BCS: Pricing in a global recession

BCS: Pricing in a global recession
The economic situation is decaying rapidly to the point where investors were even selling off gold, as they need cash as markets around the world tank
By Vladimir Tikhomirov chief economist BCS Global Markets March 24, 2020

ED: this comment by BSC Global Markets chief economist Vladimir Tikhomirov first appeared in the bank’s daily commentary. We republish selections below.

Recession is no surprise now, but uncertainty makes investors nervous. As we expected, the market reaction to another emergency rate cut [to zero interest rates on March 21] by the Fed was extremely negative. The situation is aggravated by a sharp liquidity deficit, exacerbated by the uncertainty about the duration and the depth of the fall economic downturn. Even though most assets have already priced the recession, its fallout is still unclear – both for companies, banks and funds as well as for the global economy. The global inter-connected world that we have been living in is rapidly changing.

Now, we expect that global growth could be the weakest in decades – hovering at 0-0.5% year on year. Demand for commodities will fall dramatically and the situation on the oil market will likely be amplified by the continuing price war. We now forecast the world economy will grow by just 0.5% y/y in 2020 (mainly thanks to largely still normal 1Q20). Turmoil on the oil markets will last into 3Q20, but in 4Q20 we expect prices to post a moderate recovery – on average, we forecast Brent crude to trade at around $39 per barrel this year (c$25/bbl in 2Q20).

Russian economy: GDP to plunge by 2.7% y/y in 2020

Following the downgrade of the global economic forecast, we also updated our view on the Russian economy. Our new base-case scenario is a sharp reversal from 1.3% y/y growth in 1Q20 to a decline of 3% y/y in 2Q20, -5% in 3Q20 and -4% in 4Q20. The Russian economy is also likely to post minor negative growth in 1H21 before it returns to positive growth in 2H21. The reason for our cautious macro outlook is based on an assumption that while the coronavirus (COVID-19) pandemic might be overcome in 3-4 months (by July-August 2020), the combined effect of stressed global demand and a continued price war on the oil market will not allow the economy to return to growth rapidly – not least because of the base factor effects.

Indeed, under these circumstances, the role of the government in supporting demand might become crucial. However, we take a view that the Russian Cabinet and Kremlin will prefer to stick to conservative policies – instead of increasing spending, they would keep it controlled, as the goal of preserving reserves will overshadow all other priorities on their economic agenda. This does not mean that they would not offer crisis support to industries and the population hit by the crisis – such money will be forthcoming in the form of cheap loans, regulatory adjustments and social payouts. But the size of such support will likely be limited, and definitely not be enough to serve as a growth trigger for the larger economy.

The weakening ruble and rising inflation will lead to a reversal in per capita real income – after posting an estimated 1.2% y/y growth in 1Q20, we expect real incomes to sharply decline by 5-7% y/y in the next two quarters. This will prompt similar declines in retail sales as imported goods become more expensive, while people again switch to a savings pattern – traditional behaviour in times of crisis and uncertainty.

Dramatic changes in domestic demand will preclude sharp cuts in the volume of Russia’s imports – both in consumer and investment segments. We forecast visible shifts in imports to take place in April-May. This will allow Russia to retain a trade surplus, despite an anticipated huge compression in the volume of its exports in $ terms. In our new forecast, we expect Russia to post a $102bn trade surplus in 2020 v $165bn in 2019 and $194bn in 2018. This, however, will support its current account balance, which we estimate in 2020 will be closed with a surplus of $45bn, while net capital outflows could peak at $110bn.

Overall, we expect Russia to follow the rest of the world into recession in the next couple of quarters. The carry-over negative effect from such a dramatic downturn is likely to linger for another 1-2 quarters, although we expect that by YE20 a possible recovery on oil markets could lead to visible improvements in Russia’s macroeconomic performance. Russia’s rich modern history of crises together with accumulated levels of reserves and small and manageable debt will save it from widespread social and financial instability. But the population will face a new period of hardships – and not only health-related – as incomes fall and domestic demand weakens. Ruble devaluation will trigger a spike in inflation, although we do not expect very significant acceleration in price growth as weak demand caps CPI growth.

Ruble and CBR rate – Ruble has stabilised, CBR waits on rate move

The CBR on Friday left its benchmark rate unchanged at 6% – widely expected by us and the market. The regulator removed estimates of projected inflation and GDP growth from its commentary, but added that it sees a rise in inflationary risks. The CBR also called the recent weakening of the ruble temporary, while recognising its carry-over effect on the inflation trend. However, the CBR also said that while the risks have risen that YE20 inflation will exceed the bank’s target level of 4%, price growth would be restrained due to suppressed domestic and external demand.

CBR governor Elvira Nabiullina, at the press conference following the decision, left little doubt about the regulator’s commitment to proceed with tough monetary policy. Nabiullina said the viability of moves by different governments to support demand via providing people with cash were open to debate, adding that so far there was no need to launch any Russian version of the quantitative easing via OFZ purchases.

Market reaction to the CBR’s rate decision was neutral. The ruble was also little changed – more influenced by the CBR’s interventions. The CBR, in seven trading sessions during 10-18 March, sold $450mn worth of foreign currency with daily sales gradually rising from $50mn to $100mn on 18 March. These volumes are far from critical – indeed, from 15 January to 6 February CBR bought $330-340mn per day under the budget rule.

Starting 19 March, CBR has more options to support Russia’s domestic currency – the bank received a FX-denominated payment from MinFin for Sberbank shares and immediately announced a new mechanism for selling this currency to the market. This mechanism works as follows: if Urals falls below $25/bbl, the CBR will sell foreign currency to keep the ruble stable; if this level is exceeded, selling will stop. This rule will be in place until 30 September; if FX sales are less than the payment from MinFin, we could see this mechanism extended for longer.

Following the fall in oil prices below $25/bbl for Brent (Urals is trading at a large discount, having tested the level of $19/bbl on 19 March), the ruble also weakened. Just as we expected, the ruble FX rate reached levels of cRUB80/$. Last Friday morning, oil prices rose, allowing the ruble to stabilise and even strengthen to RUB78/$, but in the evening a new wave of corrections in US markets sent the ruble back to its earlier levels. At the end of trading on 20 March, Russia's domestic currency stood at RUB79.93/$ (v RUB72.60/$ on 13 March).

In case of higher risks to financial stability – for example, in the event of a sharp increase in capital outflows from ruble bonds – we could see a rate hike, possibly ad hoc, albeit we see a low probability of this so far.

Oil – US starts to get nervous, Saudis gets ready to tap reserves

Even though it was expected, oil prices dipping below $25/bbl still forced many to start adjusting to the new reality. Several hours after setting new lows, forecasts began to appear on the market of an even deeper fall in the next month or two – some analysts see a S-T drop to $5/bbl. There were also reports of a rapid decline in oil production in Texas, the centre for shale oil production in the US. In Russia, we witnessed a public discussion in the media on Thursday-Friday between top managers of the two largest oil companies – one strongly criticised the collapse of the OPEC+ deal, the other defended Russia's position on the matter.

Headlines from the oil market made the US administration nervous. While Trump said at the beginning of last week that low prices are good for US consumers, by the end of the week we saw reports that US authorities were considering putting pressure on Saudi Arabia and Russia in order to force them to take steps to balance the oil market. US officials again accused Russia of ‘energy blackmail’, while the media reported of the possible preparation of new sanctions.

Also in the news, there were reports that Saudi Arabia is getting ready to increase spending from reserves, including via repatriation of money invested in US funds and banks. This, in particular, could trigger a rise in liquidity shortages in the US financial market.

In the evening of 20 March, information appeared in the media about direct contacts between the Texas oil regulator and the OPEC Secretary General. It was also reported that the US had received an invitation to the next Cartel meeting in June.

These events mean one thing: Current oil prices of $20-30/bbl put much pressure on oil markets and make weaker players or producers of more expensive oil nervous. A series of bankruptcies and/or shutdowns in the US oil industry could seriously exacerbate the already rapidly mounting problems in the financial sector. This explains why US authorities began to respond so quickly to the current situation. Basically, there are two ways out of it – either via the path of co-operation, i.e., the expansion of the OPEC+ deal by including the US, or confrontation via putting pressure on Saudi Arabia and Russia in various ways, including the threat of sanctions. So far, we see the US taking steps in both directions, but which of them will become the main thrust of Washington’s policy is not yet clear.

On 18 March, Brent closed at $24.88/bbl, its lowest level since November 2002. By the end of the week, prices corrected, closing at $26.98/bbl (v $33.85/bbl on 13 March) in London on 20 March Brent.

Gold – Price of gold follows the market

Demand for liquidity forced many investors to get rid of investments in any assets, including gold. From a local peak of $1,680/oz on 9 March, the price of gold dropped to $1,471/oz on 19 March and closed at $1,499/oz on 20 March v $1,530/oz a week earlier.