The effects of coronavirus: three scenarios and how to play them

Markets are seeking stabilization after a week of almost unprecedented pogrom, in particular for US equities. During it, market historians used data from nearly a hundred years ago to find a moment of equally rapid correction. The main culprit was the outbreak of the coronavirus epidemic when the market reached an area of ​​extreme carelessness regarding credit risk and volatility. Raw materials did much better, quickly demonstrating the negative effects of the current situation.

At this point, in order for stabilization to take place, clear signals of the halting of the epidemic and a decrease in the number of new cases and the rate of coronavirus spread will be crucial. Simply put, we have not yet reached this level globally - in some respects this process is beginning to be visible in China, but in terms of market capitalization the most important outbreaks are in Europe, and above all on the largest market in terms of capitalization, i.e. in the US States. Naturally, this problem is global, which we discuss later in the article.

Below we present three scenarios of possible developments, grouped from best to worst. Perhaps none of them will run as we describe it, so keep in mind that this is just an outline of the potential consequences, designed to stimulate reflection and debate on possible developments - by no means is this a forecast! Given that according to those responsible and sober-minded epidemiologists up to 40-70% of people in the world can get sick, it is worth analyzing in depth what this could mean.

Regardless of the situation, when considering the impact of coronavirus on our lives and our portfolios in the coming weeks and months, two basic priorities should be adopted - security in the context of leverage and maintaining liquidity when and if a major crisis or collapse occurs in the market, because it is precisely then the best investment opportunities appear. There is a reason why 89-year-old Warren Buffet can boast a record cash level recently.

One more thing - it is clear that central banks and governments are gearing up to cut interest rates and take other measures to bolster investor confidence. This can cause a significant increase in volatility and even a "sucker" boom in the short term. Our scenarios do not take into account this stage of the response to developments, focusing rather on the bottom line and the performance of assets at the lows, then in the recovery phase and on methods of protecting investors at the very beginning and - subsequently - looking for opportunities in an excessively pessimistic market deleveraging period.

Finally, regardless of the further development of the situation, we suspect that the other side of this crisis will be the acceleration of the deglobalization tendency, which will prove to be as inflationary as the deflationary nature of globalization. The risk of such a situation appeared after the imposition of tariffs by Trump and after the trade deadlock between the United States and China, which only led to uncertain relaxation. The final settlement of the Sino-US trade conflict is also a risk regardless of whether Trump will rule the next term. However, the coronavirus exacerbated the threat of global supply line breakdown in a deglobalizing world, the need for further reduction, and possibly even vertical integration of supply chains. A fundamental change in behavior is to be expected as corporations will change their approach to this type of risk. Thus, although the direct effects of coronavirus may be classic and deflationary, the prevailing political stimuli and deglobalization suggest that we are around a hundred-year minimum of world interest rates.

Scenario 1: optimistic - delayed V-shaped reflection

The best-case scenario continues to be associated with the global technical recession and further significant disruptions in QXNUMX and QXNUMX, however during this period it will become clear that quarantine will sufficiently contain the spread of the virus and the threat will eventually start to diminish. At the same time, significant rate cuts and wide-ranging fiscal stimulus (and most importantly extensive programs to suit borrowers) will start to impact the overall system, boosting expectations of a significant V-rebound later this year. One of the key events that could increase the likelihood of this scenario could be the news that an effective vaccine is developed and can be produced within a few months - although we are unable to assess the likelihood in this regard.

Playing the most optimistic scenario:

• Long positions in highly volatile assets (put options on S&P - 2 test), put options on USD / JPY (test below 100), short positions in corporate bonds (ETF: JNK and HYG), however with the assumption of profit taking in the second quarter
• Long positions in precious metals (20%)
• Gradual rotation to pro-cyclical raw materials and weaker shares of mining and energy companies in QXNUMX and QXNUMX
• Long positions in secure government bonds while limiting allocations as yields on XNUMX-year US bonds approach zero.
• Cautiously concluding risky long-term trades (long position in S&P call options, etc.) with new lows and a decline in implied volatility (divergence).
• The transition from 50% of long positions in the phase when the market suffers significant losses and moods deteriorate, to a full long position in risky assets only after information that a clear breakthrough has occurred on the coronavirus front and the market.
• Short positions in USD as part of a basket transaction (basket traditionale) (relative to emerging and developed currencies) after improving moods / information

Scenario 2: base - U-shaped reflection

The baseline scenario assumes that official quarantines and self-isolation in the form of a decision to postpone trips or a general reduction in activity in public places will lead to a violent recession unlike anything we have seen since the Great Depression. Despite the heroic efforts to implement the appropriate incentives, the resumption of real business will be slow due to the significant disruptions caused by recurrence episodes, quarantine policies and human behavior. However, after the recovery in this scenario, the shift from deflationary concerns to more inflationary results may turn out much deeper than in the optimistic scenario, as there will be significant supply disruptions in the energy sector and other sectors as a result of the credit crunch in QXNUMX and QXNUMX, thus, after a rebound, demand and liquidity will spike prices while supply lags behind.

In the deleveraging phase:

• Long Put Option Positions on the Nasdaq 100 and S&P 500 - Test of the Two Hundred Week Moving Average on S & P 500 around 2 - analogous to 650 in the case of Nasdaq xnumx.
• Long positions in precious metals (20%) throughout this phase - benefits in the form of a safe investment and then as a hedge against inflation
• Long positions in JPY via the USD / JPY sell option and short positions in emerging market currencies relative to JPY

In the mature deleveraging phase:

• Choosing emerging market currencies with a worse valuation after central banks raise rates to protect the currency
• Selection of assets related to raw materials (mining and energy) with impaired valuation
• Long positions in cyclical actions of consumer goods producers (revival of consumption with subdued demand!)
• Increased allocation in silver (dual-use metal)
• Rotation to valuable shares in the context of long-term investments, because in the case of rising inflation they gain an advantage
• Increased short exposure to USD in the form of a basket.

Scenario 3: pessimistic - L-shaped reflection

We really hope it won't happen, but the worst-case scenario is that global GDP will experience an unprecedented decline, unmatched since the Great Depression in the 30s, if the spread of the coronavirus makes it difficult to endure quarantine and fears of re-contamination will increase, which means that a return to normal activities will carry a fear of another outbreak. The negative effects will increase as the initial actions of central banks and fiscal stimulus will not reach SMEs, which will be forced to halt or cease operations as credit sources dry up. The spiral will wind up by itself, worsening the crisis as the loss of jobs by increasing numbers of friends and associates leads to a further collapse in business. The first signs of recovery will appear in 2021 at the earliest.

In the deleveraging phase:

• Long positions in fixed income bonds as US 0,50-year bond yields reach -XNUMX%
• Long put option positions with a small delta in the stock market (e.g. S&P 500 below 2)
• Short positions in corporate bonds (JNK and HYG)
• Long positions in JPY 
• Long positions in precious metals (20%) throughout this phase

In the mature deleveraging phase:

• After increasing pessimism in the market - increasing long exposure to sectors and instruments that will benefit from even more extreme incentives that will eventually lead to a rebound - if not real GDP. The top of the list is USD - above all in relation to risky currencies of developed markets, but also gradually in relation to hard assets. Let's remember that one of the strongest boom on the stock exchange in history took place in 1932-1933 after the shock in the form of devaluation of USD against gold by FDR.
• Increased allocation in silver (dual use - as industrial and precious metal).
• Rotation only to long positions in commodity-related currencies (e.g. RUB, BRL, CLP) and to commodity-related shares - very slow and only when supply shrinks faster than demand as operations are limited, e.g. shares of oil companies and extracting industrial metals.

Source: John J. Hardy, director of currency market strategies at Saxo Bank, Saxo Bank