V, U, or L scenario?
What a crazy week. What can you say about a week that saw the following daily S&P 500 returns: Monday +4.6%, Tuesday -2.8%, Wednesday +4.2%, Thursday -3.4%, and Friday -1.7%? And after all this the S&P finished up +0.6% for the week. Who’d of thought?
Normally we’d get into today’s strong payrolls report and how the economy had built up a decent head of steam in the first two months of 2020, but all that is old news. At least from a market perspective, the on-going debate is about how much COVID-19 will hit global growth and what will policy makers do about it? In essence the market is trying to price four things right now that are largely unknowable:
a) how severe is ‘community transmission’
b) how fatal is this disease,
c) what are the supply chain and economic impacts, and
d) what are the policy responses and do they ‘work’?
The answers to the four questions will determine whether the ultimate recovery is “V”, “U” or “L” shaped.
On the first three questions there are a lot of opinions floating about, but no one really knows. On the policy question, the response is probably going to be significant. For example, on Tuesday the Fed cut rates inter-meeting. As The Economist notes:
“It is the first time that the Federal Reserve, America’s central bank, has cut rates between meetings since 2008. Then it was in response to the collapse of Lehman Brothers, an investment bank. This time, on March 3rd, it was because of the ‘evolving risks to economic activity’ from the coronavirus.”
Obviously, rate cuts can’t cure COVID-19 or give people confidence to travel. But the Fed has a hammer and they are going to use it. There’s probably not much downside to wailing away. For all the flak the Fed gets from the chattering classes, they are doing a job we’d all struggle to do. At the press conference on Tuesday Jerome Powell was about as forthright as you can be:
“We do recognize that a rate cut won’t reduce the rate of infection. It won’t fix a broken supply chain. We get that. We don’t think we have all the answers. But we do believe that our action will provide a meaningful boost to the economy. More specifically it will support accommodative financial conditions and avoid a tightening of financial conditions, which can weigh on activity. And it will help boost household and business confidence.”
A Quick Summary of Global Actions
It’s not just the Fed swinging into gear. Actions within the last few days include:
– The Australian central bank cut rates by 25bp to 0.5%. They said they stand ready to do more.
– Hong Kong’s monetary authority reduced its base lending rate by 50bps right after the Fed cut rates.
– The Bank of Canada cut its benchmark interest rate by 50bps, also after the Fed cut.
– South Korea announced a stimulus package of 11.7 trillion won (S$13.7 billion) on Wednesday. They plan to channel money to the health system, childcare, and small- to medium-sized businesses.
– Italy will inject €3.6bn into its economy in the form of tax credits for companies that report a 25% drop in revenues, as well as tax cuts and extra cash for the health system. This will be in addition to €900m worth of measures unveiled last Friday.
– U.S. lawmakers on Wednesday unveiled more than $8 billion in emergency funding to address the spread of the virus.
– The IMF is proposing up to $50bn in emerging financing.
– The U.K.’s incoming governor of the central bank said that it was very likely the central bank and UK government would soon provide bridging finance to small companies to help them deal with coronavirus. He also said it is likely the Bank of England would provide some supply chain financing in addition to rate cuts.
We are almost certain to see more next week. And don’t forget the Fed meets again March 18th. It’s basically a toss up if the Fed cuts by 50bps or 75bps, as you can see below. There is a real possibility they are at zero by the spring.
How effective will all this be? The general consensus is that central bank actions can’t do much other than help prevent a credit crunch. Targeted fiscal policy will be key.
Something to Tell the Grandkids
The equity selloff has certainly been painful, but so far it’s in line with the historical norm, as you can see below.
However, the moves in the bond market are historic. For example, the yield on the 10-year Treasury not only fell below 1% this week, it briefly hit 0.667%. Yields were close to 2% earlier in the year, as you can see below.
Now when we say that yields in the U.S. are at the lowest point in history, that isn’t just post-war history. Robert Shiller has yield data on government bonds going back to 1871. We are the lowest since then.
Something to tell the grandkids. “Gather round children and let me tell you about the time you were able to earn a positive nominal yield on government bonds.” The kids will find this simply riveting!!
Yields were also in freefall elsewhere. For example, German 10-year yields closed at historic lows of -0.73%. Their 2-year bond has a yield of -0.89%.
One area where you haven’t seen much movement in rates is on the consumer side. The rate on the average credit card is shown below.
As for mortgages, 30-year rates are at all time lows, but they haven’t come down as much as you would think. In the chart below, the white line in the top panel shows the rate on 30-year mortgages. The orange line is the yield on the 10-year Treasury. The bottom panel shows the spread between the two.
The spread has averaged 163bps since 1998. Today we are at 291bps. 30-year mortgages would be at roughly 2.4% if they traded at an average spread.
Over the short-term mortgage rates are driven by supply and demand – and the demand for mortgage dollars is through the roof. It will be interesting to see if this spread tightens in the weeks to come.
Charts We Are Watching
For what it’s worth, we found the following charts interesting:
1) China seems to be past the worst of things. As you can see below the number of new cases each day is falling rapidly. In fact, the government just closed one of the makeshift hospitals built to house COVID-19 patients.
2) The Shanghai market was up over +5% this week. As you can see below, the Chinese equity market has basically recouped all the losses incurred after the virus outbreak. This is notable as it implies that when infection rates peak, markets can rebound.
3) Markets in China are rebounding despite dismal economic data (chart below). Markets are looking through the downturn towards an eventual rebound.
4) You can actually see the economic slowdown in China through satellite imagery. Nitrogen dioxide levels have plummeted since late January.
5) Outside China, the number of active cases continues to grow.
6) Despite this, the number of active global cases is falling as recoveries grow. China is such a big part of the infected population that improvement there is driving this trend.
7) Finally, let’s close on a constructive note, at least as it concerns markets. There’s the old saying of buying stocks when there is blood in the streets, even if it is your own. The adage essentially gets to the idea that often times the best time to invest is when everyone else is fearful.
Well, one way to look at this is through the volatility (VIX) index. When it is high it means fear abounds. And that is certainly the case now. The VIX hit almost 55 today before backing off before the close. Fear didn’t get this high during the 2000 tech wipeout, immediately after 9/11, or during the Asian financial crisis.
Now granted, it spiked higher during the financial crisis, and maybe we follow that path. But that seems like a low odds bet. The markets are trading at a historically high level of fear and emotion, and historically it has paid to fade that fear.
Regardless, this whole topic lets me close on Kipling. Feels appropriate for a Friday afternoon:
If you can keep your head when all about you
Are losing theirs and blaming it on you,
If you can trust yourself when all men doubt you,
But make allowance for their doubting too;
………. If you can fill the unforgiving minute
With sixty seconds’ worth of distance run –
Yours is the Earth and everything that’s in it…….
Have a good weekend.
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