The spread of the virus and the fear that this brings with it continues to infect nations as well as the fragilities rendered by globalisation and heavily intertwined supply chains. This along with the mounting economic damage of preventative actions to control the spread of the COVID-19 outbreak, continues to roil investors nerves. The Feds emergency 50bps rate cut and the Biden bounce provided fleeting relief for risk assets that have otherwise struggled with the left tail outcomes of a global pandemic this week. This uncertainty is reflected in the VIX, which has remained stubbornly above 30 for the longest period since 2011. Government bond yields continue to set record lows as investors seek portfolio buffers and price recession risk along with continued monetary easing, the US 10-year yield plunging below 0.82bps and the 30-year dropping ~10bps in a matter of hours throughout Asia trade to 1.43% at the time of writing. This collapse giving gold the green light, amongst other factors as our Commodity Strategist highlights. The constant flow of COVID-19 headlines continues to drive sentiment and waves of selling across the risk asset spectrum, with equity indices swinging wildly between gains and losses and havens continually reaching fresh records as risk aversion remains elevated.
The erratic swings throughout the week have been exacerbated by the present high volatility regime. This combined with above average volumes and lower liquidity, which is highly negatively correlated with volatility, creates a self-perpetuating feedback loop and increase in systematic selling that exaggerates daily price movements.
Forecasting the ultimate outcome remains a fruitless task given the cascading unknowns as it relates to containment of COVID-19 and the economic ramifications of travel bans, shutdowns and quarantines flowing through to activity, cash flow, corporate profits and confidence. But one thing is for sure, liquidity and rate cuts wont contain the virus, presenting market participants with an unprecedented set of ambiguities as monetary policy has already been stretched to the end of it tether. Nevertheless, the cavalry is here, with the RBA, Fed, BoC all delivering rate cuts this week. But conventional monetary policy is out of ammo in the virus fight. Central banks will do what they can to support financial conditions and forestall corporate casualties, but it won’t be that easy. Once again the market is front running the Fed, the market has completely priced another 50bps cut at the March 18 meeting as the global case count rises and the inevitable hit to economic output increases. If the COVID-19 outbreak continues to spread, inflicting unbounded economic displacements the Feds hand will be forced once more in order to support financial conditions and maintain liquidity for SMEs buckling under the weight of reduced demand or supply chain dislocations. Containing credit dislocations and preventing SME cashflows from drying up whilst revenues and operating incomes are scourged will keep policymakers in the hotseat as the double whammy demand and supply shock hits economic activity. Another reason why yields continue to track lower as any incremental price increases coming from supply chain disruptions are dwarfed by a collapse in demand which dominates. Consumer confidence suffers a dual hit via the wealth effect as stock prices fall, particularly prevalent in the US where consumer confidence and the S&P 500 returns are highly correlated given household exposure to equities, but also via the virus fear factor that inhibits discretionary spending and keeps people home.
Heading into the weekend as the US continues to expand testing and the headlines keep rolling it is our view that equities remain under pressure as traders de-risk, as we saw last week. The February nonfarm payrolls data will be irrelevant in the face of the unfolding and fluid developments surrounding the COVID-19 outbreak. The number of confirmed infections is likely to rise significantly in the US, comparing the current fatality rate in the US of 7% vs. approximately 1% in other countries implies the case count in the US is currently understated due to the lack of testing. This could well be the trigger for another bout of market volatility or at least a gap lower on Monday’s open, particularly whilst sentiment remains fragile, liquidity is thin and the VIX is already elevated. Now the emergency cut from the Fed has been fired there is nothing to stop bears taking control if bad news multiplies. For markets to really recover the onus will be on reduced COVID-19 transmission rates, increased immunity and a clear containment of the outbreak, only then will the downside risks to economic activity diminish.
Risk assets are focussed on an acute hit to growth but also the risk that the hit becomes more chronic via the effects on supply chains and potential credit dislocations amongst overindebted corporates. Airlines, hotels, leisure providers and autos are the most at risk industries here.
That is why the real support markets need is lacking, as outlined above rate cuts don’t fix the impending demand and supply shock that results from a pandemic virus. Instead coordinated policy action is needed to provide emergency financial support and credit lines for businesses temporarily affected by the impacts of the virus outbreak. This is key to protecting jobs and avoiding a more broad based financial shock. The problem here is the obvious limitations in implementing these support measures in a timely and efficient manner.
The incoming governor of the Bank of England, Andrew Bailey, has appealed to the government to offer emergency financial support for British companies in the midst of the coronavirus outbreak. Warning that “We are collectively now going to have to provide some form of supply chain finance in the not too distant future.” In the US similar measures are being debated in order to maintain bank provisions for businesses that are facing cashflow strains as operating incomes and revenues dry up due to demand or supply dislocations. Because it is these individual firms that collectively raise contagion risk for banking systems the longer this economic shock persists.
Credit will be in the hotseat as the economic fallout from the virus outbreak is monitored along with the emergency monetary and fiscal responses. The secondary and tertiary ripple effects via supply chain disruptions and potential funding and financing problems is where the bulk of uncertainty lies. Likely becoming a key decider in a temporary hit to earnings vs. a recession.