Values Debase

It used to be bonds were so boring
That talk induced yawning and snoring
But Covid-19
Is now on the scene
And bonds are the asset that’s soaring

Meanwhile in the equity space
Investors are having a race
To see who has sold
Their stocks and bought gold
As equity values debase

It’s important to understand that Covid-19 is not the cause of the current hysteria in financial markets, it is merely the catalyst that revealed the underlying problems. Arguably, the most critical of these problems, excess leverage, has been building since the financial crisis response in 2009. In fact, it was an explicit part of the response package, cut rates to zero to encourage more borrowing. The unseen, at the time, problem with this strategy, however, is that the vicious cycle virtuous circle that resulted, where investors chasing yield moved up the risk ladder thus encouraging the issuance of more and more risky securities, seems to be reaching its denouement. Welcome to today’s volatility!

Briefly, financialization of the economy has been growing aggressively since the financial crisis. This is the process whereby the corporate sector spends more time and money on managing the balance sheet than on delivering products or services. Thus, banking and financial services grow relative to total economic output. In essence, we produce less stuff but pay more for it. And yes, that is the definition of inflation, which is exactly what we have seen in financial markets. It has just not (yet) appeared in measured inflation indices, as they don’t include stock prices. Financialization has manifested itself in the massive equity repurchase programs, funded by record-breaking issuance of corporate debt, which has been instrumental in driving equity markets to record highs. But when more money is spent on equity repurchase than on R&D, it bodes ill for the longer term. Perhaps Covid-19 is the catalyst that will help us understand the long term has arrived.

As the global economy now is trying to address both a supply and demand shock to the system simultaneously, investors have collectively decided that risk is not as tasty as it was just a few weeks ago. And while many have warned that when this market turned, it would be dramatic, I don’t believe the type of movements possible were well understood. I’m guessing they are a little better understood today.

This process has further to run, regardless of what the central banks or government leaders do or say. Markets that have rallied for ten years do not correct in ten days. It will take much longer and there will be many unforeseen movements by different asset classes going forward.

In fact, the dollar is going to be quite interesting throughout this process. I maintain that its current decline is entirely a result of the market repricing the US rate outlook. Futures markets are currently pricing in another 50bp rate cut by the Fed a week from Wednesday, with a further 37bps by the end of the summer. That is significantly more cutting than is being priced for the ECB (just 10bps) and the BOJ (also 10bps). In other words, as interest rate spreads between the dollar and other G10 economies compress, it is no surprise to see the dollar decline. In fact, this was the genesis of my views at the beginning of the year and what underpinned my calls for the euro to trade to 1.17, the yen to 95 and the pound to 1.40. Of course, I didn’t anticipate anything like this, rather a much more gradual approach.

However, the dollar is also still seen as one of the safest places to be, with Treasury bonds the ultimate safe haven today and one needs dollars to buy Treasuries. The rally in the bond market has been extraordinary with the 10-year falling another 15bps today to yet another new record low. It actually traded below 0.70% briefly this morning but sits at 0.76% as I type. And that is true across the Treasury curve. While other bond markets globally have seen rates decline, nothing has matched the Treasury performance. (And for those of you who did not understand how Greek 10-year yields could trade below US yields, that is no longer the case!)

Meanwhile, havens like the yen (+0.9% today, +6.1% in the past two weeks) and CHF (+1.05% today, 4.9% in two weeks) are the stars of the FX markets. In fact, this bout of risk aversion is beginning to approach what we saw in 2008 and 2009. Today, the dollar is the total underperformer in the G10 space, but that is not the case in the EMG space. There, MXN is the disaster du jour, down 2.1% as it is impacted by the collapse in oil prices, the uptick in coronavirus cases and its reliance on the US, which appears to be heading toward much slower growth, if not a recession. But BRL is lower by 1.0%, and we are seeing most of the APAC and LATAM currencies falling this morning. CE4 currencies are benefitting from their proximity to the euro, but I expect that will change as time passes.

Into all this excitement, we bring this morning’s payroll report with the following expectations:

Nonfarm Payrolls 175K
Private Payrolls 160K
Manufacturing Payrolls -3K
Unemployment Rate 3.6%
Average Hourly Earnings 0.3% (3.0% y/Y)
Average Weekly Hours 34.3
Participation Rate 63.4%
Trade Balance -$46.1B

Source: Bloomberg

The thing is, all this took place before Covid-19, so all it can do is give us a final benchmark as to how things were prior to the virus spreading. If we get a bad number, that will be a real problem.

It is hard to overstate just how fragile this market is right now, with liquidity significantly impaired, bid-ask spreads widening and options volatilities rising sharply. Patience is a true virtue in these conditions and leaving orders at levels can be very effective. I maintain that the dollar’s weakness will not be a permanent feature, but rather a transient situation until the rate situation stabilizes. So, receivables hedgers, leave orders to layer into your strategies, it will pay off over time.

Good luck and good weekend