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Coronavirus pandemic: Three scenarios on the global markets


Markets require central banks to take regulatory responses, and after the chaos that occurred last week, the expectation of such measures was quickly taken into account in the forward curve. However, the traditional measures taken by central banks bring little benefit to the economy during periods of simple halt of real activity. Below we will consider three scenarios after the outbreak of coronavirus pandemic.

The markets are trying to stabilize after a virtually unprecedented defeat that reigned during the week, especially in American stocks, for which they had to look for data almost a century ago to find the point of the same sharp correction of the market from a new historical maximum. The main culprit is the COVID-19 outbreak, which occurred at a time when the market was in an extremely complacent state in terms of credit risk and volatility. The consequences of this outbreak were best reflected in the commodities market.

Now, stabilization of markets requires clear signs that the outbreak of the coronavirus pandemic has declined and that the number of new infections and the rate of the coronavirus spread are declining. But in a global sense, there are no such signs - China may gradually come out of the crisis in some areas, but with regard to market capitalization, the key points are in Europe and especially in the USA, the largest market by capitalization. Of course, this problem can be called global, which we will discuss below.

Next, we present three likely scenarios of how this situation can develop, from best to worst. It may well happen that none of the three scenarios will come true, so please keep in mind that this is not a forecast, but our indicative assumptions regarding the potential consequences, and they are intended to discuss the situation. Given the opinion of responsible and reasonable epidemiologists that up to 40-70% of humanity can become infected with the COVID-19, it is worthwhile to comprehensively study what consequences this may lead to.

Regardless of how things turn out, there are two points that need to be guided in the coming weeks and months of the influence of coronavirus on our lives and our financial portfolios - to maintain a safe level of leverage and have sufficient liquidity in case of a significant crisis point, because at this time the market presents the largest trading opportunities. It is for this reason that 89-year-old Warren Buffett recently gained a record level of cash.

One more note: it is obvious that central banks and governments are preparing for a new round of rate cuts and other measures to build confidence. This may term provoke significant volatility in the short and even a sharp rally, which will also sharply turn in the opposite direction. The scenarios below do not include the reaction phase to the unfolding situation, but show where the bottom may be and how assets can show themselves during downturns and then during the recovery phase, as well as what investors can do to protect themselves in the initial stages, and how they will ultimately seek opportunities in a market that is in a pessimistic phase of deletion.

Finally, no matter to what markets come in the long run, we suspect that after this COVID-19 crisis, the trend towards de-globalization will accelerate, which will turn out to be as inflationary as globalization turns out to be deflationary. The risk of this has already been observed due to Trump’s customs duties and the confrontation between the US and China in trade policy, which led only to a shaky truce.

The trade confrontation between the US and the EU is also likely, regardless of whether Trump stays for the second term or not. However, coronavirus pandemic affirmed the danger of stretching global supply lines in a deglobalized world, as well as the need for greater redundancy and possibly even vertical integration in supply chains. We can expect dramatic changes in the behavior of company executives, as they begin to relate to these risks in a different way. Therefore, although the direct effect of coronavirus may be routine, deflationary, powerful regulatory stimulation and deglobalization will lead to a prolonged period of low interest rates.

Scenario 1: the best option is a delayed V-shaped graph


The most positive scenario still implies a global technical recession and significant difficulties in the second and third quarters of 2020. However, during this period it becomes clear that quarantine sufficiently slows down the spread of the coronavirus, and ultimately the pandemic will decline. Meanwhile, massive cuts in rates and tremendous fiscal stimulus and, more importantly, programs to ease the credit load, are starting to work and raise expectations of a massive V-shaped recovery at the end of this year. One of the key events that can lead to the V-shaped scenario is finding an effective vaccine against COVID-19 that can be produced within a few months, although we have no way to assess the likelihood of this event.


How to trade with the best scenario

Scenario 2: Basic - U-Shaped Recovery Schedule


The basic option is that state-level COVID-19 quarantine and self-quarantine, refusal to go on vacation and reduced social activity, will lead to a sharp recession unprecedented since the 2008 global economic crisis. Despite heroic efforts to stimulate the economy, real activity is slowly recovering due to coronavirus re-infection cases that require harsh quarantine measures. However, when recovery begins in this scenario, the transition from deflationary fears to more inflationary consequences can be far more pronounced than with the “best case scenario”. The fact is that then, due to the credit crisis in the second and third quarters, there will be a noticeable reduction in supplies in the energy and other sectors, and therefore, when the recovery comes, demand and liquidity will lead to a jump in prices, as the supply will lag.


For the deleveraging phase


After the deleveraging phase is completed:

Scenario 3: Worst Option - L-Shaped Recovery Schedule


We would not like to be in this situation, but the worst option is an unprecedented reduction in global GDP, unprecedented since the Great Depression of the 1930s. It will be due to the fact that the spread of coronavirus will not allow quarantine to be lifted, because the fear of re-infection will not recede, and the COVID-19 will spread around the world. This means that resumption of work will also revive fears of a new coronavirus pandemic outbreak. The collapse will continue, as the initial efforts of central banks and fiscal measures will not affect small and medium-sized enterprises, which will be forced to curtail their activities as credit lines are depleted. The situation will exacerbate the recession, as the loss of work by friends and colleagues will lead to a further decrease in economic activity. Signs of recovery will not fully manifest until 2021.


For the deleveraging phase

After the completion of the deleveraging phase

Very slow transition to long positions in stocks and currencies that are sensitive to commodity prices, for example BRL or CLP, and only when the supply starts to dry up faster than demand due to suspension of activities, for example, in the oil & gas industry and industrial metals.

Author: Kate Solano for Forex-Ratings.com

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