Friday, 13th of March 2020
“The only thing to fear is fear itself”
– Franklin D. Roosevelt
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This week has been one for the record books. Having teetered on the edge through much of February, stock markets have now truly fallen into the abyss with some of the largest one-day declines in history, while sovereign bond yields have experienced wild swings across the curve. Panic over the economic impact of covid-19 has rapidly swept the globe, and a major dispute over oil production between Saudi Arabia and Russia, which on Monday sent energy prices tumbling faster than at any time since the First Gulf War in 1991, has compounded investor pessimism. The sell-off has been indiscriminate with the Japanese yen, US dollar, and Swiss Franc the only safe havens left for investors – even gold has fallen back to a 1500 handle. Although some losses have now been recouped as of Friday morning, we do not see light at the end of the tunnel – at least not yet.
Monday witnessed the biggest losses on major US equity indices since the depths of the 2008 Global Financial Crisis (GFC), with the S&P 500, the NASDAQ, and the DJIA falling -7.6%, -7.3%, and -7.8%, respectively. The 2000 points drop on the DOW was the largest ever – but not for long. On Thursday, the index fell a further 2300 points (-10.0%), as investors lost faith in the US fiscal policy response after Congressional pushback on a payroll tax cut favoured by the President and Treasury Secretary Mnuchin floated some limp alternatives. The S&P 500 also had an abysmal Thursday session, falling -9.5% in the single worst day since the Black Monday crash on 19 October 1987. To make matters worse – and facing criticism for his allegedly blasé approach to the outbreak so far – the Donald also abruptly decided to bar travel (by non-US citizens) from EU Schengen Area countries with no prior warning, sparking a rift with European leaders. This week’s US market moves have been so great that ‘circuit breakers’, which pause trading for 15 minutes after a 7% intraday decline of the S&P 500 index, were triggered both on Monday and on Thursday for the first time since they were introduced in the wake of the GFC.
Despite having cut interest rates by 50bps on 3 March and intervening in repo markets three times this week, the Fed has been unable to stem the tide. The repo interventions come amid concerns about the rising cost of overnight funding and a possible liquidity squeeze in fixed income. The Fed first increased daily limits for ongoing repo operations from $50bn to $150bn on Monday, as it abandoned efforts to roll back the financing provided since September’s repo stress. On Wednesday, it then expanded those limits to $175bn and announced that at least $45bn in two-week loans would be offered on a biweekly basis until April 13. However, as the sell-off deepened on Thursday, the Fed finally announced a $1.5tn package of funding measures. These include asset purchases of coupon bearing securities for the first time and $500bn in 3-month and 1-month repo operations (alongside the previous limit extensions). The response from the DOW was to climb 1000 points in two minutes before all gains were lost and the market ended sharply lower for the day. Given the size of the funding package, the disappointing market reaction suggests that monetary policy cannot work alone in this instance. The market is now pricing a 100bps rate cut after next week’s FOMC meeting (i.e., America will be zero-bound from Wednesday), but until the government gets a fiscal stimulus agreed the market bottom looks some way off.
In Europe, where the spread of the coronavirus is much more advanced than it is across the pond, this week’s stock market bloodbath has been proportionately worse. The Stoxx 600 Index, which represents a broad cross-section of European equities, was down -7.4% on Monday and a whopping -11.5% on Thursday. The latter figure represents the largest daily decline in the history of the index – yet another record of dubious merit amid the turmoil this week. In Italy, where the virus has spread most widely and which is on lockdown, the benchmark FTSE MIB Index fell by as much as -16.9% on Thursday. However, other markets fared little better: the German DAX, French CAC 40, and UK FTSE 100 (with its large exposure to financials and energy) were all down -12.2%, -12.3%, and -10.9%, respectively. The main driver of Thursday’s massive losses was the failure of the European Central Bank (ECB) to cut interest rates as expected. Instead of echoing her predecessor’s promise to “do whatever it takes” to protect the Eurozone from recession, the new ECB President Christine Lagarde lambasted governments for failing to support indebted countries via fiscal stimulus and announced that the ECB was “not here to close…spreads”. Needless to say, these comments proved disastrous and they compare unfavourably with those of the Bank of England Governor who cut rates by 50bps and freed up funding for banks on Wednesday to support the UK economy.
In light of the above, we are pleased to have had our defensive stance heading into March. We do not believe that the sell-off is over just yet, despite the strength of the market rebound this morning and the high probability that central banks will intervene further to boost the economy next week. Demand shocks of uncertain length, such as the one we see today, inevitably take some time to work their way through financial markets. And until cases of coronavirus infection reach a peak and the runway to recovery is clear, quarantine measures will continue to harm economic activity while uncertainty caps any rebound in risk assets. Moreover, the longer the economic slowdown, the more likely it is that cracks will emerge in overleveraged pockets of the HY credit market, for example. Should defaults spike then the technical recession we forecast will have become more systemic in nature. It would then be a major threat to the medium-term outlook that looked so rosy at the start of the year. That said, the magnitude and ferocity of the moves this week – the VIX which represents S&P 500 implied volatility hit 75 late on Thursday – suggest that the worst of the risk-off is perhaps now behind us. As we survey the landscape, many assets look undervalued on a long-term view. Once the market volatility abates, the sell-off is likely to provide us with many ways to ride the rally and benefit from secular trends with looser monetary policy an additional tailwind. Having dry powder to deploy into the market at that time will be vital.
In addition to the spread of the coronavirus, the spectacular collapse of the OPEC+ alliance in the wake of talks failing between Saudi Arabia and Russia has been a significant cause of equity volatility this week. Since 2016, Russia has been collaborating with OPEC to support the oil price and reduce global oversupply. Last weekend, however, the country announced that it would no longer comply with further supply cuts after the expiry of current quotas in April 2020. One reason is that Russia wants to put a protracted squeeze on US shale and has an approximately $40 oil price breakeven in its fiscal budget. As such, it has nothing to fear – and potentially much to gain – from a crude oil price of, say, $50. On Monday, Saudi Arabia, which needs a higher oil price (~$80) for its fiscal budget to breakeven at its current market share, declared a massive increase in oil production in response, and WTI and Brent Crude fell -23.5% and -24.1% for the day. The Kingdom aims to ramp production quickly, flood the market with oil, tank the oil price at a time when demand is very weak, and pick up market share from high cost producers who are forced to cut CAPEX and production sharply. Saudi Arabia can produce oil at $5-10 a barrel, so the country can still make a positive return from pumping at today’s prices (i.e., $33.3 per barrel for Brent Crude). The medium-term strategy is to bring Russia to the table to discuss production cuts, and to do so having seized market share from other producers. However, Russia may well be able to survive low oil prices longer than Saudi Arabia given its less precipitous fiscal position, so the standoff could be protracted. Still, with oil touching the lows of 2016 there may yet be a buying opportunity down the line… and oil is not the only asset looking cheap today.
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