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As the COVID-19 pandemic continues across the globe, many of us have been assessing its economic impact. As cases surged in March, there were record levels of volatility and a collapse in investor risk appetite across markets. Although in Q2 volatility and risk appetite stabilised in certain markets, such as equities, the nature of this initial shock still allows for comparison with previous economic crises. This can be instructive, as it provides a useful yardstick to measure the effects of the ongoing situation and can help to judge the effectiveness of policy interventions.
As the Deloitte COVID-19 Economics Monitor predicted, the immediate hit to British economic activity has been far greater than that seen during the Global Financial Crisis or the Great Depression. Deloitte’s Economics team has identified that the COVID-19 shock drove record GDP contractions in Europe, Japan and the US, with the UK experiencing the sharpest quarterly contraction in activity in more than a century during Q2.
Comparing the effects of COVID-19 on financial markets with those of the Global Financial Crisis, we see that the two are different in nature and there are distinctions in how governments, legislators and regulators have managed the disruption to the market during both these periods. One major distinction is that the Global Financial Crisis brought a recession in developed economies, but emerging markets managed to avoid that outcome, instead experiencing slower growth. This time it is different. In the Global Economic Prospects published by the World Bank in June 2020, an emerging market recession was predicted for the first time since 1960, and the UK fell into recession for the first time since 2009 after GDP contracted in Q1 and Q2.
In this blog, we compare certain market data categories in the Global Financial Crisis and the early months of the COVID-19 pandemic. We identify similarities and differences in the market movements in each period, and use this economic analysis to consider how the pandemic may affect future disputes and litigation.
A key period in the Global Financial Crisis was between September 2008 and December 2008, where a series of well-reported events took place that led to a period of heightened market volatility and uncertainty. These notable events saw the collapse of a number of financial institutions, the rise of bailouts, quantitative easing, and ultimately, economic recession.
During this time there was a risk of liquidity drying up in the gilts and treasuries markets that the Fed and the BoE acted on; markets experienced fluctuations in exchange rates, the stock market plunged, commodity prices declined and credit spreads widened.
As we explore further below, these market movements are similar to what has been observed more recently, and in particular, from January 2020 to April 2020 – the early stages of the COVID-19 pandemic.
Turbulent currency movements
At a time of economic unrest, parts of the economy, including foreign exchange rates, become unstable. Indeed, the British Pound depreciated against major currencies during the Global Financial Crisis and has again suffered a similar fate in Q1 where the pound fell sharply in March 2020.
In 2008, this depreciation took place because of a period of temporary economic decline, during which trade and industrial activity was reduced. However, in 2020 this depreciation resurfaced because of increased cases of the COVID-19 pandemic in the UK and an apparent flight to safety; it took place immediately before the economic collapse during lockdown. In particular, it seems that US securities were perceived by investors to be a safer haven, believing that, in times like this, the trade-weighted dollar would appreciate in a rush to safety.
However, it is noteworthy that whilst in March 2020 the British Pound depreciated significantly, it recovered at a faster rate than what was observed in 2008. The graph below demonstrates this point.
As much of the world slowly emerges from “lockdown”, with the ever-present threat of “second waves” across the globe, there are challenges ahead - including a potential second spell of turbulent currency movements. Well-advised businesses should be evaluating contracts and cost bases given the negative exposure that is married to currency fluctuations. In preparation for this, businesses may also, seek to leverage off the derivatives market which can be used to hedge exchange rate fluctuations that are a direct by-product of events such as the pandemic.
We have already observed that the currency fluctuations that the market has experienced recently have led to an increase in margin calls putting pressure on firms to post collateral, sometimes requiring them to close out positions at short notice, often at a loss. Increased access to derivatives markets, the potential for exotic product solutions and on-going currency volatility could lead to future disputes between counterparties and banks; for example, should firms fail to post adequate collateral or not agree on the terms of any trade close-outs or valuations. Indeed, these types of disputes were prevalent during the 2008 Global Financial Crisis.
The condition of the stock market in February 2020 and March 2020 behaved similarly to that of the 2008 crisis. In 2008, the Dow ended the year at 8,776.39 points; down nearly 34% for the year. Likewise, in February 2020 leading stock markets around the world faced a tough week, their worst since the 2008 financial crisis. The Dow Jones Industrial Average tumbled by 11.99% by the end of the week ending 28th February 2020. Many feared a sustained pattern of decline was returning.
Stimulus measures were employed in March 2020 by major central banks and some markets eradicated parts of these losses. In general, the UK, US and European markets recovered gradually from the trough in March until June, and then flatlined, although the US market continued to recover.
As the pandemic hit, investors had investment decisions to make in a challenging environment. We observed measures such as the VIX Rate¹ moving significantly higher in February 2020 (as it did in 2008), albeit it remained high for a longer period of time in 2008 than in 2020, suggesting that policymakers and governments may have reacted quicker in 2020 than in 2008. As it stands, volatility is lessening, meaning that VIX Rates are trying to return to their normal “mean” levels, albeit many will argue that the future remains uncertain.
As we consider the potential issues in the wider market, we note the market volatility experienced in February 2020 to April 2020 may have affected leveraged equity and other derivative positions causing a significant collateral liability for a number of counterparties on a daily basis (based on the market value of their trading positions). Time will tell, but similar to the volatility observed in the currency markets, this could give rise to disputes and litigation in the future.
The Global Financial Crisis induced a bear market in oil and gas; the price of a barrel of Crude Oil decreased by 49.98% and Brent Oil decreased by 49.68% over the last four months of 2008 (refer to Figure 2a below). During this time there was increased levels of unemployment, and lower spending led to less demand for oil by both consumers and businesses.
More recently, as COVID-19 cases increased from January 2020 to March 2020 and financial markets became unstable, oil prices again fell (refer to Figure 2b below). Although oil prices were already falling before this, the increased uncertainty brought by COVID-19 and the lockdown measures depressed demand causing prices to fall even more.
Overall, the commodities market is potentially experiencing longer-term changes due to the effects of COVID-19 as demand for transport falls, potentially dampening the longer-term demand for oil. Businesses in the commodities sector face numerous potential risks and losses. Revenue drops for a number of sub-sectors are inevitable, which in turn is forcing businesses to cut investment and costs. Challenging debt markets and volatile equity markets will add to the difficulties. Companies adapting to the new reality will also, likely review and re-assess their current contracts and projects, which could lead to a new wave of energy sector disputes. Furthermore, those investors who experienced significant losses due to the commodities market movements through trading or derivative positions may also have reason to bring legal challenges.
A risky credit market
During February 2020 to April 2020 we saw an evolution from ‘risky’ credits to safe assets - similar to that which took place during the 2008 Global Financial Crisis; corporate spreads spiked in March 2020 but not as high as they did 2008. They quickly came down, in part this was driven by monetary intervention. The 2020 Global Financial Stability Report published by the International Monetary Fund suggests that the yields on CLO Debt have increased since the COVID-19 outbreak indicating that we may need to prepare for further stress in the credit markets as the economy reopens and there have been talks of a “second wave.”
The future still looks uncertain as more corporate downgrades are predicted, particularly once government backed support schemes are removed. Many corporates may face a prolonged downturn in earnings, making them more vulnerable in the market they are operating in and potentially exposing them to “Material Adverse Change” clauses, i.e. where a buyer has the right to call off an acquisition before closing. Further to this, corporates will need to investigate their current financial covenants, reassess their going concern status and ensure sufficient disclosures are made to investors. These events will lead to a greater need for negotiations, increased scrutiny and a risk of financial misstatement or misreporting.
What does the future look like?
Overall, we have observed that whilst there are similarities between the Global Financial Crisis and the economic situation resulting from COVID-19, one very important distinction is that the pace of intervention by policymakers and those charged with governance was not the same during both periods. The pace of intervention in specific markets through quantitative easing and targeted asset purchases was much quicker and more sure-footed in 2020 than it was in 2008, perhaps as a result of lessons learned in the first period.
One difficult question is estimating the level of economic scarring as a consequence of the current crisis. The Global Financial Crisis was succeeded by the sharpest and most prolonged squeeze in incomes since Victorian times in the UK, coupled with weak investment and productivity growth. It is too early to assess the long-term effects of COVID-19 but a V-shaped recovery with minimal scarring, as many had initially estimated, looks increasingly unlikely. Deloitte’s COVID-19 Economics Monitor forecasts suggest that activity should return to its pre-pandemic levels in the second-half of 2022, quicker than the more than four years it took to reach pre-crisis levels following the Global Financial Crisis.
The big uncertainty remains as to whether we will experience a second wave of the virus and what effects this potentially could have on the market - at present this is unquantifiable. Nevertheless, we will follow the next series of events closely, including the potential for a rise in loss claims and high value disputes.
¹ VIX Rate - Cboe Global Markets created the Cboe Volatility Index (VIX Index), a benchmark index to measure the market’s expectation of future volatility. The VIX Index is based on options of the S&P 500 Index, considered a leading indicator of the broad US stock market. The VIX Index is recognised as a gauge of US equity market volatility.
Mark is a Partner in our Banking & Capital Markets Audit Group in London. He is a leading member of our Benchmarks Assurance & Advisory team and a co-Chair of Deloitte’s Global IBOR Reform Steering Committee. Mark has 16 years’ experience across financial services audit and assurance, regulatory compliance, regulatory investigations and financial services disputes. This experience has provided him with a strong technical understanding of wholesale markets, financial benchmarks and related risk and control frameworks. His experience across the industry with respect to IBOR reform has provided him with a unique perspective on the regulatory reform agenda and he is actively assisting clients in this space at present.
Amber Andrade is a Director in Deloitte’s Forensic team. Her practice spans investigations into accounting misstatements, whistle blower allegations, regulatory reviews and skilled person reports, as well as large, complex expert witness and advisory engagements. She works with clients across a variety of industries and as part of the Deloitte Financial Services Disputes leadership team. Amber has significant experience in contentious matters in the financial services sector, where she has prepared many expert accountant reports, requiring her to work closely with clients and their legal teams in a wide variety of high-value, global, disputes and investigations.
Audrey is a part-qualified accountant and Senior Associate at Deloitte within the Markets Assurance Team. Audrey’s experience in Credit Risk and Audit have giving her the platform to build her financial markets and sector knowledge. More recently, she has joined our FS Disputes team where she is building her knowledge on navigating through the technical and complex nature of disputes against banks and other investment bodies.