Financial stability report: The good, the bad and the ugly

It is hard to imagine that Hollywood could have produced a more dramatic script. There have been more than 1.8M confirmed Covid-19 cases in the United States and 6.4M worldwide. Tragically, there have been almost 400K Covid- related deaths. Since the pandemic hit the U.S., 42M people have filed for unemployment benefits, industrial output contracted by the most in 100 years, while consumption of recreational and transportation services declined by nearly 100% on an annualized basis. Moreover, the contraction in GDP in 2Q20 is poised to erase five years of economic growth while the unemployment rate (UR) skyrocketed from 3.5% in February to 14.7% in April. In the end, the decline in GDP and the spike in the UR will be the worst since the Great Depression.

Yet, Covid-19 not only poses an unprecedented risk to the health and economic wellbeing of the U.S., it also presents a substantial risk to financial stability. In a recent report published by the Federal Reserve, it seems that while the measures taken up to this point have been successful in moderating the immense pressures faced by financial markets in the immediate aftermath of the pandemic, financial stability will remain a concern going forward. As it stands, risks to financial stability are not uniform with areas such as household leverage showing significant resilience and others like leveraged loans showing increasing strains.

While there remain significant nuances to each sector such as the level of accommodation that the Federal Reserve is committed to providing, the amount of uptake and the incentives to access emergency lending facilities and the response of the private sector to the evolving risks to the economy from the pandemic fallout, we believe there are varying degrees of inherent risks.

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Equity prices: After a historic drop in the earliest phases of the crisis, which saw trading halted on a number of occasions, measures of stress within equity markets have improved. Implied and realized volatility have declined and measures of the premium required above risk free alternatives such as the spread between the forward price-to- earnings ratio and the real 10-year yield have receded. Moreover, the relaxation of stay-at-home orders and reduced voluntary distancing should also boost the outlook for publicly traded firms. However, sector-specific risks in segments that will continue to struggle in a world without a vaccine such as leisure and hospitality will remain elevated and could eventually lead to a bifurcation in the market and a stagnation of equity price gains. Likewise, a resurgence of the virus or another wave could cause a broad reversal in asset valuations.