I hope some of you have been following my twiter feed.
If so you will get an strong indication of the issues at hand. Technical analysis is a useful tool but sometimes events over take the tech. And this is one of those situations i’m afraid.
Let me be clear here. This is the first time in 12 years we have faced such a dramatic situation. If you know me of old you know I am not a scare monger on these things but this situation is the central planners dream. Whether the virus is as bad as it seems or not the situation will be used to seize control of capital by our elites.
My base case is as follow:
The global economy was already weak. Many markets already had bear market charts. Many central banks are already at zero interest rates or below and have been unable to raise rates. The US tried and then reversed course. The US recovery has only been narrow and lifted a few sectors but the cycle is tired and the US is running large 5% public deficits as her private sector adds yet more debt. She is achieving a 1.5 to 2% GDP growth rate whilst adding to debt at a combined 7%. Net of debt addition this is not growth at all. She continues to run large trade deficits that supports the world as the world buys US$s and invests in US risk. But breadth has been narrow and earnings anemic. Outside of the the top five tech cos SP500 earnings growth was negative in 2019. Inflation adjusted its deeply negative outside of 5 companies. The Fed kicked off not QE4 in the repo markets and this helped to propel a narrow US equity advance.
Nonetheless we are paid on price and price has risen, until the last few days.
NCOV19 comes at the worst moment for global growth. And already very weak and very narrow market is about to face a hammer blow to growth. Its a hammer blow to the supply side (due to industrial disruption) and its a demand side hit due to consumers and companies suspending demand due to the uncertainty of events.
In this world of social media and 24hr news the rapid unfolding of news flow will inevitably create a panic. Government actions will worsen this with multi city quarantines. Draconian laws will be imposed to stop the travel of citizens. Death rates will soar upwards due to a lack of facilities for the treatment of pneumonia which is the real killer. At present the death rate is around 1 to 2% or x10 to x20 prior bad cases of flu. The ratio of 1 to 2% is based on a large supply of medical care and treatment for a limited number of ncov19 cases. There is no vaccine and wont be for another 12 to 18 months. The treatment of pneumonia here: https://www.nhs.uk/conditions/pneumonia/treatment/
I’m confidentially getting reports of various companies shutting down travel and even closing offices in high profile areas of London. Private emails sent to staff from HR departments. Airplanes are empty at present and likewise many hotels in cities.
Financially what will bite first? Consumer discretionary, Consumer luxury durable. leisure and travel related companies. Who are most vulnerable to this? Companies with poor balance sheets. Junk bonds yields will rapidly expand. The door to exit junk bonds is small and the crush would be systemically damaging. As would a sharp reversal of the risk on, USD long overnight due to the 200bp spread. The euro could appreciate for technical reasons as the euro carry unwinds. The rush could produce market shut downs to stem the price moves. Within weeks the central banks will have to quantitatively support the system.
The US 2/10 is nearly inverting again.
https://ycharts.com/indicators/10_2_year_treasury_yield_spread
The ten year 3 month spread has already inverted. The last time it did so produced the repo interventions
https://ycharts.com/indicators/10_year_3_month_treasury_spread
No matter their jaw boning, the fed will have to take action soon and governments will have to support demand, legally prevent private sector layoffs and prevent private sector racketeering. As said all these interventions are the central planners wet dream. This is the situation i’m afraid. The cries of free market libertarians will shut down in 2 seconds. This is akin to a war type situation. As human life is at risk, all measures are considered on the table. The mis allocation of capital we are about to endure will be immense.
Gold is the go to asset. No question.
A tactical trade is short leisure and balance sheet exposed hotel and leisure cos. They can bounce but they are going one way here in the next 8 weeks, even if my base case is wrong.
An asymmetric tactical trade is long euro vs the usd on option calls. The historic volatility on the pair is down at historic all time lows. As a general comment we want to be targeting a step change in volatility across all assets. Eurusd is a good one as everyone is long usd and or US risk and they are funding the position by being short the euro. The spread differential is 200bp on the over night between the two. 200bp plus as a base or high capital appreciation on US equities has been a one way bet the last few yeas. The trade is full and the volatility low. Its unwind could be very dramatic indeed. The HongKong peg will be back on the table as will the UAE dirham peg. Individual country stories like the expo20 in the uae (alongside a collapsing oil volumes and price) as well as the Japanese Olimpics will likely be foot notes.
What if i’m wrong on my base case. How could i be wrong?
- Infection slows. Treatment improves. Authorities contain. We must monitor this but also look out for disinformation. When authorities see the systemic threat the flow of reliable data may end. Its possible infections slow and things improve but the behavioral damage is already quite great and the spread of the virus has widen considerably in recent days. We have every continent now infected and the containment appears lost.
- Vaccine. Clinical trials would need to be completed before use on humans. According to medical practitioners the vaccine will take 18 to 24 months. Due to the rate of spread its reasonable to assume millions upon millions of cases would by then be present across the world.
Its possible the base case is wrong but i would place the probability at 20% wrong. I place trades on lower probabilities than 80% so i must run on the assumption that the base case will play out.
The coming government interventions will create many losers and a few winners.
Its impossible to predict exactly how this plays out at a securities or company level. Knee jerk bets like big pharma will do well doesn’t necessarily hold true as price controls will likely come into force to prevent private gain from the virus. It will be support services and non core treatment and services that will benefit without expropriation from government. As government will be controlling and directing more capital expect a lot of wastage and misallocation. It will not be a good time for wealth.
For disclosure I am still long many very strong balance sheet cos including commercial office reits and financial cos like Aviva and several others that show roes of 15% and are strongly cash generative. I have narrowed my holdings in recent days inc selling mining cos like rio and bhp. Governments later in the cycle will use their new powers to stimulate via giant infrastructure programs like supporting ev vehicles which will be great for rio and others but this later in the cycle of things. First we have the demand collapse to endure. Central banks are far behind the curve on events. Their historically based quant models cannot anticipate the coming storm. Within weeks they will start to adjust to the new reality. Fed meeting in slightly less than 3 weeks and counting.
Best wishes to all. I hope im wrong and look back at this post with a smile at my alarmist tone. I would be sincerely happy if that occurs and we quickly can get back to business as usual.
I will be putting some technical levels up via the swiss team shortly so please look out for these more usual posts. I expect their guidance to adjust as price supports and patterns emerge. I will update on this.
All the best
Rich