In my last post (see 2020 bounce = 1987, or 1929), I had been searching for a template for the current bear market. I had suggested in the past that the roots of this bear has thematic similarities to 2008 (see A Lehman Crisis of a different sort). Today, health authorities are urging the use of social distancing to mitigate COVID-19, while financial institutions practiced similar social distancing at the time of the Lehman Crisis, which ended by seizing up the global financial system.

As the growth of COVID-19 cases continues outside of China, one other template comes to mind. 9/11.
 

 

The 9/11 analogy

As most of Europe and America go into lockdown to start the week, a review of The Transcript, which is a compilation of earnings calls, brought to mind a 9/11 analogy for the current situation.

COVID-19 is now a global pandemic with Europe as the epicenter
“We have therefore made the assessment that COVID-19 can be characterized as a pandemic. Pandemic is not a word to use lightly or carelessly…Europe has now become the epicenter of the pandemic with more reported cases and deaths than the rest of the world combined apart from China” – WHO Director-General Tedros Adhanom Ghebreyesus

Daily life has come to a halt in many places
“Daily life has come to a halt, it certainly appears if you are a human being on this planet.” – Korn Ferry (KFY) CEO Gary Burnison

This is a fear-based event more akin to 9/11 than 2009
“I think this event is very similar to 9/11 in terms of the psychology of what’s driving it. It’s a fear based event” – JetBlue Airways (JBLU) CEO Robin Hayes

“This is a fear event, probably more akin to what we saw at 9/11 than necessarily what we saw in 2009. I think you’re seeing a suspension of activities, whether it be corporate activities, group activities, events where people get together in large numbers, all of which impact our demand set. So, I think it’s really premature to try to be drawing too many corollaries.” – Delta Air Lines (DAL) CEO Ed Bastian

“We are in a situation which is exceptional in every respect…more exceptional than at the time of the banking crisis, I would say.” – The German Chancellor Angela Merkel

with significant demand deterioration for airlines worse than after 9/11
“when I look at how the demand has deteriorated last couple of weeks, it appears to be worse than what we saw after 9/11.” – JetBlue Airways (JBLU) CEO Robin Hayes

What caught my eye was the comment, “This is a fear-based event more akin to 9/11 than 2009”. Indeed, Open Table restaurant bookings are down -36% year over year globally, -36% in the US, -40% in Canada, -61% in New York, and -49% in Toronto.
 

 

Bloomberg also reported that most airlines could be bankrupt by the end of May.
 

Limitations to the 9/11 analogy

However, there are limits to the 9/11 analogy. The post-9/11 sell-off occurred in the middle of a bear market and recession. The latest COVID-19 shock is the spark for a new recession. The market bounced as fear subsided, but didn’t bottom until about a year later with a double bottom in July and October 2002.
 

 

Today, Wall Street is just coming to to grips with a sudden slowdown which is only just starting, and analysts are scrambling to estimate its magnitude, but the situation is so fluid that any estimates are virtually worthless by the time they are published.

Joe Wiesenthal at Bloomberg made a sensible comment this morning about the fears gripping the market: Physical social distancing is creating financial difficulties for households and the corporate sector, which is worrisome for financial solvency [emphasis added]

The House passed a bill on Friday night to provide relief to some people who are affected by the virus, but it’s far short of the fiscal bazooka that several economists believe we urgently need. What’s weird about this situation is that we need massive fiscal help from DC, but we don’t exactly need stimulus, per se. Stimulus typically implies an attempt to get the economy moving positively again. But that’s not exactly what we want right now, because in the ideal scenario everyone could just wait this thing out by spending a month or two in their homes eating canned goods, watching Netflix and facetiming. Then when the virus is mostly gone, go out and have a bacchanal for the ages in the warmer weather. The problem, as Larry Summers eloquently put it, is that “economic time has been stopped, but financial time has not been stopped.” In other words, if we all cocoon for two months, we might physically survive, and the infrastructure of the modern world would be waiting for us upon our re-emergence, but in the meantime the bills pile up. The rent’s due. The mortgage is due. Or the landlord’s mortgage is due. The credit card bill is due. Taxes are due. For a business, paychecks must go out. Suppliers must be paid. Sp we don’t need economic stimulus right now. We don’t need people out shopping or building new infrastructure or building new homes. Every one of those things involves people congregating and risks spreading the virus. What we need is cash to keep people from going bankrupt or evicted. Cash to keep the lights on. Cash to keep people employed; to keep their healthcare. Cash to buy basic necessities, like food and medicine. So let’s not think in terms of reviving growth for now. Let’s think in terms of cash, so that for as long as we’re in deep freeze, people can stay alive and continue to meet their financial obligations.

Former Bush era CEA chair Greg Mankiw recently made the following sensible policy prescriptions:

• A recession is likely and perhaps optimal (not in the sense of desirable but in the sense of the best we can do under the circumstances).
• Mitigating the health crisis is the first priority. Give Dr. Fauci anything he asks for.
• Fiscal policymakers should focus not on aggregate demand but on social insurance. Financial planners tell people to have six months of living expenses in an emergency fund. Sadly, many people do not. Considering the difficulty of identifying the truly needy and the problems inherent in trying to do so, sending every American a $1000 check asap would be a good start. A payroll tax cut makes little sense in this circumstance, because it does nothing for those who can’t work.
• There are times to worry about the growing government debt. This is not one of them.
• Externalities abound. Helping people over their current economic difficulties may keep more people at home, reducing the spread of the virus. In other words, there are efficiency as well as equity arguments for social insurance.
• Monetary policy should focus on maintaining liquidity. The Fed’s role in setting interest rates is less important than its role as the lender of last resort. If the Fed thinks that its hands are excessively tied in this regard by Dodd-Frank rules, Congress should untie them quickly.

The analysis from Wiesenthal and Mankiw leads to the idea that the economy has suffered a sudden shock, and recovery will take some time. Wall Street analysts have not fully modeled or even had the time to estimate the full impact of the COVID-19 pandemic. It will therefore take time for the market to adjust to new expectations. This leads to the following market scenario:

• The market will bounce as fear fades (but don’t ask me when the bounce occurs).
• Watch for a rally and a test of the old lows several months in the future as the realization that the global economy is slowing, and the magnitude of the slowdown.

I am reiterating my downside estimate for the S&P 500 of 1600-2160 (see My recession call explained), which is based on applying a range of 10x to 13.3x P/E multiple to a forward 12-month EPS discounted by -10%.

 

In the past week, I have had several discussions with investors about my recession call (see OK, I’m calling it). Since the publication of that note, Bloomberg Economics’ US recession probability estimate spiked recently up to 55%.

The odds of a 2020 recession at betting sites are even higher.

To reiterate, I would like to clarify the reasoning behind my recession call, which is based on a triple threat:

• The emergence of COVID-19 in China has created a supply shock that disrupted supply chains all over the world.
• The Saudi-Russia oil price war, which has devastated the oil patch in the US.
• The COVID-19 pandemic, which is expected to result in both a supply shock and demand shock in the US.

China’s supply chain shock

I covered most of the effects of the COVID-19 epidemic in China in a previous publication (see Don’t count on a V-shaped recovery), so I will not repeat myself. The Chinese leadership was faced with a painful trade-off between the health of their population, and economic growth. Once the bureaucracy got over the denial phase of the epidemic, Beijing chose to focus on the health of their people with a containment strategy of quarantine, mass-testing and contact tracing. These measures effectively shut down their own economy for Q1, and likely part of Q2. Once the infection rate stabilized, they pivoted to economic growth as a priority.

Nevertheless, the slowdown created supply chain bottlenecks all over the world, and threatened the global growth outlook. Axios reported that the coronavirus disrupted supply chains for nearly 75% of US companies. Bloomberg reported that the effects of the slowdown is worldwide:

U.S. seaports could see slowdowns of as much as 20% continue into March and much of April, according to the American Association of Port Authorities. The same trend is seen in more distant places, with Rotterdam — Europe’s economic gateway to Asia and beyond — seeing a similar cut of about 20%.

China is recovering from the virus. Even if you are dubious about China’s official statistics, consider this NY Times interview with Dr. Bruce Aylward, who led World Health Organization (WHO) team that visited China and found no apparent evidence of fudged numbers.

During a two-week visit in early February, Dr. Aylward saw how China rapidly suppressed the coronavirus outbreak that had engulfed Wuhan, and was threatening the rest of the country.

New cases in China have dropped to about 200 a day, from more than 3,000 in early February. The numbers may rise again as China’s economy begins to revive. But for now, far more new cases are appearing elsewhere in the world.

China’s counterattack can be replicated, Dr. Aylward said, but it will require speed, money, imagination and political courage.

Indirect market and anecdotal evidence does show that the worse of China’s downturn is over. Hong Kong has the epidemic well under control. Neighboring Macau announced last week that they were discharging their last COVID-19 patient.

The Baltic Dry Index, which measures shipping costs, is recovering after a deep slide.

As well, Bloomberg reported that American exports of chicken is starting to return to normal:

U.S. chicken exports to China are flowing freely again as logistical bottlenecks caused by a deadly virus dissipate and the Asian nation issues tariff waivers to buyers, according to Sanderson Farms Inc.

The U.S.’s third-largest chicken producer has shipped 522 loads to China of mostly dark meat and paws, Chief Executive Officer Joe Sanderson Jr. said in a presentation Wednesday.

That’s up from 420 at the end of February, when the company reported earnings for the first quarter
.
The coronavirus outbreak, which has claimed more than 4,000 lives globally, disrupted transport operations in China and left thousands of meat containers piling up at ports. While retaliatory tariffs were until recently a hurdle for U.S. shipments, China is now giving duty waivers to buyers, Sanderson said.

China is returning to work, albeit slowly.

The Saudi-Russia oil price war

If the Chinese COVID-19 epidemic wasn’t enough, the global economy was unexpectedly hit with a oil price war when Russia could not come to terms with OPEC on oil price cuts in the face of falling global demand. Saudi Arabia responded by not only pumping at capacity, but selling above their production capacity with sales of their reserves.

This sparked a different sort of supply shock. The market saw the effects of an oil shock in late 2014 when the price skidded from over $100 to about $40 in short order. The US economy experienced a shallow industrial recession, which was especially evident in the oil patch. Earnings estimates fell, and stock prices weakened in the latter half of 2015.

Forward 12-month consensus EPS estimates have been flat, and they have just begun to decline as a result of the Chinese supply chain disruption, indicating negative fundamental momentum. What will happen once the full effects of the oil price shock work their way through earnings expectations?

Can America flatten the curve?

Even worse, COVID-19 has landed upon American soil and it is expanding its beachheads and spreading all over the country. Since there is no cure or working vaccine, health authorities use two types of strategies to combat the virus in order to “flatten the curve”, containment and mitigation. As shown by the stylized diagram, the infection can either run rampant in an uncontrolled fashion (yellow curve) or in a slower way (violet curve). Each country has a limit on healthcare resources, and an uncontrolled epidemic will quickly reach and overwhelm care capacity, in hospital beds, healthcare providers, and so on. Strategies to slow down the outbreak buy time so that care capacity does not become constrained.

Anecdotes from northern Italy, which has a first-rate healthcare system, indicate a society that is in a desperate fight against COVID-19, as reported by Bloomberg:

More than 80% of the region’s 1,123 acute care beds are dedicated to coronavirus, after many other patients have been moved elsewhere and 223 extra places have been opened to cope with the emergency. About half of those are occupied, Gallera said.

Newspapers and WhatsApp groups are rife with personal accounts from doctors on the front lines of the epidemic. When new patients come in with pneumonia, a symptom of advanced coronavirus infections, doctors have little time to decide whether to assign them intensive-care beds, ventilation machines or respirators that could make the difference between life and death.

Some doctors have said that they sometimes make the call on who gets treatment based on the age of the patient. In some areas, hospitals are suspending other treatments to focus personnel on the contagion.

A doctor who asked not to be named because of potential repercussions painted a dire picture of the situation in a hospital in Milan. While the coronavirus is best known for causing severe disease in elderly patients, even some young people are affected, the doctor said, and without sufficient beds and ventilators, some can’t be treated.

The hundreds of patients needing treatment for pneumonia have swamped the supply of available specialists, the Milan doctor said. Physicians such as gastroenterologists, who normally focus on the digestive system, have been conscripted to help out with lung patients, and they’re still not enough, the doctor said.

This NY Times account of a Seattle area hospital provides a glimpse of what will probably be common scenes all over the US in the very near future:

While much of the country is just starting to see clusters of cases emerge, the hospital east of Seattle offers a window into the challenges set to cascade through the nation’s health care system, testing the resilience of workers, the readiness of institutions and the flexibility of supply chains.

The past few weeks have seen medical workers operating at the very edges of their capabilities, facing a virus so virulent that some patients were dying within hours of coming down with their first symptoms.

Caregivers who had been sent home into quarantine had to be called back to work to face the overwhelming task at hand. Engineers spent late nights scrambling to overhaul rooms so that contaminated air could not escape. Sanitation and janitorial crews struggled to swab down rooms where even a trace of the virus could infect the next patient. Supplies were so strained that nurses turned to menstrual pads to buttress the padding in their helmets.

If an outbreak is caught in its initial stages, health care authorities can utilize the containment, or quarantine, strategy to prevent the virus from spreading to other patients. This approach can be useful if patients from infected regions, e.g. China, can be identified and isolated. Once the infection spreads into the community, a combination of isolation and mitigation strategies have to be employed. Mitigation include personal hygiene practices such as frequent hand washing, and wearing a mask in order not to infect others. Social distancing is another mitigation technique, which includes closing down public events where crowds gather, such as schools, arts and sports events, and any other large gatherings. The downside of social isolation strategies is an economic shock that significantly reduces the demand for goods and services.

China has been relatively successful with draconian isolation and mitigation strategies, and so did Singapore. South Korea managed to contain its outbreak with a combination of mass testing to identify patients so that they could be isolated, and social distancing strategies that made most of the country virtual ghost towns. For some perspective, read this American ex-pat’s account of living in Seoul in the Dallas Morning News, which she described as “living in end-times”.

One way of measures the success of COVID-19 countermeasures is the time it takes for confirmed cases to double, as shown at Our World in Data. Outperforming countries include China (doubled in the last 32 days), South Korea (12), and Singapore (15). By contrast, the same metric for Italy is 4, Iran is 6, France 3, and the US is 3, which is probably affected by an under-counting of cases due to a shortage of testing capacity.

While the American healthcare system is generally thought of as first rate, access is uneven. In particular, many rural counties lack primary care doctors, or even hospitals. Notwithstanding the problems of insurance coverage, and lack of sick days, which can be an obstacle to a patient seeking care, the lack of proper facilities in these under-served rural areas highlight a key US vulnerability.

The policy response

In the face of this triple threat, what can American policy makers do?

Former New York Fed President Bill Dudley laid out what the Fed can do under these circumstances in a Bloomberg op-ed. Dudley believes that lower rates is a no-brainer.

At this point, more short-term rate cuts seem certain. After all, the outlook has deteriorated since the Fed’s 50 basis point cut on March 3. Moreover, historical experience indicates that rate cuts between Federal Open Market Committee meetings have typically been followed by rate cuts at the subsequent FOMC meeting. Finally, the language accompanying the last rate cut — that the FOMC would “act as appropriate” — also has been a reliable predictor of future rate adjustments. Thus, it would be very surprising if the FOMC didn’t cut its federal funds rate target by 50 basis points, or possibly more, at next week’s meeting.

QE would be the next tool once rates have reached the zero lower bound.

The decision to use the monetary policy tools such as forward guidance and quantitative easing will be straightforward. If the Fed has pushed short-term rates to zero and the economic outlook suggests the need for greater monetary stimulus, these tools will be used. They are now part of the Fed’s standard tool kit.

Like other central bankers, Dudley called for fiscal policy support in addition to monetary policy. Monetary policy is of limited utility under the current conditions.

The stresses that emerge as a result of the coronavirus are likely to be very different from those that occurred during the financial crisis. This time we are likely to see considerable stress on small businesses that encounter cash-flow problems and on households, especially if unemployment spikes.

These types of problems probably are better addressed through fiscal policy than monetary policy. Payroll tax cuts, sick-leave pay, extended unemployment benefits, and block grants to state and local governments to forestall layoffs should all be considered.

Governments face policy trade-offs between the health of their population and economic growth, but much of the US focus has been on growth (Wall Street) over public health policy (Main Street). A coronavirus bill is working its way through Congress. as the Democrats and Republicans bargain over its many provisions. A WaPo article outlined the policy choices that lawmakers face:

The first is spending aimed directly at stopping the spread of the virus: buying masks, producing a vaccine, paying for testing and so on. Everyone, Republicans and Democrats, agrees that’s necessary.

The second set of actions is focused on the people most directly affected by the economic fallout. Some of that can be done by extending existing programs such as unemployment insurance and food stamps and paying for sick leave, but it can also include simply giving people money.

Up until Friday’s dramatic declaration of a national emergency, it appeared that the Trump administration was prioritizing economic growth (Wall Street) over public health (Main Street). It remains to be seen how quickly the federal government can make the Main Street pivot.

What’s next for Main Street?

How bad can things get for Main Street? As a reminder, I previously highlighted the results of a CBO pandemic study (see A Lehman Crisis of a different sort).

The Congressional Budget Office conducted a study in 2005-06 that modeled the effects of a 1918-like Spanish Flu outbreak on the economy. The CBO assumed that 90 million people in the U.S. would become sick, and 2 million would die. Those assumptions are not out of line with current conditions. The population of the US is about 330 million, so an infection rate of 27% (90 million infected) and a fatality rate of 2% (1.8 million dead) are reasonable assumptions.

The CBO study concluded that a pandemic of this magnitude “could produce a short-run impact on the worldwide economy similar in depth and duration to that of an average postwar recession in the United States.” A severe pandemic could reduce GDP by about 4.5%, followed by a V-shaped rebound. Demand shocks would also be evident, with an 80% decline in the arts and entertainment industries and a 67% decline in transportation. Retail and manufacturing would drop 10%.

In all likelihood, somewhere between one-third and two-thirds of the population will be exposed to the coronavirus. Using the Chinese experience as a guide, 81% of the cases will be mild, 14% severe, 5% critical, and 2.5% will die. As it is set up, the healthcare system will be overwhelmed.

Add to that the recent hit to the US energy sector, which became a net exporter as fracking techniques took hold in the oil patch. We saw in 2014-15 that plunging oil could cause further weakness in business investment. In addition, China’s decision to shut down its economy to battle the COVID-19 pandemic has caused supply chain disruptions that rippled throughout the global economy. It is difficult to see how the US can avoid a recession under these conditions.

Investors should brace for an equity bear market. Ryan Detrick of LPL Financial pointed out while not all bear mean recession, bear markets that accompany recessions tended to last longer and the drawdowns are more severe.

Please stay tuned tomorrow for our tactical trading commentary.

Remember the Lehman Crisis? The failure of Lehman Brothers marked the start of the Great Financial Crisis that destabilized and almost brought down the global financial system.

What we are seeing is a Lehman Crisis of a different sort. The Lehman Crisis of 2008 was characterized by financial institutions unwilling to lend to each other and banking system liquidity seized up.

Today’s version of the Lehman Crisis is characterized by countries and regions in lockdowns, and the propensity of individuals or groups to increase their social distance, either owing to quarantine, or by fear. This is leading to both supply and demand shocks. It is a supply shock because production and transportation are seizing up, which is leading to a collapse in global trade. Even before the onset of the COVID-19 outbreak, global trade had been weak. It is about to become even weaker.
 

 

It is also a demand shock because when social distance rises, it leads to a collapse in the demand for goods and services. As an example, France’s Finance Minister Bruno Le Maire told CNBC at the G-20 meeting that tourism had fallen 30-40%.
 

The outbreak is not “contained”

The latest update from Johns Hopkins shows that the spread of the COVID-19 virus is growing steadily outside China. Infectious clusters in South Korea, Japan, Italy, and Iran show that the strategy of containment has not been very effective. Much of northern Italy is in lockdown.
 

 

The New York Times reported that CDC officials are warning Americans to prepare for an outbreak:

Federal health officials starkly warned on Tuesday that the new coronavirus will almost certainly spread in the United States, and that hospitals, businesses and schools should begin making preparations.

“It’s not so much of a question of if this will happen anymore but rather more of a question of exactly when this will happen,” Dr. Nancy Messonnier, director of the National Center for Immunization and Respiratory Diseases, said in a news briefing.

She said that cities and towns should plan for “social distancing measures,” like dividing school classes into smaller groups of students or closing schools altogether. Meetings and conferences may have to be canceled, she said. Businesses should arrange for employees to work from home.

“We are asking the American public to work with us to prepare, in the expectation that this could be bad,” Dr. Messonnier said.

The American healthcare system does not appear to be very prepared for an outbreak. To start, virus testing capability is limited. Initially, tests to identify infected patients had to be sent to the CDC lab in Atlanta. The CDC has now sent out test kits to state and local authorities in all 50 states, but at the time of this writing, only three states, California, Illinois, and Nebraska, can actually conduct the tests. The New York Times reported that a California coronavirus patient had to wait days to be tested because of the CDC’s strict screening criteria for conducting tests. If you can’t look for an infection or you are unwilling to look, how will you even find it?

While the CDC has conducted hundreds of tests for the coronavirus, South Korea has tested tens of thousands to identify possible victims.

In addition, Axios reported that much of the supply chain of pharmaceutical drug production is locked up in China. While not all of the pharmaceutical plants are in China, much of the precursor materials are principally sourced from China, and a prolonged Chinese production slowdown could cause worldwide drug shortages.

About 150 prescription drugs — including antibiotics, generics and some branded drugs without alternatives — are at risk of shortage if the coronavirus outbreak in China worsens, according to two sources familiar with a list of at-risk drugs compiled by the Food and Drug Administration.\

An 2019 article by the Council on Foreign Relations made a similar point about supply chain vulnerability:

As Rosemary Gibson noted in her testimony, centralization of the global supply chain of medicines in a single country makes it vulnerable to interruption, “whether by mistake or design.” If we are dependent on China for thousands of ingredients and raw materials to make our medicine, China could use this dependence as a weapon against us. While the Department of Defense only purchases a small quantity of finished pharmaceuticals from China, about 80 percent of the active pharmaceutical ingredients (APIs) used to make drugs in the United States are said to come from China and other countries like India. For example, the chemical starting material used to make doxycycline, the recommended treatment for anthrax exposure, comes from China. When an influential Chinese economist earlier this year suggested that Beijing curb its exports of raw materials for vitamins and antibiotics as a countermeasure in the trade war with the United States, the worries surrounding our API dependence to China seemed to be vindicated. Concern about a disruption in the supply chain could explain why the tariffs on Chinese products proposed by the United States Trade Representative in May 2019, worth approximately $300 billion, excludes “pharmaceuticals, certain pharmaceutical inputs, and select medical goods.”

Indeed, the FDA issued its first notice of a drug shortage due to COVID-19 supply chain disruptions in China:

A manufacturer has alerted us to a shortage of a human drug that was recently added to the drug shortages list. The manufacturer just notified us that this shortage is related to a site affected by coronavirus. The shortage is due to an issue with manufacturing of an active pharmaceutical ingredient used in the drug. It is important to note that there are other alternatives that can be used by patients. We are working with the manufacturer as well as other manufacturers to mitigate the shortage. We will do everything possible to mitigate the shortage.

 

Modeling the economic impact

How bad can things get for the US and global economy?

The Congressional Budget Office conducted a study in 2005-06 that modeled the effects of a 1918-like Spanish Flu outbreak on the economy. The CBO assumed that 90 million people in the U.S. would become sick, and 2 million would die. Those assumptions are not out of line with current conditions. The population of the US is about 330 million, so an infection rate of 27% (90 million infected) and a fatality rate of 2% (1.8 million dead) are reasonable assumptions.

The CBO study concluded that a pandemic of this magnitude “could produce a short-run impact on the worldwide economy similar in depth and duration to that of an average postwar recession in the United States.” A severe pandemic could reduce GDP by about 4.5%, followed by a V-shaped rebound. Demand shocks would also be evident, with an 80% decline in the arts and entertainment industries and a 67% decline in transportation. Retail and manufacturing would drop 10%.

A recent paper by Luo and Tsang at Virginia Tech entitled “How Much Output Has The Coronovirus Reduced?” studied the effects of the outbreak on China and the world. It concluded that Chinese GDP would fall by a minimum of 4%, and there would be considerable spillover effects outside China.

Using a network approach, we estimate the output loss due to the lockdown of the Hubei province triggered by the coronavirus disease (COVID-19). Based on our most conservative estimate, China suffers about 4% loss of output from labor loss, and global output drops by 1% due to the economic contraction in China. About 40% of the impact is indirect, coming from spillovers through the supply chain inside and outside China.

The researchers concluded that the direct and indirect effects of Chinese dislocation alone could amount to 1-2% of global GDP growth.
 

 

A Federal Reserve international finance discussion paper published in October 2019 entitled “Global Spillovers of a China Hard Landing” also yielded some clues on the economic impact of Lehman 2.0. Here is the abstract:

This paper analyzes the potential spillovers of acute financial stress in China, accompanied by a sharp slowdown in Chinese growth, to the rest of the world. We use three methodologies: a structural VAR, an event study, and a DSGE model. We find that severe financial stress in China would have consequential spillovers to the United States and the global economy through both real trade links and financial channels. Other EMEs, particularly commodity exporters, would be hit the hardest. The U.S. economy would be affected to a lesser degree than both EMEs and other advanced economies, and the primary channel of transmission to the U.S. could well be adverse financial spillovers through increased global risk aversion and negative equity market spillovers.

The authors’ estimates based on a Chinese 4% hit from normalized growth (blue) and 8.5% hit (red) indicate considerable damage to US GDP growth.
 

 

Effectiveness of policy response

During the Lehman Crisis, central bankers swung into action and flooded the global financial system with liquidity. In the current crisis, it is unclear whether either fiscal or monetary policy are effective to combat both a supply and demand shock. The authorities can stimulate all they want, but if people are unwilling to, or unable, either go to work, or to brave reducing social distance to spend on goods and services, fiscal and monetary stimulus cannot boost economic growth. These policies are likely to have limited effect until the supply shock begins to wear off, and people return to work.

To be sure, the monetary authorities can act to reduce risk premiums and inflate asset prices. Credit spreads have begun to edge up, and central bankers can act to put a lid on spread expansion.
 

 

However, measures of financial stress remain relatively low, and policy makers will loath to engage to excess stimulus and create another bubble.
 

 

Nevertheless, China is certainly trying the stimulus route. Xinhua reported that the Chinese leadership has turned on the fiscal taps and decreed a series of infrastructure projects to jump start the economy.

The Chinese capital has announced to push forward 300 urban projects in 2020, involving 252.3-billion yuan (around US$35.9 billion) in investment.

The projects will include 100 infrastructure projects, 100 livelihood improvement projects and 100 high-tech industrial projects, according to Beijing’s development and reform commission.

 

Investment implications

What should investors do under these circumstances? A recent Bloomberg article surveyed 10 market strategists. Their views were highly disparate. They ranged from “gold rally” and “risk aversion” to “a short sharp V” and “hello TINA”, or There Is No Alternative (to risky assets). In other words, no one knows anything.

I have experienced a series of market crises during our tenure as a quantitative bottom-up equity manager. While our quantitative factor sets were well diversified across growth, value, momentum and other dimensions, we learned to turn off all of the quantitative factors when faced with a sudden crisis, such as the Russia default or 9/11. As details of the shock became known, the following classes of factors began to add value, in the following order:

1. Technical Analysis Factors: The market’s price signals were the fastest to respond.
2. Estimate Revision and Earnings Surprise: When the crisis hits, company analysts will not revise their estimates because they cannot quantify the impact. First, top-down strategists begin to revise their estimates, then the bottom-up company analysts. We saw one such example when the U.S. stock market rallied on Trump’s tax cuts.
3. Fundamental Factors: As the environment normalizes, fundamental factors such as growth and value begin to add value once again.

Today, the market is only in the first phase, where technical factors are in ascendance. Here is what the market technical outlook is telling us.

The intermediate term outlook is uncertain. The monthly S&P 500 chart printed a doji candle in January, indicating indecision and a possible turning point. The turn was confirmed by a bearish red candle in February. Such patterns have been followed be at least 1-2 months of either sideways or bearish price action.
 

 

In addition, my “Ultimate Intermediate Bottom Spotting Model” has not turned bullish yet. This model flashes a buy signal based on two conditions; when the NYSE McClellan Summation Index (NYSI) turns negative, indicating intermediate bearish momentum, and the Zweig Breadth Thrust Indicator becomes oversold, which is a short-term oversold indicator. We are not there yet.
 

 

In the short run, the market may be setting up for a short-term bounce and all indicators are in maximum oversold territory. The oversold signal flashed by the Zweig Breadth Thrust Indicator has usually been resolved with a relief rally.

As measured by the 5 and 14 day RSI, the market is as oversold as it was at the Christmas Eve bottom of 2018, as more oversold than the VIXmageddon bottom of early 2018. A similar oversold condition occurred in October 2018, which was followed by an interim relief rally.
 

 

Non-US markets are also acting in a constructive manner. I had suggested in the past that investors might be better served to buy commodities and EM equities while avoiding US stocks (see The guerrilla war against the PBOC). It was a contrarian call because of the high sensitivity of commodities and EM to a possible Chinese downturn. Both commodity and EM markets have begun to stabilize and exhibit positive relative strength, indicating a possible turn in market psychology. The worst may be over.
 

 

To be sure, a deeper examination of EM market strength shows that most of it comes from China and India. EMEA and Latin American markets are still lagging. However, EM leadership cannot be dismissed as purely a China and India effect, as frontier markets are also turning up in relative strength.
 

 

There are other signs that the world is edging back to normalcy. The Baltic Dry Index, which measures shipping costs, is showing signs of bottoming after a catastrophic decline. The worst of the global supply shock may be over.
 

 

Finally, copper prices are stabilizing and have not breached their early February lows. Copper is a cyclically sensitive metal that it has been dubbed “Dr. Copper” by traders because it is said to have a Ph.D. in economics.
 

 

A long bottoming process

This bottoming process is just beginning, and it is likely a long process. Nick Maggiulli at Of Dollars and Data compiled the past market reaction after drops of over 6% over two days. On average, the stock market was but volatile for the next 100 trading days before rising again.
 

 

The option market is also signaling a prolonged resolution to this COVID-19 induced Lehman Crisis. The term structure of the VIX Index has inverted, which is not a surprise during these periods of fear. A recent article by Luke Kawa at Bloomberg pointed out what is unusual is the inversion is extending out past the front month:

And what makes this inversion scarier than normal is what’s happening just a bit further out on the curve. Typically, when the front of the VIX curve inverts, the rest stays relatively flat. It’s an acknowledgment that the market tumult is expected to be a relatively short-lived affair.

Not so this time. The April VIX future has closed as much as 1.3 points above May’s during this pullback, the biggest such backwardation between the second and third-month contracts since the idiosyncratic volatility blowup in February 2018. This is an indication that traders expect an environment of heightened volatility to persist for longer than your run-of-the-mill stock market correction.

This dynamic speaks to the evolution of traders’ perception of the coronavirus: what was first a contained supply shock is now morphing into a potent threat of unknown magnitude to a fragile global economy.

Even if the market were to stage a relief rally from current levels, the bearish episode is likely not over. A more typical bottoming pattern would see the markets rally, falter to retrace and retest the previous lows. There are no guarantees whether the retest would necessarily be successful.

The next shoe has yet to drop. While we have seen selected profit warnings from corporate management, such as MasterCard and United Airlines, estimate revisions so far are still positive. As well, the negative Q1 guidance rate is roughly in line with the historical average.
 

 

Historically, analysts have been overly optimistic in forming EPS estimates, and they tend to revise them downwards as the date of the earnings report approaches. The current experience indicates that Street estimate revisions are not especially negative compared to history, indicating that Wall Street has not fully factored in the effects of the coronavirus yet.
 

 

We need to see EPS estimates start to fall, followed by a period of stabilization before the fundamentally driven institutional investors feel more comfortable in taking more risk. Current survey data indicates that institutions are in a crowded long in equities, and they are just beginning to de-risk.

In conclusion, the global economy is undergoing a period of stress that will take some time to resolve. Asset prices are likely to be highly volatile for the next few months until the full extent of the uncertainty is resolved. In the short run, the stock market is extremely oversold and washed out. A relief rally and climatic reversal can happen at any time. However, I expect that any rally would be followed by re-tests of the old lows, which may not necessarily be successful.

Investment oriented accounts should be minimizing risk and aim for asset allocations with below average equity risk. I reiterate my call to overweight emerging market equities and commodities because the market has already embedded low expectations for their outlook, and underweight US equities because of their valuation risk.

Remember to tune in tomorrow for the trading analysis.