Unlimited Liquidity as Policymakers Catch a Glimpse of the Abyss

March 24, 2020

During his testimony, Hotez, who himself developed a SARS vaccine that never reached human testing, went out of his way to ding companies for raising expectations. “Unfortunately, some of my colleagues in the biotech industry are making inflated claims,” he told the legislators. “There are a lot of press releases from the biotechs, and some of them I am not very happy about.” – MIT Tech Review

As the WHO declares a global health emergency and countries around the world move to quarantine China, risk assets sold off with the S&P 500 returned -2.12% for the week. […] As long as the epidemic doesn’t deteriorate going into the second half of February forcing factory closures in China and impeding international trade, the global economic and markets outlook remains bullish, especially from 2H2020 onward. – Market Update – 2 February 2020

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.

A similar approach should be taken to trying to figure out the market bottom in the S&P 500. There is a loud chorus calling for a re-test of the recent lows around 2,200 based on the empirical fact that almost every major market sell-off of more than 20% has a retest of the lows, but that looks a bit complacent and as the old saying goes, in markets “the obvious rarely happens, and the unexpected constantly occurs.”
So far the current bear market looks strikingly like the textbook model, if it weren’t for the fact that what started off as a garden variety sell-off where investors flee risk assets into safety such as gold, the euro and the yen quickly turned into the liquidity crunch kind in which the only safe asset is US dollar cash with the euro and the yen rapidly giving up the initial 5% gains from the beginning of the market turmoil.

The Textbook Sell-off Model

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.

Weighted average monetary policy rates have hit all-time lows

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.

30% crash in 1 month less impactful on sentiment than 20% in 3…

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

I will skip this section for now. Given the fluidity of markets at this point and the fact that the Covid-19 crisis is still nowhere near under control, it would be unwise to set any sort of cyclical or secular views in stone. There will be more dislocations coming and as such, what looks like an excellent opportunity today, may look like a terrible one next week.

Tags: #markets #trading #investing #SPX #ES #equity #VIX #volatility #crash #bearmarket #bullmarket #sentiment #Fed #centralbanks #liquidity #GDP #economy #China #Russia #SaudiArabia #crudeoil #wti #covid19

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