May 26, 2020

Fathom Recovery Watch 26.05.2020

by Fathom Consulting.

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  • Likelihood of V increases to 55% as lockdown measures ease
  • US equities reaching a plateau some 10% below pre-crisis peaks
  • UK probably has the largest number of excess deaths in Europe
  • Impact on EMs still rising and still largely unknown thanks to lack of testing — likely to lead to a wave of sovereign defaults
  • Corporate defaults also likely in advanced economies
  • Global impact is contained in the V; but results in a credit crunch in the L
  • Euro area and emerging markets in the frame for transition from V to L, if it happens

The global outlook has improved slightly over the last week or two as restrictions on movement have generally eased in advanced economies, while the number of new cases and of deaths has continued to fall (notwithstanding some disturbing news from a few US states where the number of new cases appears to be rising again). It is not just the trajectory of the virus across advanced economies, but also some early signs of a bounceback in confidence and in activity (new job openings have risen sharply across most US states so far in May, albeit from a very low base in April), and continued bullishness in equity markets that supports our slight change of view, shifting more weight into the V-shaped scenario and out of the L. In our view, a V is now more likely than not.

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Bond markets continue to interpret this shock as deflationary in the medium term, and they continue to be wrong about that in our view. The US 5y5y forward inflation expectation is down around 35 basis points since the start of the year. But it remains to be seen whether the damage to aggregate demand in the medium term will exceed the damage to aggregate supply — in the short term, both have fallen sharply, but in the medium term it is likely that demand will recover most of that loss, although the impact on global supply chains could be permanent or very long-lasting.

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Similarly, there is no real anxiety in markets about the risk of substantially higher inflation in the medium term, at least not as might be captured in the value of real assets like oil or in the value of alternatives to fiat currencies, like gold or Bitcoin.

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Advanced economies are showing tentative signs of recovery with, in the view of the markets, no risk of inflation. But the same is not true for emerging economies, where tests for the virus tend to be much less prevalent (see the reading list below) and where the options for macroeconomic policy to support growth are much more constrained. EM equities remain some 25% off their start-of-year levels, compared to around a 10% reduction in the S&P. That gap may well widen further in the months to come.

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Corporate debt is high in many advanced economies, but so are equity valuations, even after the impact of the virus. Both are supported by ultra-low interest rates. Debt/equity ratios remain low, certainly by comparison with the experience of the Great Financial Crisis. That does not mean we should be relaxed about the risk of corporate default: there is a tail of highly geared companies who are very exposed if earnings stay low as the economy more widely recovers, as the example of Hertz illustrates.

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Emerging economies face substantially worse problems. The impact of the virus is largely unknown as yet, but the options for supporting the economy through this shock are substantially less than in advanced economies, since the governments of many emerging economies will struggle to borrow in the scale required to mitigate the worst of the economic impact. Fathom’s proprietary Financial Vulnerability Indicator (latest update out later today) captures these issues in an objective measure of the risk of sovereign, currency and banking crisis across 170 economies. The Top 5 movers in sovereign risk over the course of the last month are shown in the table below.

Belize is the biggest mover, while Lebanon, which defaulted on some of its government debt in March, still occupies the unenviable #1 position globally (expressed here in terms of how far out of line it now is compared to its own history). But the threat of sovereign default hangs over many EMs, not just those in this table.

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