Unquantifiable Uncertainty

Risk assets finally awoke from their complacent stupor, as the geographical spread of the Coronavirus (COVID-19) became apparent. The unquantifiable nature of the threat to public health and to the global economy that was made clear from health organisations and other quarters was initially ignored in favour of V shaped recovery predictions with no statistical validity, given the huge dispersion of possible outcomes; but eventually the risk was noted.

This isn’t to suggest that the outcome for the economy necessarily has to be dire, simply that it’s not yet possible to make any assertions with confidence. However the longer that supply chains are disrupted, travel restricted and businesses operate below capacity, the more the skew moves to the downside. Indeed, Chinese PMIs for February released over the weekend after the market closed showed unprecedented lows, with manufacturing at 35.7 and non-manufacturing at 29.6 both deeply in contractionary territory.

For risk assets in financial markets, the skew is also to the downside in one sense, in that a constant drip of bad news on the spread of COVID-19 or the economy can incrementally move or hold the market down, whereas to have good news from a health perspective requires a meaningful period of time. Against that, ‘good news’ is available from other quarters for markets, in particular from central banks who are widely expected to ride to the rescue once again. Whether this is a good or bad thing will be debated later. Is it filling the punchbowl again at 5am, or is it stopping the economy tipping into recession? For now markets don’t really care and just want to get their fix and central banks around the world have said they stand ready to cut rates if required. For once though these central banks were admirably slow/measured in their response, allowing nature to take its course at least for a few days first before reacting.

The above chart shows that equity markets in the US, Europe and Japan all lost 10% or more in the last week of February, wiping out all previous gains for 2020 and taking year to date returns deeply into the red. China was surprisingly resilient with more moderate losses and a flat month overall; presumably due to a mixture of the more recent concern being the spread of COVID-19 to developed economies and most likely a good measure of government support for Chinese equity markets.

Looking at the US equity market, from a sector perspective the sell-off has been fairly indiscriminate. In the last week, ignoring the outlier of energy (-15.4%), all other sectors were in a range from financials (-13.2%) to communications (-9.7%). For the year as a whole now, tech still leads (-3.6%) with energy the laggard (-24.0%).

The sharp drop in WTI oil (shown above) is fairly easy to follow, taking into account the curtailment in travel, whether through restrictions or just lack of demand. The movement in Gold has been more perplexing as gold lost 3.5% in the final week of the month, closing February at $1,585. After spiking at an intra-day high of $1,688 at the start of the last week of the month, gold lost its usual lustre in times of crisis and fell as low as $1,568 before recovering a little. Various theories are in circulation, the most popular of which is margin related de-risking, with people selling what they can, rather than what they want to. Support may return if interest rates are cut (lower real rates benefit gold as it has no yield); and the fact that most portfolios have relatively low holdings in this time of uncertainty may also lend support. For now US Treasuries seem to be the safe haven of choice (below).

US fixed income saw many new all-time lows. In the chart below, the lower green line shows the yields for different maturities as of month-end, whilst the yellow line above illustrates the yields just 1 week earlier. Whilst at first glance this chart looks quite unexciting, compared to the glacial pace at which bond yields usually change, these moves are astronomical.

US Treasury Actives Curve

The US 10 year yield ended the month at 1.15% compared to 1.47% only a week before. The 2 year yield fell even more to 0.91% from 1.36% a week before, as the front end of the curve is pressured by anticipated Fed action.

In the last week of the month the DXY dollar index lost 1.1% trimming its gains for February to 0.4%. Whilst the dollar may be in demand, rate cuts on the horizon are taking their toll. The yen, always a favoured safe haven, clawed back most of its monthly loss adding 3.3% in the final week to end at 107.89. The euro also did a round trip ending almost flat at 1.10 after gaining 1.7% in the last week.

Where to from here?

On this question, it’s probably instructive to first remember how we got here. Markets had been moving relentlessly up and were priced to perfection in a late cycle environment. As such only a fairly minor catalyst was required to knock things off course. In the event a large boulder arrived. Whilst COVID-19 is undoubtedly a serious threat to the global economy and not just a minor catalyst, at the same time the impact is exacerbated by how far things had overrun previously. As with any major sell-off price action is also exacerbated endogeonously through margin selling and other feedback loops.

Moving into March, volatility remains elevated with the VIX close to its month end close of 40.11 at the time of writing and huge intra days swings still in motion in equity markets. As the week began there was a feeling that there may be at least a brief pause in the bleeding helped by central bank action and co-ordinated action from G7 finance ministers. Futures markets are already pricing that US rates will fall 1% by February of next year, from the current effective rate of ~1.6% down to 0.6%. Most of this is expected to happen in the shorter term with rates forecast at 0.8% by August this year. Any action that actually takes place will therefore be judged against that backdrop which in theory is already priced in.

As alluded to above, whether the Fed (and other central banks) should cut rates or not is the subject of much debate. If the justification if to continue providing a drug to an addicted stock market, the argument is fairly weak as nature needs to be allowed to take its course. If it’s about trying to stop the economy tipping into recession, this is obviously a more worthwhile pursuit – although again all things must come to an end at some point. However no central bank head wants to be the one judged by those with the benefit of hindsight not to have acted when required.

It does feel though like the effects of COVID-19 may be more powerful than central banks can necessarily counteract in full. As this is a real issue affecting the real economy, more is required than just a confidence trick to assuage equity markets.

At some level, there will always be a buyer, however bad things are. But whether a 12% sell off is enough, or whether another 12% is required is an open question. Frustratingly, it may be harder to try to answer than normal, given that the base assumptions lie within the fields of epidemiology and virology, before other economic assumptions are layered on top. In the meantime the uncertainty will persist and whilst the brave (?) may start buying this dip, for as long as cities remain locked down, travel restricted and production curtailed (not to mention the eventual impact on demand), there is certainly room for further downside from here.

All data above from Bloomberg.