Market report February 2020

What does Covid-19 mean for financial markets and economic growth?

The Covid-19 outbreak, which began in the Chinese province of Hubei in December 2019, has spread to other regions of the world. Given that Covid-19 is a new strain, we do not yet know how it can grow, which makes it difficult to estimate the risk associated with the virus. Apart from China, Iran, Italy, South Korea and Japan were the most affected areas at the time the report was made.

Impact on growth will be determined by the scale and duration of the epidemic. Don’t need to convince anyone about China’s share in the global economy and how important its share in the global supply chain is. An analysis of the current situation in China shows, that the Chinese economy has practically stopped (link to the article about the situation in China). We estimate that quarterly growth in China may reach around 2%. Although the Lunar New Year is seasonally calm for the industry and busy for the service sector, most of the missed consumer activities are unlikely to be recovered. However, it is expected that delays in industrial activity will cause rebound after the reactivation of companies, which may cause acceleration of growth later in the year.

Governments are implementing policies to mitigate the negative impact of Covid-19. In China, both tax reliefs and liquidity measures have been introduced, in Italy the measures include increasing funding for exemptions and deferring tax accounts and mortgage payments. Germany is also preparing for accommodative fiscal measures.

The initial response of financial markets to the news of the Covid-19 outbreak was relatively optimistic and emerging markets were the only region where shares fell significantly at the end of January. After news of epidemics outside the Asia-Pacific region, we have also seen a clearer downward movement in global equity markets. Unsurprisingly, companies that are more sensitive to economic growth have suffered slightly more from the effects of the virus. The sale is wide, as companies are beginning to estimate the likely impact of the virus on the profitability of their operations, global supply chains are also disrupted, which indirectly affects many companies.

Given the risk of further spread of the virus, markets may go down further. However, we point out that once markets are able to fully value the impact of the virus on growth, stocks may again look attractive and provide an opportunity to buy. There is a balance between immediate market alarm and reasonable, long-term judgment based on fundamentals. With this in mind, in mid-February we limited exposure to shares to the necessary minimum by reallocating funds.

UK Inflation

Inflation in the United Kingdom increased in January to 1.8% y/y from 1.3% in December, which exceeded market expectations and was in line with the forecasts of the Bank of England. Core inflation (which does not include energy, fuels, alcohol and tobacco) also increased slightly to 1.6% from 1.4% in December. A significant part of the increase was caused by the energy price caps fading in 2019, but also by higher oil prices and travel fares. Given the strong wage increases observed in 2019, consumption may rise in 2020, which would be conducive to growth and inflation. Another budget may also bring higher government spending in 2021 and later. Data consumption may take some time, given the level of global growth and uncertainty associated with Brexit, it seems likely that the Bank of England will keep interest rates unchanged.

US Policy

Bernie Sanders is currently the leader of the race against President Donald Trump in the US presidential election in November, according to the first national poll in Nevada. Senator Sanders, a left wing candidate, gained 28% support, followed by left wing Senator Elizabeth Warren, with 19% support. The fact that none of the leading candidates is seen as business-friendly could have an impact on market sentiment. If such a candidate is elected, we can witness an increase in market volatility caused by the survey results flowing as the presidential race intensifies.

Risk of denomination in the Euro Zone

The risk of denomination is mainly related to the risk of default. It basically appears suddenly as a reaction to the shock of expectations when market participants begin to fear that state solvency can only be secured by restoring the national currency in combination with an unconditional reserve guarantee by the national central bank. This is the legacy of the euro crisis. Before the crisis, sovereign spreads in the euro area were only explained by default risk premiums.

Source: Allianz Research, RCieSolution Research

The ECB reduced the risk of re-denomination during Draghi’s time by implementing „whatever it takes” program and OMT (Outright Monetary Operations) operations – the purchase of bonds issued by euro zone members. The possibility of a self-strengthening loop between default risk and re-denomination has been significantly reduced. Thanks to OMT, euro countries are entitled to a rescue guarantee secured by (potentially) unlimited central bank reserves. Earlier, the guarantee was provided by European rescue funds, supported by limited tax possibilities of the member states. However, OMT remains a conditional rescue guarantee, provided that it participates in the European Stability Mechanism program. Therefore, the risk of denomination is currently limited but still exists.

In mid-2018, a new type of stress related to denomination appeared related to the government involvement of eurosceptic parties in Italy (M5S and Lega). At this time, the increase in the risk of denomination has not materialized the risk. It was an episode of an isolated valuation of political uncertainty.

The risk of denomination and political uncertainty (measured for example by the EPU indicator) are two different types of risk. The denomination risk only captures the systemic risk of the tail of the eurozone breakup, while the EPU index is a much broader measure of risk. For political uncertainty to be reflected in the denomination risk, there must be a combination of significant expected exit probability and expected change in the valuation of the new national currency. Especially in the case of smaller export-oriented countries, the opportunity costs associated with leaving the euro zone may be seen as prohibitive. This may be the reason why premium for denomination hardly occur in countries with relatively strong eurosceptic parties, such as the Netherlands, even at a time when political uncertainty was high.

Situation in Germany

In 2019, a technical recession was avoided. With a GDP growth of 0.6%, which is about half less than in the entire euro area, Germany’s GDP has been growing at the slowest pace since the debt crisis in the region. We do not expect 2020 to bring significant relief, as GDP growth is likely to slow down to around 0.4% seasonally adjusted. Moreover, the risk that the “golden” decade of uninterrupted economic growth in Germany – the longest expansion period since reunification – will end in 2020 is still valid. Given the cautious outlook for global trade and the automotive industry, as well as increased political uncertainty regarding trade and Brexit.

Europe’s economic power is trying to keep up with structural changes, putting it at risk of becoming an “orphan economy” with its long-term competitive advantage in industry, especially in the automotive industry, which will become obsolete. While the German economy remains highly innovative, it is becoming increasingly difficult to tap its potential given the lack of even basic digital infrastructure, the growing gap in digital skills and insufficient funding to set up.

A significant long-term investment plan is needed to modernize the infrastructure, update the education system, increase research and development capabilities and create a venture fund for co-investment in promising start-ups. The digital catching-up initiative in the German economy must be accompanied by a ‘simplification shock’, i.e. reduced bureaucracy, to enable better implementation of large infrastructure projects, as well as to make life easier for enterprises, in particular SMEs.

Chart: Real GDP Germany vs Euro area (y/y,%)

Source: Datastream, RCieSolution

Warning signs are hard to ignore, suggesting that Europe’s largest economy may be left behind by the 21st century technological revolution:

– Apple’s market capitalization has recently exceeded the total value of the 30 largest listed companies in Germany. It doesn’t help that Germany doesn’t have a technological success story in the DAX index. After all, the youngest listed IT company SAP was founded almost half a century ago.

– Comparative data for emerging unicorns – private companies worth more than a billion dollars – provide additional reflection: of the 445 companies that qualify as unicorns around the world, only 12 are based in Germany, compared to 217 in the US, 106 in China and 24 in Great Britain.

– For key technologies such as artificial intelligence (Al), whose economic significance is often compared with the invention of a steam engine or electricity, Europe and Germany are lagging behind. In fact, over 80% of Al’s global investments come from only two countries: the US and China.

– Recent research indicates that in the SME sector – which accounts for 70-80% of Germany’s economic strength – only every fifth company has a digital strategy and treats this topic as a priority.

– Number of startups established annually: 250,000 clearly cannot keep up with over 6 million companies annually in China and the United States respectively. Worldwide, Germany currently accounts for around 1.5% of all new companies – this is only half their share in global economic production, which is about 3%.

The above-mentioned concerns are at the centre of the automotive sector, which represents 5% of GDP and one-third of total R&D expenditure. Germany has been a car country for over a century. The fall in production in the 2018/2019 season – which in volume was comparable to the trend from 2008/09 – was already to some extent caused by adverse structural effects, including stricter environmental regulations (in particular those related to compliance with the WLTP deadline in September 1, 2018), the transition to e-mobility and emerging trends such as car sharing.

The car sector is just one example in which Germany’s long-term competitive advantage may become outdated. But with digitization changing most sectors of the economy, there is much more at the stake.

Chart: Car production, export and new registrations (12-month moving average, in millions)

Source: Datastream, RCieSolution

Global Stock Markets

The table includes rates of return in terms of pound sterling (GBP), local currency (Loc.) and relative (Rel.) / 24.02.2020

Source: RCieSolution Research

The views expressed in this document do not constitute research, are not investment or commercial advice and do not necessarily reflect the views of all management teams. They change over time.