richard de Groot
Global Head of Investment Centre, ABN AMRO