Théo Dolle – ESCP Alumni – Commodities Derivatives Sales, BNP Paribas
Cécile Kharoubi – Professor of Finance, ESCP Business School
In the impact paper we wrote as part of the ESCP Business School’s “Managing a Post-Covid19 Era” series, we investigate the consequences of the Covid-19 crisis on financial markets, focusing on the wide divergence between equity and commodity markets, the risky involvement of non-professional investors, and the rehabilitation of the banking sector.
While the health crisis represented by the Coronavirus puts our globalized society in an unprecedented situation, it is also a great post-Subprime fire test for the financial markets. Following the crisis of 2007-2008, the financial markets were unanimously decried as the source of the financial crisis. The current crisis, which is primarily an economic crisis and whose source is totally exogenous to the functioning of the markets, nevertheless provides an opportunity to test their viability, efficiency and usefulness in a context of global crisis.
In order to draw lessons from this situation that markets have never seen before, it seems important to assess the extent to which markets represent a synthesis of available information, as Eugene Fama assumes in his theory of efficient markets. However, the opposing movements in equity and commodity markets suggest that financial markets, particularly equity markets, are currently out of touch with reality. Moreover, 12 years after the collapse of Lehman Brothers, the changing role of banks in the economy continues and could prove decisive in the context of a potential economic recovery and market stabilization.
The wide divergence of equity and commodity markets
The academic doxa still perceives financial markets as a synthetic representation of available information. However, in our world punctuated by an uninterrupted flow of often contradictory news, information is plural and already tends to threaten the informational efficiency conditional on the validity of orthodox financial theories. But what happens when financial markets offer us several distinct representations of reality? This is what the case of the divergence between equity and commodity markets shows us today. Indeed, while the equity markets, supported by the exceptional expansionary measures taken by central banks and states to reduce the economic impact of containment measures, have already rebounded close to their historical highs reached before the start of the health crisis, the commodity markets, particularly gas and oil, are still at the heart of a historical crisis whose repercussions threaten the future of the energy industry in the long term. This is evidenced by the prices of U.S. crude oil, whose major index, WTI (West Texas Intermediate), plunged into negative territory for the first time in history on April 20, dropping to a price of -40.32$/barrel. So how do you explain such a divergence? The major explanation lies in the fact that energy commodity markets, unlike equity markets, are always linked to the macroeconomic reality that drives the supply and demand dynamics on a daily basis. The price of WTI became negative for the first time on the eve of the expiry of the May contract. Traders who had to “roller” their futures position from May to June in order not to receive physical delivery were then faced with the scarcity of storage facilities and were therefore willing to pay to get rid of the oil they did not want (or could not) physically receive. It was therefore a reality on the ground that caught up with the oil market. If they are sustainable in the medium term, the historically low levels of energy indexes will lead to a profound rethinking of our global energy production model, while pushing traders and analysts in these markets to rethink their forecasting models in order to include scenarios never before imagined in concrete terms. However, this return to reality has not yet been experienced by the equity markets, which are still being boosted by the aggressive policies of central banks. The Financial Times even describes this divergence between the depressed economy and the rising equity market as “so extreme that it leaves analysts at a loss to explain*” This major dislocation shows that the different markets are offering distinct diagnoses in a new situation where uncertainty is the rule.
Banking sector: All is forgiven?
If there is one point on which this crisis is opposed to the crisis of 2008 it is on the role of banks. Indeed, if banks have been found guilty of the subprime crisis, they are now potentially supporting the economic recovery and hope to see their image improve in public opinion. Indeed, banks, through the granting of loans often guaranteed by the State in order to finance an economy in free fall, have the opportunity to partially restore their image. Moreover, when banks’ results are published, it is noted that the role of the market activities of these institutions paradoxically mitigates the impact of the health crisis on their results. Indeed, the rise in transaction volumes and the explosion in volatility on all financial markets has boosted the earnings of banks’ trading divisions. The example of Barclays, whose trading revenues, up 77% in the first quarter of 2020, have made it possible to increase provisions for credit losses, is particularly telling. We can therefore expect banks that still have significant market divisions to outperform those that have already relegated these activities to the retail sector. This trend is all the more paradoxical since most banks tend to focus their strategy on reducing trading activities, which were often decried after the subprime crisis and whose declining margins have squeezed earnings.
Faced with the economic difficulties caused by the containment policies implemented by governments to contain the virus, banks then presented record provisions in their balance sheets to prepare for possible massive credit losses. The behaviour of central banks in the face of these uncertainties then presents a new paradox compared to the previous crisis. Indeed, some of them advise commercial banks not to be too conservative in their provisioning levels so as not to discourage lending to businesses and individuals in the context of the future economic recovery. This is the case of the Bank of England, which advised English banks not to be too cautious about provisions made in the first quarter of 2020. Central banks are therefore advising commercial banks to take more risk, while the latter are particularly cautious. The current health crisis has indeed pushed the banking industry into an unprecedented situation giving rise to particularly counter-intuitive paradoxes.
Although the crisis did not start in the financial markets, it will nevertheless have profound impacts that will affect the financial industry in the long term. There has been a dislocation of markets by asset class, and a rethinking of the role and model of banks. It is also likely that this crisis will have a lasting impact on the risk appetite of all investors, traders and banks.
