April 28, 2020 / 4:19 PM / a month ago

COLUMN-A fork in the coronavirus road - the financial cost of relapse: Mike Dolan

(The opinions expressed here are those of the author, a columnist for Reuters.)

By Mike Dolan

LONDON, April 28 (Reuters) - Financial markets are now pricing an optimistic view that the world economy starts to reboot by mid-year, even though many investors still fear that assumption is fragile and darker alternatives are barely affordable.

The colossal cumulative cost of keeping a frozen world economy afloat may in itself hasten the search for alternatives to lockdown in the shape of testing, tracing and treatments should the coronavirus pandemic not abate quickly.

But either way, markets are headed for a fork in the road and their destination may determine the scale of the shock.

Many governments now plan easing restrictions over May and June as new infection rates flatten and death tolls recede.

China has mostly returned to work, while Australia and New Zealand are partially re-opening this week. In Europe, Germany, Austria and Switzerland and even the worst-hit countries Italy and Spain are slowly unlocking factories, shops and schools. And a growing number of U.S. states are following suit.

Encouraged by cumulative government and central bank stimulus which now exceeds $15 trillion, investors are increasingly frontloading the reboot.

MSCI’s all-country stock index has jumped 28% in just one month from its March trough, adding more points since then than it lost from February’s record high.

Still lofty volatility levels are also dissipating rapidly and fractured credit markets have healed considerably.

Strikingly, the whole saga has played out in less than 50 trading days, reinforcing the view among many investors that this is a crisis more akin to a natural disaster than a deep cyclical recession or prolonged credit crunch like 2008.

If they are wrong and fears of second waves and repeat lockdowns into the second half of this year or even into 2021, the premise that overwhelming policy action can be extended long enough to bridge the yawning cashflow gap will be challenged.

The UBS economics team has crunched those numbers and come up with a central case that lockdown restrictions start being lifted in May and world output contracts 3.2% for 2020 overall, with a sharp rebound of 5.2% next year.

But two more negative outcomes involve lockdown extensions to mid-year or even a complete failure of containment that sees the coronavirus returning in waves until mid-2021.

Those scenarios could lead to a 4.5% and 5.1% drop in global activity respectively this year, UBS said, with additional losses of between $1 and $2 trillion in output.

Crucially, the most negative view involves only a tepid 2% rebound in 2021 and a 30% of GDP jump in public debt ratios, which are already forecast to vault 100% of output in a third of countries on the most benign scenario.

While central bank capping borrowing costs limits that fallout, UBS reckons it still leaves debt dynamics unstable for many countries, pushing fiscal positions far from debt-stabilizing primary budget balances in the likes of Italy, South Africa, Brazil and even the United States.

With a collective 9 percentage point of GDP expansion of annual budget deficits now forecast for this year, even on the benign view, the pressure is immense as most of the new stimulus is ‘income replacing’ rather than ‘income enhancing’.

“If the stimulus fails to contain a large unemployment spike, more may be needed. However, the debt deterioration resulting from the existing stimulus is already very large, and starting to raise debt sustainability concerns.”

ONE WAY OR ANOTHER

For markets, the fork in the road then becomes clear.

On the view that lockdowns ease from next month, UBS sees a further 8% rise in world equities by year-end. But if the coronavirus is not contained this quarter, they see a reversal back through the March low.

Despite the relative ebullience of markets, there is no shortage of funds betting on a double dip.

Doubleline’s Jeffrey Gundlach said he was betting on a relapse below the March low, while hedge fund Elliott Management has predicted U.S. stocks will drop 50% from February’s high.

Even for the less bearish, the scenarios vary hugely.

Amundi has an almost 1,000 point range of estimates for where it sees the Eurostoxx50 index, involving either a 12% drop from here in the most negative twist or a further 20% rally if a U-shaped recovery emerges after the mid-year.

And the bulls also acknowledge lockdowns must be bookmarked quickly for support to remain affordable and stave off a deeper financial crisis, that could in turn amplify the economic shock.

The world’s biggest asset manager BlackRock expects the lasting impact will be less than the banking collapse 12 year ago, but also warned timing is everything.

“There is the risk of permanent damage if the freezing of economic activity lasts for an extended period of time,” it told clients on Tuesday. “An extended interruption could morph into a financial crisis if it were to lead to an unprecedented wave of corporate insolvencies, putting pressure on the banking system.”

By Mike Dolan, Twitter: @reutersMikeD; Editing by Alexander Smith

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