Coronavirus and quarantine + oil crisis = credit crunch

news-single-imgcaption" style="width:240px">Florian Roger, head of asset allocation research, Exane Derivatives.

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Italy decided this weekend to quarantine all of Lombardy, northern Emilia-Romagna and eastern Piedmont until April 3, before extending the measure globally on Monday. The economic consequences will be major for the country, and investors anticipate that this type of measure will multiply in the developed world, which generates a renewed risk aversion.

Russia and OPEC failed to reach an agreement to cut oil production to balance the market following the demand shock caused by the coronavirus. Saudi Arabia then decided to cut prices and potentially increase production substantially. The price of a barrel of oil fell around 30 dollars. Saudi Arabia likely believes that falling prices will put pressure on Russian oil production. Russia likely believes falling prices will weigh on US shale oil under pressure, prompting the United States to put pressure on Saudi Arabia. The oil market is therefore facing a major geopolitical crisis.

The quarantine measures implemented in Italy and the collapse in oil prices are putting acute stress on the credit market and are likely to jeopardize the entire macro-financial scenario. Liquidity tensions will be exacerbated, causing risk premium dislocations. Given the level of corporate leverage and the weight of the energy sector (around 13%), US high-yield bonds represent a particularly vulnerable asset class.

The cooperation of the authorities and the coordination of the policy mix will be decisive

Central banks are expected to inject massive liquidity over the next few days to ease tensions in the credit market. Coordination of interventions will be key for the foreign exchange market. The Bank of Japan and the Swiss National Bank are already making extensive use of their balance sheets. They may therefore find it difficult to contain pressures to appreciate the JPY and the CHF.

US sovereign bond yields and those of the core countries of the euro zone will continue to compress. Peripheral spreads in the euro zone are likely to widen. The scale and relevance of the policy mix at the global level, especially the ability of different countries to cooperate, to counter shocks will be crucial.

In Europe, after several years of rising populism and the development of an anti-European sentiment, the ability of the euro zone to provide a community response to the difficulties of the member states affected by the coronavirus is a major challenge but can, at the same time time, constitute a real opportunity: more common spending, issues of community bonds to finance health spending, a potentially unlimited quantitative easing of the ECB during the duration of the pandemic …

Risk aversion goes up a notch in the markets. Nominal long rates are crashing in the United States. Quantitative easing programs will increase global excess liquidity. This environment is very positive for gold, even in the medium term.

The sanitary measures taken to curb the coronavirus also have a colossal economic cost, especially if they result in quarantine. The resilience of the Chinese equity market nevertheless suggests that investors are able to “digest” these impacts, if health measures make it possible to contain the disease. On the other hand, the coincidence of an oil crisis which blocks the world credit market, causes a credit crunch and prevents companies from refinancing could break the global macro-financial scenario. To curb this risk, central banks will inject liquidity.

In addition, political actors must propose a relevant and coordinated policy mix:

1) That Europe is able to offer a strong community response to the difficulties of the member states;

2) That Russians, Saudis and Americans succeed in getting back around the table to rebalance the oil market. The impending presidential election in the United States should prompt Donald Trump to put tremendous pressure on it … a paradox for a president who has spent his mandate weakening all forms of international cooperation!

* Head of asset allocation research, Exane Derivatives

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