Monetary Policy & Inflation | Rates | US
US equities just finished their worst first-quarter performance in history only to be met with the worst first-day start of a new quarter. 2020 started off with a bang as stocks melted up to new highs, but the rest of the quarter felt like an eternity with multiple days of limit-down moves amid elevated volatility. In addition, we saw high cross-market correlation eliminate places to run for shelter (other than cash). Meanwhile, central banks have been working around the clock to keep things from further coming unglued.
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US equities just finished their worst first-quarter performance in history only to be met with the worst first-day start of a new quarter. 2020 started off with a bang as stocks melted up to new highs, but the rest of the quarter felt like an eternity with multiple days of limit-down moves amid elevated volatility. In addition, we saw high cross-market correlation eliminate places to run for shelter (other than cash). Meanwhile, central banks have been working around the clock to keep things from further coming unglued.
In the economics and financial world, sometimes predicting the path for the markets can result in overlooking the sensitivities of the topic at hand. So, we should remember the aim is to overcoming crisis while minimizing the health shock and loss of life from the COVID-19 outbreak above all else. We truly cannot get back to business until this health crisis passes.
Until then, we are in uncharted territory, so forecasting in this environment is a challenge to say the least. However broadly speaking there are three outcomes that come to mind where the bad (my baseline) is more likely than the good and preferred to the sinister outcome of the ugly scenario.
Scenarios: The Good, The Bad and The Ugly
The Good: Western governments were initially much slower and less aggressive than China at enacting tough measures to try to contain this outbreak. At last, however, the majority are getting serious. This is coming in waves across the globe, but as each jurisdiction starts to flatten the curve (crucial to allow healthcare systems to provide care) there should be a period in the not-so-distant future (1-3 months, hopefully) that will see a slowdown in new cases and, more importantly, the death count as well.
The COVID-19 outbreak has shocked individuals around the world and battered companies via the lack of business activity. Luckily, governments and central banks have been much more preemptive this time and are offering unprecedented levels of stimulus as a buffer. If the economy can reboot by late summer in the northern hemisphere, given the record levels of liquidity in the system, it is possible that leads to a V-shape recovery into the 2nd half of 2020. That, coupled with any progress on a cure and vaccine, would really change the narrative for the markets. However, judging by the news and price action, this seems to be the consensus view.
The Bad: Unfortunately, as much as we hope for the good scenario and a quick bounce in the economy, more likely is a dragged-out malaise as economies re-tool and adjust to the impact of COVID-19 while dealing with too much debt. For starters, it’s unclear how quickly the outbreak will subside and how much damage it will do to the healthcare industry and those on the frontline fighting this invisible enemy. In the US, for example, it’s been a tag team of the federal and state governments. However, some states were already in bad fiscal health, and this is making matters worse. The loss of activity will probably not be fully regained either, especially if consumers and investor sentiment have been severely shocked.
The crisis is reminding everyone the value of unencumbered cashflow and, just as important, of actually having a nest egg versus just living off of debt. In addition, given how late-cycle we were coming into this crisis, and given the high debt loads (and where they will go given the bail out packages) and stretched valuations that existed prior to this move, we doubt there will be the same sort of appetite to allocate capital so quickly. At best, if we were to get a move lower in risk assets, bringing stocks into the value zone (another 20-30% lower), then perhaps stability could return. After such a move, we would expect a pop up and then a gradual rise versus a V-shape.
The Ugly: In this scenario it’s all about the boomerang effect as this virus spreads around the world causing multiple waves to hit the healthcare sector and with it repeated instances of stop-start-stop in economic activity. Leaving aside the risk of a mutation, if the pharmaceutical industry is unable to produce a vaccine fast enough, relying on herd immunity could take too long – resulting in consumers being even more cautious about going out in public and spending freely as before. As our economies are based on human interaction with the service sector, a key part of the economy, the longer this drags out the more bankruptcy will occur irrespective of the quantity of stimulus being thrown around. Then there is the possibility of countries re-thinking the benefits of globalisation. It’s bad enough we are having supply-chain disruptions, but if firms need to change how they do business real-time to regain control of key factors of production, that could further delay any sort of global economic recovery.
Meanwhile we cannot overlook how ugly it will get with the GDP figures that are being thrown around out there (forecasts that are matching levels seen only during the great depression in the 1930s). We realise we live in a fast-paced world and many are praying that this will just go away, but once faced with how bad this could get, it probably will leave an economic scar. Bottom-line we’re facing an acute depression, lets hope its not long lasting.
Market Implications
The one good piece of news is that after tremendous focus and creativity, the Fed’s easing actions are slowly starting to reduce rate volatility. With that, other markets should start to see smaller swings in our view. Looking back at the move index we notice that this spike in rates vol. was the second-largest relative to the trend coming into this crisis. We have been highly critical of central banks pre-COVID because their attempts to keep extending the business cycle led only to malinvestments and an underestimation of true market risk by suppressing vol. for so long.
Chart 1: MOVE Index Analysis: 2nd Largest Deviation From Trend in History
Source: Bloomberg, Reuters, Macro Hive
At this point we think the Fed is truly focused on market function first, and that will allow market participants to assess value as things calm down. The one benefit from such an environment is that this will allow investors to recalibrate prices to the macro outlook more so than just to the prospects of central bank largesse. Fixed income funds and ETFs are starting to see a realignment of underlying asset values and that should prevent fire sales.
Things like TIPS got oversold and bounced back but are now probably a hold for long-term investors, whereas day-traders should look to trade UST nominals instead. All of the actions of the Fed (both in terms of easing and a relaxation of regulation) favors keeping and adding to steepeners on dips. The amount of debt that is coming down the pike and investors preference to sit this out in the front-end means we should see curves remain steep. Meanwhile, once we get past this crisis we will certainly see inflation ahead.
Credit will see more 2-way risk and this time is at the mercy of the ratings downgrade cycle ahead. It’s probably best to see what happens in stocks first because credit could get pulled lower one more time in a risk-off move.
George is a twenty years fixed income markets veteran. Over that time he has covered rates, structured products and credit. He worked both on the buy-side and sell-side.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)