No Easy Fix

As fears ‘bout the virus increased
Supply and demand growth have ceased
There’s no easy fix
Or policy mix
But funding soon will be released

Words fail to describe the price action across all markets recently as volatile seems too tame a description. Turbulent? Tumultuous? I’m not sure which implies larger moves. But that is certainly what we have seen for the past two weeks and is likely to be what we see for a while longer. The confluence of events that is ongoing is so far outside what most market participants had become accustomed to over the past decade, that it seems many are simply giving up.

Consider; signing of phase one of the trade deal between the US and China was hailed as a milestone that would allow trading to return to its prior environment which consisted of ongoing monetary support by central banks helping to underpin economic growth with low inflation. As such, we saw equity markets worldwide benefit, we saw haven assets come under some pressure as havens were seen as unnecessary, and we saw the dollar rally as the US equity market led the way and investors everywhere wanted to get in on the party.

But that is basically ancient history now, as the combination of the discovery, evolution and spread of the coronavirus along with a pickup in US electoral excitement essentially destroyed that story. The past two weeks has been the markets’ collective effort to write a new narrative, and so far, they have not agreed on a theme.

The interesting point about Covid-19 economically is that it has created both a supply and a demand shock. The supply shock was the first thing really observed as China shut down throughout February and companies worldwide that relied on China as part of their supply chain realized that their own production would be impaired. So, we had a period where the focus was almost entirely on which multinational companies would be reducing Q1 earnings estimates due to the supply problems. This also encouraged the economics set to assume a “V” shaped recovery which had most investors looking through Q1 earnings warnings and remaining fully invested.

Unfortunately, as Covid-19 spread though, and I think it is now on every continent and spreading more rapidly, governments worldwide have imposed travel restrictions to the hardest hit countries (China, South Korea, Italy). But an even bigger problem is that many companies around the world are imposing their own travel and hiring restrictions, with Ford, famously, halting all business travel alongside a number of major banks (JPM, HSBC, Credit Suisse). In fact, yesterday, I was visiting a client who explained that our meeting would be their last as they are not allowing other companies to visit their headquarters starting today. The point is this is a demand shock. Travel and leisure companies will continue to suffer until an all clear is sounded. Talk of postponing or canceling the Olympics in Tokyo this summer is making the rounds. Talk of sporting events being played in empty arenas has increased. (March Madness with no crowds!) And there are the requisite stories about store shelves being emptied of things like toilet paper, paper towels and hand sanitizer.

The problem for policy makers is that the response to a supply shock and the response to a demand shock are very different. A demand shock is what policymakers have been assuming since the Great Depression, as easing monetary and fiscal policy is designed to increase demand through several different channels. But a supply shock requires a different emphasis. Neither monetary nor fiscal policy can address Covid-19 directly, curing the ill or protecting those still uninfected. The closure of manufacturing capacity as a response to trying to avoid the spread of a disease is going to have a massive negative impact on corporate finances. After all, interest is still due even if a company doesn’t make any sales. To address this, central banks will need to show forbearance on banks’ non-performing loan ratios, as well as incent banks to continue to lend to companies so impacted. It needs to be more finely targeted, something at which central banks have not shown themselves particularly adept.

And of course, after a decade of central bankers teaching markets that if there is a decline of any magnitude, the central bank will step in, policy space is already quite limited. In sum, the next market narrative remains unwritten because we have never seen this confluence of circumstances before and there are millions of different ideas as to what is the right way to behave. Volatility will be with us for a while.

So with that long preamble, turning to the markets sees that after yesterday’s remarkable risk-on rally in the US, arguably catalyzed by the fact that Senator Sanders fared more poorly than expected in Super Tuesday voting, (thus reducing the chance of his eventual election), Asia picked up the baton and rallied. But Europe has not been able to follow along with virtually every European equity market down at least 1.5%. US futures are also suffering, currently lower by 1.75% or so across all three indices. Meanwhile, 10-year yields, which yesterday managed to trade back above 1.0%, are down nearly 10bps this morning as risk is being jettisoned left and right. The yen is rocking, up by 0.6%, with the dollar trading below 107.00 for the first time since October. In fact, the dollar is generally on its back foot this morning, as the market continues to price in further significant rate activity by the Fed, something which essentially none of its counterparty central banks can implement. At this point, the market is pricing in almost 50bps more at the March meeting in two weeks, and a total of 75bps by July. The ECB doesn’t have 75 to cut, neither does the BOJ or the BOE or the RBA. So, for now, the dollar is likely to remain soft. But as the market has priced these cuts in, I would have anticipated the dollar to fall even further. This hints that the dollar’s decline is likely near its end.

On the data front, remarkably, yesterday’s ISM Non-Manufacturing print was stellar at 57.3, but nobody is certain how to interpret that and what impact Covid-19 may have had on the data. Today we see a bit more data here with Initial Claims (exp 215K), Nonfarm Productivity (1.3%), Unit Labor Costs (1.4%) and Factory Orders (-0.1%). My sense is that Initial Claims is the one to watch. Any uptick there could well be interpreted as the beginning of layoffs due to Covid-19, but also as a prelude to weaker overall growth and perhaps a recession. It is still early days, but arguably, Initial Claims data, which is weekly, will be our first look into the evolution of the economy during the virus.

For now, the dollar remains soft, and I doubt any data will change that, but the dollar will not fall forever. Layering in receivables hedges seems like a pretty good plan at this point.

Good luck