In last month’s report we spoke of the new Coronavirus that was primarily affecting citizens in China, with some minor spreading in other Asian countries. It provided a quick shock to the market erasing all returns for the year by the end of January. As all of you are aware, the virus now, has spread to over 73 countries with over 90,000 cases and over 3,000 have died. This has unsettled many people in the world who are worried that we might be facing a serious health pandemic. The World Health Organization (WHO) is still not calling it a pandemic, although in my minor scientific opinion, I think it is. The U.S. now has close to 100 cases and with 6 deaths as of this report. But when the first cases were uncovered in the U.S., we saw a sledgehammer come down last week as the stock market had the worst week ever. From the 20th of February, the market (Dow Jones) sank almost 4,000 points or roughly -14%. It was also the fastest 10% drop in the history of the market. We are seeing over 1,000-point intraday swings in the Dow Jones that are unprecedented along with huge volumes causing rapid moves in either direction.
We suspect this volatility will continue as long as there is uncertainty with the spreading of the virus even if the “bazooka money” arrives, which is liquidity that is poured into markets by Central Banks. As a matter of fact, our Fed did an emergency cut of 0.50% yesterday morning that was met with even more volatility as the market threw a fit like a child receiving a bad gift for his/her birthday. The 10-yr. Treasury yield shot lower to new levels we have never seen, under 1.00%, touching 0.908% at one point. To summarize, even though this is a reminder of the nauseous feeling we all had in the midst of the 2008 crisis, this is not a recession at this time. But we caution that a badly implemented response by our administration and medical system could easily create more panic, beyond the additional rice and toilet paper that some of my friends have been stockpiling lately. This is a virus that is spooking people and it was a valid excuse to sell a U.S. market that was quite frothy and had run-up on the liquidity of the Fed that was sparked in October, due to spiking overnight REPO rates. We mentioned this in our past reports. Even though we were up 28% last year, the market was flying high not on real jet fuel, meaning higher corporate earnings, but was floating like a paper airplane right before a windstorm came or in this case, a virus. We expect that we will have a period of 3-6 months of the same increased volatility as the next two quarters report earnings. Its obviously important that there is containment of the virus, which is going to continue spreading. There are estimates that we have maybe thousands of people who are currently carriers of the virus in the United States. The thing is if we get proper containment and have certain vulnerable individuals remaining cautious, we could get a handle on this until we see warmer weather or a vaccine in 12-18 months. We hope this does not entail the level of quarantining that China is enduring. But we must admit that they did a good job as it could have been much worse in China. Our economy is still the strongest in the world and we expect the second half of this year to be robust with lots of good companies at fire sale prices. But we have to get through this virus and its impossible to quantify a disease. All we can do is to compare this Coronavirus to previous virus’ and to track the rise of new cases and to see if the death per case ratio is increasing or decreasing. We are seeing the slowing of new cases in China. Our concern is the increase in other countries and the containment procedures.
Chart B: Dow Jones Industrial Average (DJIA) Daily Points Move (since 2/20/20)
Source: AETOLIA CAPITAL
We are now seeing more new cases in other countries, besides China, and this is causing more fear. Its not good that you can have no symptoms, but you may still be a carrier of the virus. Its spreads easily and we could see thousands more cases globally and with many new ones in the United States. This path of new cases in other countries will continue and its impossible to place a number on this. We know that there are many companies working on a vaccine and that it will take anywhere from 6-18 months (testing and approval), or possibly longer, to be viable as a cure for this virus. That is not good news but there is a hope that this virus will die off as warm weather approaches, but this is not guaranteed. Its possible we will go through another phase of this virus in the fall or winter. All we can do hear is to hope that these talented scientists find a cure and be able to go through testing quick enough before we attain more panic or deaths. Companies, like Gilead, are going directly to China for testing and approval as their system moves faster ours. The good news is that a majority of people will only get flu-like symptoms, but the most vulnerable individuals who are elderly and ill, must be cautious.
Supply Chain Disruption
In 2002, there was another lethal virus scare, called SARS, that emerged from China. At that time China was producing low-cost goods for customers around the world. Since then the economy has grown exponentially, as their annual economic output is now $14 trillion versus the $1.7 trillion in 2002. Their percentage of global trade is almost double now at 12.8% with an economy that grew at a 6% GDP in 2019. China produces very sophisticated products for technology companies, such as Apple, but they also produce most of the consumer products and medications like Ibuprofen (80%). They are also the largest consumer of resources and luxury goods in the world. I think you are seeing the picture here, that we will definitely see supply chain disruptions for certain U.S. products. We won’t know what the real effect is until we get Q1 earnings. Certain companies are coming out with negative future guidance. We are likely to see many companies showing lower earnings and revenue, but this could easily fall into Q2 or even Q3, depending on many factors, like demand shock. This is something we are closely monitoring with current company exposure and also with regards to future positioning.
The next level of concern above a supply chain disruption is “demand shock”. This is where people are so frightened of catching the virus that they do not go shopping in a store, they avoid a restaurant or other crowded places like a stadium. As a matter of fact, many companies like Ford, Google, and Twitter are not allowing their employees to fly overseas. Many conferences and conventions, like the Geneva car show have been canceled. They are discussing that cancellation of the Olympics in Japan. So, you can imagine the economic effect this would have and especially on small companies with cash or debt constraints. Again, there is no way to project the area or industry that might be affected by demand. The obvious ones, we all know, and they are airlines, cruise companies and mostly the entire travel industry worldwide. We have seen empty streets in China as a large part of the country was adjusting to a life under quarantine. We don’t expect to see this here but its difficult to predict fear as we are already seeing increased shopping to stock up on supplies (empty Costco shelves) or the purchasing of masks (which you should not do). What I don’t hear is that people are lining up for a flu shot as the common flu still kills about 30,000 people a year in the United States. Again, as investors we try to foresee areas that might be more affected and to target companies that might see an increase due to a stay-at-home tendency.
Could this lead to a recession in the U.S. or globally?
This week CNBC did an investor survey and the results stated that there was a 41% chance of a recession in the U.S. this year. We think in a base case scenario (discussed below) the probability is lower and maybe between 20-30%. In an escalated risk scenario, we think that the probability of a recession is above 50%, but again difficult to quantify with the virus being the major risk. We have faith in U.S. companies and their ability to adjust to supply disruptions but how can you sell products or services if demand slows significantly. Of course, you can order online, but someone needs to package that product and ship it to you. So, any upticks in demand disruption are being closely watched in our portfolio positions. We would say that China has a higher probability of a recession, than we do, but you must remember that their Communist government has their tentacles in all parts of the corporate world. As a matter of fact, their quick shift to disallow the selling of securities in the stock market in large quantities probably helps their market from crashing to much lower levels. We would have more concern with Japan and Europe as they were already on thin ice with regards to a recession.
Can the Federal Reserve, or global Central Banks, curtail a recession?
Well as mentioned the “bazooka money” is coming. They will cut rates closer to zero and you will see increased purchases of government securities forcing that money into the stock market as a liquidity injection. You will likely see “helicopter money” which is direct cash infusions to citizens. We recently reported that in Hong Kong each citizen was given $1,250. There are talks of some kind of payroll tax cut for U.S. citizens. There have been discussions of supplemental income for workers who cannot go to work, and are unable to conduct business from home. A waitress can’t work from home, but an employee from a tech company can easily work online and do conference calls. We just had a 0.50% emergency cut here, which was the first since October of 2008. Some people have been arguing that this cut was done sloppily and maybe without more coordination with a fiscal plan or with other Central Banks. You will see the other Central Banks come out almost daily with a temporary solution. But guess what, rate cuts won’t cure a virus or panic. It can stabilize stock markets for a short period of time. But this is where we fault our Fed again, for waiting too long raise rates in the past, and then cutting rates last year as the market was quite strong. Even yesterday they stated the economy was strong and chopped 0.5% like they have a lot of room to do so. The Fed Funds rate is now at 1.25% and likely to go to zero at the next Fed meeting on March 18th, or soon after. Also, our 10-yr. yield is getting comfortable under 1.0% and we can’t have a 10-yr. yield below a Fed Funds rate. Its like borrowing money at a higher rate and getting a risk-free rate of return at a lower rate. About $14 trillion of global government debt is trading at negative rates. We must hope we never see that here as that would very likely be a major sign that our economy is much weaker and could easily push into a recession. So, some traders were concerned that the Fed is creating an emergency cut while also saying how good our economy was. As I am typing this, the IMF just announced a $50 billion package of interest-free capital to assist poorer countries that might have issues with virus containment.
Since we have the benefit of creating this memo after Super Tuesday, we are able to pinpoint a revival in the Joe Biden campaign as he performed well last night. He is not yet projected to be the nominee, but after Mike Bloomberg dropped out today and he is likely leaning to support Biden, which will help him. We have pretty much eliminated all of the other Democratic candidates as Warren was unable to even win her home state. Previously this week, we saw Mayor Pete and Klobuchar drop out and shift their support to Biden. Not to dig deep into Democratic politics but there seems to be push by the moderate side of the party to lower the probability of a Sanders win. There are expectations that a Sanders win in November was improbable as he was positioning himself as a Democratic Socialist and would be an easy target as some of the large expenditures he is promoting, are not viable. We welcome readers to view a recent show by CNN’s Fareed Zakaria (GPS Show) where he compared Scandinavian countries that were more socialist. Its true there are benefits like nationalized healthcare, but there is also a 25% sales tax and also a tax rate up to 55% for most individuals making a certain percentage above the national average. Fareed pointed out that the same level in the U.S. would be anyone making over $66,000 per year. I don’t think the Sanders Socialistas would be willing to accept those terms and prefer to hear the theme of “oh Wall Street will pay”, which would never pass as most Congresspeople receive money from financial institutions. There is no doubt our country has issues with healthcare and wealth separation that creates a strong split among parties and people. We can say that recent market volatility was reflecting a small percentage of traders who were seeing a limited response by our administration that might create more panic, and could open an opportunity for a Sanders win. But today we are seeing a big market rally not only in the indexes but in Health Care (like hospitals) as there is more relief that Sanders cannot win the nomination. We do believe that a Trump – Biden race will be quite competitive.
The chart below looks like we climbed to the top of a mountain and took a bungee jump as we continue to bounce between the Jan. 2018 high of 2872 and the two levels above, at 3025 and the 200-day moving average. On the upside the 100-day moving average is the next peak to climb. But it is concerning that we did not retest the 2872 level again, which is typical in a sharp pullback. It’s difficult to make projections on a virus and its things get much worse we might even reach the Dec 2018 low of 2351 (lower probability).
S&P 500 (3/4/2020)
Source: AETOLIA CAPITAL
The 10-yr. yield is another metric we are watching closely as we are starting to hover around all-time lows under 1.0%. If there is to be confidence in our economy and the expansion, we will need to see more safety-seekers move into stocks causing the yield to reach the previous low near 1.30% or hopefully above 1.50% and headed closer to 2.0%. Our concern is that we keep heading to zero which we monitor in our overall equity risk model.
10-yr. Treasury Yield (3/4/2020)
Source: AETOLIA CAPITAL
S&P 500 (20-year Chart)…..Always good to view the big picture when things look bad.
Source: AETOLIA CAPITAL & KOYFIN