Equity Update: Liquidity and Credit in the Hotseat
Australian Market Strategist, Saxo
Summary: The spread of the virus and the fear that this brings with it continues to infect nations and permeate the cracks in globalised architectures 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 and movements across financial markets have become increasingly erratic. Cross-asset volatility has surged and correlations have lifted significantly.
Top of mind: VOLATILITY! CREDIT! Policy action - policy panic following ineffectual actions to date – expect MORE, liquidity
Now adding to anxious markets and the strains of a world teetering on the edge of a double whammy supply and demand shock, add in an oil price war and breakdown of the OPEC+ alliance. Plunging oil prices is a big risk in the midst of a period of economic frailty, the collapse in capital expenditures and employment will outweigh any consumption boost via cheaper prices for consumers and industrials, particularly as confidence and output is hammered by the COVID-19 outbreak. The ramifications of a cratering oil price will send ripples through already nervous credit markets where high yield spreads are already blowing out as the virus outbreak sees corporate operating incomes and revenues dry up due to demand or supply dislocations. Although todays focus is on the fallout across the energy sector, the eventual impact will be much larger and credit will be in the hotseat as the economic dislocations from the virus outbreak unfold, now with the added stress of an oil price shock. Funding stresses and an imploding credit cycle will only exacerbate recession risks. Although the panic will eventually subside, nobody knows what the eventual outcome will be here, but the longer it takes to contain the COVID-19 outbreak the more heightened the risks of a broad scale meltdown become.
There is considerable uncertainty, but in our central scenario the COVID-19-related shock, liquidity pressures and now oil price hit exacerbate heightened anxieties and could see the S&P 500 heading towards 2650-2700 range as a first support.
Funding Stresses in the Hotseat
The ripple effects via funding pressures and increased defaults amongst overindebted corporates is where the bulk of uncertainty lies in magnifying the fallout from the COVID-19 outbreak. Likely becoming a key decider in a temporary hit to earnings vs. a broader financial shock culminating in recession. Airlines, hotels, travel and leisure providers and autos are the most at risk industries here. But now we also face a wave of chapter 11 bankruptcies across the US shale industry for smaller unhedged players and high cost producers. The energy sector is a highly capital intense sector with many highly leveraged players already struggling prior to this collapse in oil prices driven by a simultaneous sustained oversupply and demand wipe-out due to COVID-19 containment measures.
As a result, traders have woken to carnage across Asia this morning, with S&P 500 futures limit down, Asian equity indices deep in the red, oil prices collapsing – Brent crude at one stage down more than 30%. Government bond yields continue to crater, setting record lows as investors seek out portfolio buffers, recalibrate inflation expectations lower on sharp moves down in oil, a disinflationary tidal wave, and reprice recession risk on the COVID-19 hit to growth, along with increased odds of continued monetary easing. The US 10-year yield plunging below 0.50bps and the 30-year dropping ~29bps in a matter of minutes at the open of Asia trade, falling below 1.0% for the first time in history. Australian government bonds also printing fresh record lows as investors price QE as an inevitability – “not if, but when”, the yield on the 3-year note hit an all-time low of 0.32% and the 10-year note slumped to 0.55%, another record low. This ongoing collapse in yields continuing to give gold the green light, along with real yields sustained breakdown and flight to safety. As equity markets hit fresh lows, there is the risk that gold faces short lived pressure as margin calls force investors to liquidate their gold holdings to raise cash.
Dramatic moves in haven assets not only whiff of heightened recession fears but a liquidity breakdown as panic infiltrates all corners of financial markets. The erratic swings are 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.
This breakdown in liquidity is also driving wild moves in FX markets. A rush to the safe haven yen saw a swathe of stop losses triggered and huge intraday moves in yen crosses, exacerbated by the compromised liquidity environment. Norway’s krone traded the weakest against the USD since 1985, and against the yen the Aussie fell more than 5%, bigger moves than the Jan 2019 flash crash.
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 won’t 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. Markets know this and remain sceptical that rate cuts can counteract the demand destruction and simultaneous supply chain disruptions, especially with many G10 central banks already below or nearing the zero lower bound.
Conventional monetary policy is out of ammo in the virus fight, we move onto the unconventional and perhaps (but hopefully not!) even the unconscionable if all out panic is reached. Three weeks ago, former Fed Chair Janet Yellen floated the possibility that during the next crisis, the Fed should consider buying stocks. And last week Boston President Eric Rosengren, also pondered a facility that would allow the Fed to buy stocks in order to stave off recession if needed.
Central banks will do what they can to support financial conditions, find a floor for asset prices and forestall corporate casualties, but it won’t be that easy. In the face of financial panic as the lenders of last resort and “guardians” of financial stability they will do what they can to backstop confidence, ease financial conditions and maintain liquidity. The circuit breaker - from policymakers across the globe, expect coordinated action this week.
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. At this stage a return to ZIRP with aggressive balance sheet expansion from the Fed cannot be ruled out and there is the possibility of another intra-meeting rate cut. 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.
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 so that supply and demand can bounce back once the COVID-19 shock eases. The problem here is the obvious limitations in implementing these support measures in a timely and efficient manner.
Adding to market anxieties is the lagging US response to the COVID-19 crisis. 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.
Plan for the best and prepare for the worst
Given the elevated tail risks of unknown magnitude we remain defensively positioned with a focus on capital preservation. We stick with our overweights in gold, silver and US treasuries relative to equities. Buying the dip not recommended unless its gold!
The VIX remains above 40, another reason to be wary of any bounce and a short term negative for equities. Whilst the present volatility regime remains in play, alarm bells are still sounding. With VIX significantly above long term equilibrium, the current market state is characterized by negative return expectations and high kurtosis (fat tails). Caveat emptor!
We are in for an unpredictable week with added liquidity risks. We advocate adjusting positioning down and a heavy focus on risk management as economic risks rise against a backdrop of receding liquidity heighten gap risks and sharp reversals. 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, a long way off at this stage.
Although equity markets will eventually look past the inevitable hit to earnings presenting opportunities for long term investors, we have not yet reached that point. Valuations have corrected from high levels but remain above long-term averages with a heightened degree of inaccuracy embedded in forward earnings estimates. In combination with continued downward pressure on earnings/revenues leaves room for declines in equities over the coming period if the outbreak cannot be contained and economic dislocations mount.
Tactical trading interest: CAD/JPY, Gold, USTs, HYG Puts, trading upside policy action
Our Strategy team have more on trading Coronavirus here:
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