Throughout the covid-19 crisis, Funds Europe presents some of the best market commentary from fund professionals. Today, David Riley, chief investment strategist at BlueBay Asset Management, looks at the severity of the recession and the potential market recovery following the week when oil prices turned negative.
What we saw last week was extraordinary. After getting used to negative bond yields, this crisis has now brought us negative oil prices. That said, it was the price of US West Texas Intermediate oil for short-dated delivery – so for delivery next month – that collapsed on Monday from around 10 dollars per barrel to minus 40 dollars per barrel. It did subsequently bounce into positive territory and the actual volume of oil traded at that level was very small.
A key driver was selling by oil exchange traded funds that hold short-term futures contracts that do not take physical delivery of oil but could find no buyers because the oil storage hub in Cushing, Oklahoma – the world’s biggest with around 76 million barrels capacity – is almost full.
But I don’t think the volatility and negative oil prices should be dismissed as due to market technicals, even though it does raise questions over retail investor participation in exchange traded funds and the sometimes-destabilizing feed-back loops they create in markets.
The oil market is saying loud and clear that it does not expect a quick and strong recovery in the global economy and hence oil demand.
I think this underscores a key tension in global financial markets right now between deteriorating economic fundamentals and central bank liquidity. Right now we are in the midst of the deepest recession in modern history with a very uncertain path to recovery. But the unprecedented scale of central bank liquidity is supporting financial assets – the question mark is whether it will ultimately work in underpinning the real economy.
In terms of the severity of the recession, every month of stringent lockdown probably means the economy is producing 35% less than normal. So for example six weeks of lockdown will knock 4 percentage points from annual growth, bigger than the annual GDP decline during the global financial crisis.
The longer the lockdowns and slower the re-opening of the economy, the greater the risk that a liquidity problem for businesses becomes a solvency problem.
However, getting the exit strategy from lockdown correct must be the priority – allowing the economy to re-open while ensuring that testing and other measures are in place to contain the infection rate of the virus – is vital. The experience of China suggests an initially strong rebound in manufacturing, but consumers will remain cautious despite pent-up demand.
Our current assessment is that there will be an initial bounce in the 3rd quarter as lockdowns are relaxed but thereafter the recovery will flatten – a sort of tick-shaped recovery.
But all predictions of the future should be taken with a barrel, rather than a pinch, of salt in the current environment. After all, we are only six weeks into the crisis and at the start of a recession in major developed economies.
The rally in equity markets suggests that investors are beginning to anticipate a relatively strong rebound in corporate earnings and the economy, while bond and oil markets are much more pessimistic.
Credit sits somewhere between the two, with credit spreads implying meaningful defaults and downgrades consistent with a more gradual economic recovery but not a prolonged recession.
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