• Market participants were largely caught off-guard by the string of national quarantines forced by the rapid spread of Covid-19 around the world causing markets to face the first liquidity crunch and US dollar shortage since 2008. In the fastest 20%+ drop in the S&P 500, we can expect markets to outrun the newsflow, and the newsflow to outrun the economic data as Covid-19 will dominate the three at least through Q2.

• The questions on everyone’s minds right now include some variation of when everything will return to normal and/or whether the S&P 500 has bottomed yet, but the unpalatable reality is that Covid-19 has rendered most forecasts and economic data relatively useless beyond pointing to the obvious. As expected PMIs have plummeted and GDP growth projections for Q1 and Q2 look as dire as they ever have, but anyone claiming to know what a PMI in the 30s and GDP growth of -20% looks like, and what happens from here is being naïve at best and disingenuous at worst. Current conditions bear close watching as clues on what’s next will unfold quickly.

• The logical starting point for any analysis begins with Covid-19 and from a naïve perspective, Europe and the United States seem to be roughly 2 months behind China, which is now in the process of lifting Hubei travel restrictions, with Hubei coming back online in early April. From a crude perspective, that, along with the fact that the average latency period of Covid-19 is around 14 days, suggests that by the end of April we should start seeing more re-openings in the US and Europe than closings, but it bears repeating that the situation is fluid and many relevant factors can change over the next 5 weeks.

• At this point, it is odds on we see a relief rally that puts the S&P 500 20-25% above its recent lows as liquidity returns to the markets. Whether that is the recovery, I don’t know – it may be, but I find it unlikely. I would expect the newsflow to still deteriorate materially as the US continues to struggle in running enough Covid-19 tests, a key component of South Korea’s success. However, South Korea managed to quickly ramp up and achieve a 1:14 infected-to-tested ratio. As of yesterday, the US’s ratio stands at a meager 1:7.

• As long as the US economy is under Covid-19 siege, we can expect risk assets to have a ceiling above them, but longer-term, as we put Covid-19 past us and faster and better testing comes online, the flood of liquidity from central banks and from expanded fiscal policy, which will be extremely difficult to withdraw once we are past the crisis, is set to create a bull market of epic proportions and the type of generational investment opportunities that rarely come about.

• For now however, it is striking that S&P 500 shorts are more in line with levels seen near peaks rather than troughs. Moreover, the AAII Bull-Bear Spread is still less bearish than it was in December 2018 and early 2016, and therefore not even close to 2008 levels. As such, I will make my base case that this week’s rally in S&P 500 is merely a relief rally caused by a return of liquidity to the markets rather than the start the new bull market.

Putin Gifts MbS a Harsh Lesson in Realpolitik

• Sensing blood in the water, Putin did not hesitate to turn the Covid-19 crisis to his advantage. After a misguided attempt to try and corner Russia into oil production cuts, Putin not only did not play along, effectively ending the OPEC+ collaboration, but he decided to drastically increase production in a struggle for global market share as well as a decisive move to permanently cripple US shale production.

• As far as the US energy sector is concerned, the only thing worse than having Putin wage an all-out war on it is KSA joining by engaging in a maximum pain strategy and increasing output by 1Mbpd in a bid to try and bring Russia back to the negotiating table. Markets have recently turned slightly more optimistic on crude following rumors that Trump may try to mediate the Russia-KSA spat along with the Texas oil regulator looking at cutting production for the first time in decades. Indeed, the main oil ETF had the largest amount of inflows in its history last week, which will serve to put a solid long-term bottom in oil prices at about $20 per barrel and there is a fair chance these lows will be retested.

• However, it would be unwise to bet on a reality where Putin doesn’t achieve a decisive victory. Whether that comes with face-saving or not is unimportant, but the reality is that with $500+ billion in reserves, a depreciating currency, and a much lower fiscal breakeven than Saudi Arabia’s, this tussle is Russia’s to lose. In the meantime, KSA’s strong peg to the US dollar, which has already come under pressure, will serve as a deflationary trap at a time when what was originally the Covid-19 supply shock is quickly turning into a demand one. MbS’s prospects of staying in power much longer look grim if he doesn’t cry uncle soon…

• Looking out to the longer-term, High Yield OAS for the Energy sector has skyrocketed to around 2,000 bps. If Permian oil rigs had already been declining fast before this, they are now headed towards a cliff as most shale producers will not be able to finance new wells at these rates. The narrative that oil is soon to be replaced by clean energy also looks set to be tested as investment in additional output had been declining pre Covid-19. Crude prices have plenty of room to run on a secular basis.

Portfolio Strategy

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Economy

• There is a fair chance that US Inflation will become a concern this year given that the US Economy is operating above potential, wage growth has been strong with labor markets tightening and the Fed is likely to maintain easy monetary policy if not cut rates further
• US Employment continues to be strong as the simple unemployment based SAHM Recession Indicator is at a low 0.03 (a reading of 0.5 or above implies a Recession is expected)
• US Consumption continues to be strong as well:

  • Real Earning Power is at 15-year highs
  • Consumption Growth has been between 2-3% year-over-year since 2016
  • Personal Savings Rate is at multi-year highs
  • Financial Obligations as a percentage of Disposable Income remains very low
• The US is also currently undergoing a strong Housing boom, though the possibility of a choke collar (i.e. prices rising so much that low interest rates become less important in making homes affordable) putting a halt to it is become more likely
• All in all, while there is a Manufacturing Recession in the US, there is clearly scarce evidence of it spreading to other sectors of the economy. This makes sense given that Manufacturing is only roughly 10% of the Economy while consumption is around 70%
  
  
• US, Eurozone and China Citi Economic Surprise indices continue their rebound, but Business Confidence will remain a challenge
• Germany Manufacturing recovering as EU Economic Activity rebounds as the ECB downgraded inflation forecasts giving it the scape goat to continue easy monetary policy while inciting governments to loosen fiscal policy
• Japan manufacturing shows a modest improvement while services show a sharp improvement. However, the leading index continues to deteriorate
• Australia manufacturing and services PMIs continue to deteriorate, but new orders improved
• China Consumption is vulnerable to a Coronavirus shock though easy monetary policy in EM (including China) is set to boost the Economy
• Dry Bulk Shipping costs are at their lowest since 2016
• Evidence suggests that the Economy is undergoing a passing Slowdown and that Recession is unlikely; Corporate Bond Yields just hitting all-time lows is an extremely bullish sign into 2H2020
• Economic booms typically end with too tight Monetary Policy, or with Credit problems. We are nowhere close to either of these situations

Markets

• Coronavirus will likely shakeout bulls. Ahead of the dip in markets risk parity funds carried 65% US Equity exposure. Moreover, there were aggressive longs with a 1.0 Z-score
• It is difficult to envision a recovery in the bull market without China participating given how important its Economy has become to the rest of the world, though money managers rushing for the exits is bound to create solid opportunities
• Jay Powell will likely not have the courage to hike interest rates in 2020, in fact, should the Coronavirus pandemic continue to roil markets, given the US Yield Curve inversion, he may be force to 1 or 2 rate cuts of 25 basis point each. The fear of a significant and extended global health emergency, easy monetary policy looks set to remain for even longer than originally planned
• However, by keeping monetary policy so loose the Fed runs multiple risks involving potential bubbles due to misallocation of resources. Deflation worries seem misplaced as innovation-led deflation has shown no evidence of leading to postponed consumption
• UK is set to do well post Brexit as money managers close their underweights/shorts and reposition and low expectations are dashed
• Base Case: markets will be dominated by low cost of capital, economic growth will be at or below potential, and there will be heightened geopolitical concerns, though there is a fair chance they won’t matter much
• On the other hand, the more likely factors to trigger a bear market are:

  • Election of an anti-capitalist (e.g. Sanders, Warren; the hedge would be to short US Equities and USD)
  • Unexpected surge in Inflation that will force the Fed to tighten monetary policy
  • Credit event; there are many “bad apples” that were able to over-lever at low cost
  • Bubble collapses on itself because valuations have become ludicrously high, though this is not likely to happen in the near/medium-term
• Overall, it is difficult to not be bullish risk assets when the Economy is strong and there is so much Monetary Stimulus coming from Central Banks around the world, but the current US administration makes it difficult to be too bullish given the harmful policies it seems willing to adopt. The election this year should offer some (temporary) relief on that front

Fixed Income and Currency

• US Yields (10Y) will likely remain rangebound between 1.50% and 2.00% as the upside will be capped by inflows from Europe and Japan
• Nonetheless, DM fixed income remains expensive as bond ETFs approach a grand total $1.2 trillion in AUM
• US Yield Curve is likely to steepen as the Global Economy continues to improve
• FX Vol has remained subdued since 4Q2018 as GBP traders turn upbeat

Equity

• Ahead of the correction due to the Coronavirus, US Equities were trading above bull channels with institutional cash near lows, though on strong breadth
• However, there are unrealistic earnings growth expectations for US Equities:

  • -2%, 4Q2019
  • 5%, 1Q2020
  • 7%, 2Q2020
  • 10%, 3Q2020
  • 15%, 4Q2020
• Hedge funds are currently underexposed to Value and Small Caps; Tech is overbought vs Financials
• Share buybacks, which have helped buoy US Equities, are now fading
• European companies face materially higher cost of equity financing vs debt financing – bullish equities as leverage increases
• Japan Equities entering the buyback game, set to be a key consideration in asset allocation
• With Defensive assets extremely expensive, EM is more likely to lead Global rebound
• EM ex-Tech has maintained resilient earnings with improving momentum

Commodities

• Slump in Crude will lead to underinvestment compounded by imposed capital discipline
• Shale well productivity is declining as Permian Shale production seems to be peaking. At the same time, OPEC is running low on spare capacity
• Natural Gas net short positioning is at extremes, reaching all-time lows
• As New Energy Vehicles (NEVs) gain traction as well as electrification overall, storage capacity will gain importance creating a backdrop that is bullish Lithium

Portfolio Strategy

• Various opportunities are apparent in markets:

  • Value vs Growth Equities
  • US and European Financials
  • Non-US Equities
  • US Small and Mid-Caps
  • EM Equities, especially EM Asia
  • Crude Oil and Copper
  • Natural Gas on a tactical exposure basis
• On the other hand, there are also plenty of crowded trades:

  • DM Gov’t Bonds
  • High Yield
  • Bond substitutes such as Utilities Stocks, REITs, etc
  • FAANG Stocks
• Asia Tech Stocks, especially those exposed to DRAM production are attractive with the Capex cycle turning, and Sony and Microsoft launching next-gen videogame consoles late 2020

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