• Since the market lows of March world governments and central banks pulled together and successfully avoided having a health and economic crisis also become a financial crisis by pumping nearly $10 trillion in liquidity. Much to the disbelief of most market participants, equities have staged a steady recovery with the S&P 500 returning nearly 13% in April followed by a 4.5% return in May. The reality is that while most were too busy gawking at how much worse things could get, the massive injection of liquidity into markets was busy utterly overwhelming economic and financial fundamentals, with the Fed clearly leading the way.
  
  

• Between the Fed’s intervention and extremely loose fiscal policy enacted via more generous unemployment protection and stimulus checks deposited direction into Americans’ bank accounts, financial conditions promptly recovered. Surely enough, the combination of underemployment, lockdowns, spare cash and the Internet 2.0, beckoned Millennials to download the Robinhood apps and participate in financial markets. Indeed, the S&P 500’s nearly 20% run up from the March lows has been mostly enjoyed by retail investors, with institutions largely staying on the sidelines, in what has become the latest humbling of the market consensus. Notably, the lion’s share of the returns accrued to tech names as well as other brands with which Millennials are most familiar.
  
  

• As of now, institutional investors remain largely underinvested, but with the S&P 500 now back above its 200-day moving average and the VIX curve back in contango, they are likely, along with trend-following quant funds, to be pushed back into long positions. Between the possibility of a second pandemic wave and a precarious political situation from the US to China, there is plenty that can upset the apple cart, but given multi-year high spec shorts in equities, a low volatility melt-up remains the more likely scenario.

• Indeed, the desire for a return to normalcy is palpable and sure enough the economy has been slowly recovering, with air travel, restaurant reservation and hotel occupancy showing signs of modest improvement. Amid a mandate for construction to be labeled an essential service, housing has been a remarkably strong performing sector of the economy. However, and perhaps more notably, in yet another example of unforeseen circumstances, gasoline consumption has strongly recovered and driving rates are now above pre-pandemic levels as most people remain apprehensive of using mass transit and opt to use private transportation.

• Sure enough this, along with relentless shale capacity destruction has pushed crude oil prices back to the mid 30’s on convincing price action. While the rate of decline in shale oil rigs has eased, the full impact will take a while to feed back into oil prices, but bar another large-scale shutdown, we are unlikely to see extreme oil price volatility in the coming months.

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• 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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