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Episode 18

The Big Conversation Special - Coronavirus - Your questions answered.

Published on: March 3, 2020 • Duration: 20 minutes

In this week's big conversation special we help answer some of the key questions being asked about the market turmoil. Will central banks provide support, should we buy the dip and how long will it last? Was gold liquidation at the end of last week a one-off event or can we expect more and is Europe again looking vulnerable?

  • [00:00:04] Things are clearly moving extremely quickly at the moment. Last week's price action was dramatic across a wide range of assets from equities to bonds and commodities, and comparisons have been made with the worst excesses of the 2008 financial crisis. And because this is such an extraordinary time for markets this week, The Big Conversation is dedicated to answering your big questions. Last week's decline on the S&P 500 was the fastest ever 10 percent decline from an all time high, according to Deutsche Bank. The spot VIX, or Volatility Index reached the top of its 10 year range, almost touching 50. On Monday morning, March 2nd we saw the U.S. government 10 year yield at an all time low of under 1.03% percent. U.S. crude oil last week was bouncing off key supporters in the $43 region. And a break of that would open up a retest of the decade lows around $26, whilst the broader commodity index, the CRB, has also broken through its key supports. And what we've also been seeing just this morning, and this shows how fast things are moving, is that the eurozone banks, the SX7E, started the morning up 1 percent. And over the 2 hours since then, it's now fallen to minus 4 percent, which is showing some real problems in Europe. So we wanted to do was look at some of the questions from our viewers and from people in the market who we've been talking to over the weekend to see what really is the themes and what is the tone that's being set. And the first one we've got is from Max, which is “why did the market sell off so hard last week when the coronavirus risk was in some ways nothing new?” I think the key here is that obviously it went global. It was a China story. That's where most of the seriousness was. And then it starts to gain momentum and that the end of the week before last and then three last week we saw it build in Italy, build in Iran, build in places like the UK and the US. So there's been that element to it. But I think also we've got to look at the broader context, which is how do we kind of get here and why didn't we actually sell off much earlier? And one of the main things here is that we've seen the US Federal Reserve being a big player and they've been adding liquidity since since September of last year. It might have been a little bit of a faux pas on their side, but just before the outbreak went global, the Fed said, actually, you know what, we're going to reduce our repo operation, liquidity operation. Now, since September, when they've added liquidity, markets have gone up and when they've taken it away on three previous occasions, the markets fell a bit. The last two weeks saw them take liquidity out of the market on two consecutive weeks for the first time since September. And funnily enough, its that second week is when we got the collapse. So not only did the coronavirus outbreak spread, but the Fed happened to step away from the market and if we’re being cynical, it could be that the Fed was in some ways happy to see some of the excess taken out that they created. And as of Monday morning, the S&P was back to where it was when they started the whole repo operation in September. But the fact remains is that they've got to now step in to stabilise markets. So it is a key juncture for them. Another key thing also is that last week we're seeing the end of month lows for the February month. And this is obviously the beginning of month lows for March. And often people have to readjust their positions into that month and some people might really need liquidity. So given that we've had such a big sell off, what we saw is people often having to take profits in certain areas in order to pay for those losses. So a month and probably helped accelerate that selloff. And we got a little bit of a bounce into the last half hour hour in the US market and that's where people rebalance their portfolios. Now, as of this morning, it's kind of really key because in many ways the expectation is there'll be more rebalancing equities. It's sold off so hard and bonds have rallied so well over the previous week that a lot of pension funds would need to buy equities and sell bonds to get back to that, the general level of of portfolio allocation. So far this morning, it's actually been the reverse. So this is a really key moment here and this is why these central banks may need to come back into the market. The second question, I think, which is the the big one that we're all worried about, and this one comes from Zach. And it's basically is this going to be the trigger for a recession? And I mean, this is clearly a big question that people were talking about before. There are very clear signs that manufacturing is slow down throughout last year. But obviously with the liquidity from central banks, it had staved off the worst of it. Now, what we've got to look at is a number of things. Firstly, in terms of recession, we need is to be global. What we've seen before and throughout the last two, three years, we've seen recessions. We've seen recessions in the shale patch in the US and 2015, we've seen an ongoing you could call restructuring, but it's sort of recession in retail in most of the developed markets as well. And we've also seen a global manufacturing slowdown that's been going on for 12 months, centred on autos, but none of those created a correlated event across all markets. We've seen regional slowdowns like in Germany and clearly we've been seeing it in China. In fact, if we look at the China PMI, it's absolutely collapsed in this last month. The data came out today and down to 40 on the Caixin and below 40 on the headline index. So it's very clear that some of these economies are now in terms of their manufacturing, well into recession territory. The key question will be, is going to be what will central banks do? Will central banks come in with significant liquidity, as we've seen before? Are they going to have a coordinated response? I think that is going to be the defining factor, because it's been the defining factor for the last 10 years. We had a European crisis. The Banks came to the rescue. We had that dollar crisis, an oil crisis. Central banks came to the rescue. And last year, when we had the repo issues, the central banks came to the rescue. So again, here, this is going to be the key. If it becomes a recession, it's because those central banks have been unable to defend asset prices. I think we can get an economic recession, a GDP recession. But really, in terms of the market expectation, what the asset prices do, if asset prices collapse along with GDP, then that's when you get the sort of recession which is all pervasive like we saw particularly in 2008 and 2009. Next question up is from Aroon. And that is “why did”…… and this we're now looking at some of the currencies out there, “Why is it that the euro and the yen rally” and I'm also going to come into “why is it gold sold off?” But why did euro and yen rally and therefore the dollar sell off? Because a lot of people look at the dollar and think of the dollar as being a safe haven asset. And I think that's the key here, is that the safe haven assets are places like the yen, the euro and the Swiss franc. So what we saw and there's a little bit of a kind of a curveball two weeks ago, which is Japan's GDP figures for Q4 2019 came out and they were terrible because the sales tax as a result of that dollar yen strengthened, the yen weakened and it broke out of a five year range. So it looked like Japan was now on the back foot. And this was during the coronavirus building momentum. The yen was weakening, so it looked a bit like it had lost its safe haven status. But last week, once again, yen and euro regained the self safe haven status, particularly the yen. And the yen is the key one because Japan is a creditor nation. They stuck loads of money into the global system. When things become difficult, they take the money back, which is what they're doing right now. Yen is strengthening, so I think we can expect that to continue. But what that hides is that this is the DXY, the dollar index, which is 58 percent euro and around about 14 percent yen. So when euro and yen strong, the dollar looks like it's weak. However, if you look at the dollar versus emerging market currencies or commodity currencies such as the Aussie dollar and the New Zealand dollar in particular, you can see that actually the dollar is strong vs. those commodity currencies and emerging market currencies, but weak versus the safe haven currencies. So it's very much bifurcating market. If people want to play currencies, maybe they want to look at is being short. Aussie dollar, yen - so the yen would go up, Aussie dollar would go down in this sort of environment. And as I mentioned earlier, Europe's looking like it's on the back foot. And there you want to look at some of the major exporting currencies or particular those that are open economies. So Sweden looks vulnerable. That's the Swedish krona and Poland, the Polish zloty, which is very much levered to the European economy. That's another currency that should be under pressure in this in this environment. And it was, I think, Robert, who is talking about gold. In fact, everybody's been talking about gold. Gold's the safe haven asset. So why wasn't gold going up throughout last week? Couple of elements here. One is we talked about the month end and gold had its big sell off, 3 percent sell off on Friday on month end. And now in an environment where you're losing money, you will sell your winners to pay for your losers. And gold has been a winner and gold will probably continue to be a winner. However, in the very short term, positioning is quite long in gold. And we can see this because it was a futures market in gold that was driving the gold price. The gold price had actually been moving in lockstep with real yields in the US, which we've covered before. And it did the same throughout last week until Friday. Real yields fell, but so did the gold price. But I think that that was futures being liquidated into month end proper.Gold is still a relatively long position out there. And if we look at 2008, when you had all hell breaking loose, gold also sold off through most of 2008, not as badly as most other risk assets, but it still was a weaker asset itself. But these should be good buying opportunities for anybody who believes in the defensive qualities of gold. I think this is a repositioning in gold and was particularly evident with that that month and activity that we saw. Now the next question is perhaps the one of the most important questions comes from Krystof, which is, “is the central banks regime in jeopardy?” And with this, I'll also look at whether cutting interest rates can can really help the market. Now, that regime that we've seen has been one where central banks have been cutting rates, but more importantly, adding liquidity. And they've been doing it in the sort of sise it's kept, risk assets elevated even as profits have flatlined or even as risk assets have started to roll over. Now, risk assets rolling over today begs the question, are central banks going to come back? And I think the first thing is there's already looks like there's a coordinated response coming. We've seen Jerome Powell on Friday said we're watching, we will do something. Bank of Japan Monday morning said we're going to do something. Bank of England has said that as well. And the PBoC have already been out there putting liquidity. And in fact, maybe the first bounce that we saw from the coronavirus scare a few weeks ago was because of the PBoC, the People's Bank of China. But what's worrying here is that we can see, in Europe, particularly this morning, that this is the risk environment once again, and it's actually the periphery of Europe is suddenly coming under pressure. So today you might have thought it would be commodities that are under pressure within the equity market, but it's actually the banks, as I mentioned, the beginning. And what we're seeing here is that, yes, yields are falling when you look at German 10-Year yields and U.S. yields, but Italian yields are starting to rise. So the spread between Italy and Germany has been going up quite dramatically over the last couple of days. Spain also, it looks like the market is now saying this is a big problem for Europe. Once again, that that real kind of problem we've had in the background the last 10 years is rearing its ugly head again because you have a slowdown and revenues start to fall and tax receipts start to fall. Well, how the hell do you bail out these countries on the periphery that never actually fix their problems? I think that's what the Monday morning price action is currently saying. Now, the coordinated action from central banks, therefore, is most likely. We’ll certainly get the ECB in there as well. But I think what it needs is a combination of of the monetary, which could be more rate cuts. But how Europe and Japan does that when they're so negative already vs. adding more liquidity, which again, the limitations for Europe are quite, quite significant. The U.S. is in a relatively good place to cut. And also add more liquidity. And I think the first instance for a bounce is when you see that happening in decent size. As I mentioned earlier, the Fed had been reducing its balance sheet. It now needs to bring it back up. But more importantly for Europe, it's got to be something on the fiscal side. This has got to be government spending as well. The U.K. has already said it's going to do this just because of Brexit and the change in government. But I think all the European governments will need to complement the monetary, which is. Rate cuts in liquidity with fiscal, which is government spending. So the the regime is in jeopardy. Can interest rates have an impact? I personally think 50 basis points of rate cuts, which everyone is expecting now from the US will only have a limited amount of upside. It's a liquidity. It's the balance sheet expansion. That's what we've got to look for. That's what's worked in the past. And I think it will certainly help create at least a short term bottom in these markets. So that's what I'm looking for, for a bounce and to say the least, that that central bank regime is still going. The next question we have is from Robert, and it's maybe the golden question, which is how long is all this going to last? How long is this weakness going to last? Notwithstanding what we just said about liquidity coming into it, what should we look for? And the question that pretty much everybody's asked so Robert and everyone else is when do we look at buying the dip or trying to catch the falling knife……. never try and catch a falling knife. But in terms of how this has been playing out, I think we can look at China here. So China hit first. The market sold off about 15 percent in two or three days. Then the PBoC came in with liquidity, the market bounce. So this morning, the Shanghai Composite was up 3 percent, even as we saw U.S. yields rolling over once more and the European banks rolling over. So certainly they can provide some form of support. And if we look at the Chinese PMI is when we look at manufacturing the Caixin fallen below 40. But that's the rear view mirror is a China we know has had the problems. And if you look at fear sentiment, usually what you get is two stages of Fear and sentiment. The first stage is the realisation there’s a problem. The second stage where it becomes a panic. And after the panic, even though outbreak may increase, the number of people may increase, the number of deaths may increase, fear and and sentiments have reached a peak and a low. And actually that's when asset prices start to bounce. I think we may have seen that in China. In the European and U.S. markets, we're nowhere near that yet. It certainly feels like we've got the second wave of fear to come through. But maybe ways to play this would be looking at places like China for your longs versus shorts in Europe and the US. I still think basic resource stocks, this is miners, are going to be under pressure. Copper, I think, is going to be under pressure. The oil price is very, very at risk. If it breaks through 40 to 50 and I think if it breaks 40 to 50, we can look at 30, maybe even 26 and lower because it'll be the combination of a slowing economy in China. Now it's a global slowing economy. Plus, the fear factor. I think we'll see a lot of liquidation going on in there. And the net position and speculative position is still slightly long within most the commodity sectors at the moment. So it's not time to buy the dip yet. But what we need to look for is relative performance. We see high volume in the downside, which we did see at the end of last week with the month end on, particularly the Nasdaq. But if we see the high beta sectors, things like autos in Europe, miners, et cetera, starting to outperform, then we might look at a short term rebound to high volume, high beta sectors outperforming. That might be the opportunity. But this probably won't be V-shaped. This is more likely to be something which continues for the next couple of months, creating a, not a slow burning, but a significant issue for a lot of the manufacturing sector. And we've seen services getting drawn into that as well. Then a final question that we've got from Jose is as “how do we protect our portfolios?” Well, that kind of goes onto that “Do we buy the dip?” And if we don't buy the dip, well, what are we going to do? So I think bonds clearly still look like they've got some upside with yields downside from here. So when you buy in bonds, you're buying them for protection. You're looking for capital gains, not your yield on those bonds. With bonds in the US now being close to that 1 percent. The euro dollar future we've mentioned before, this is the short term interest rate contract. It's a future in the US. We've talked about December 2021 that still looks like it's in play. It broke to the highs. And I think if you're all very, very nervous and you want to price in U.S. yields and U.S. rates going negative, then you buy the 100 strike call. Volatility is now higher, pretty much everywhere. But that's certainly something that you could look at doing. Aussie dollar yen mentioned that one earlier because it's a past trade which focuses on the flight to safety in yen and the weakness in the commodity cycle, which is the Aussie dollar. I think you'd also want to have some things within the US because the US is effectively an enclosed market. It's it's not a global exporter, it's a global importer. So domestic US will be impacted, but not to the same extent as the open economies of Europe and Asia that are really dependent on exporters. So I think certain parts of the US market, maybe even the real estate sector over there. Housing shouldn't theoretically be that massively impacted. It might get dragged down if all markets come down. But I think those are areas that we'd look for. And then within Europe, I think the banks looking at risk. If you look at something like the UK banks where the UK is going to be the first to do the fiscal side of things versus those European banks where the periphery looks like it's bringing those eurozone banks lower, again, buying volatility. It's a harder one now because we've seen this huge spike. If anything, volatility would be sold, but no one should be recommending selling volatility at this point unless you absolutely understand those risks. So I think with this is more a case of, yes, take some cash, take a bigger position in the bond market, maybe look at some of those Asian stocks that have already been hit and have now rebounded, was looking at high beta Europe in particular from the short side. And I think overall this is a case of if we get a response from the central banks and we get a bounce, then you might want to look to unload some of your positions into that because you might not get a second bite to the cherry. If you look at those Chinese PMI. That is that's what's in store for the rest of the world. If that's the case, then we have got a significant slowdown in GDP. The big question that we're asking that everyone's asking is if we get a big slowdown in GDP. Can central banks with liquidity allow risk assets to find a base and rebound? And the key thing, the final key thing here, we sincerely sought in 2018 when we had that sell off at the end of the year, there's a mistake by the Fed when they raised rates in December. We were about 200 or 300 points off, from an economic slowdown (which is effectively what we've got right here) to it becoming a market structure breakdown and that's when you see volatility, or volatility of volatility explode. So far, volatility has gone higher, but vol of vol has been relatively well behaved. If we break through those trapdoors to the downside, then a 15 to 20 percent move becomes a 40 percent move. Central banks have got to stop that happening. They stopped it in 2018. They're going to have to act here today. And if they don't, then yes, absolutely, that's going to happen. And I think the things that we've mentioned before in terms of the currencies, in terms of the commodities, big level $42.50 on oil, copper $250 is held there. These are all things which if they go, then we know it's getting worse. And in terms of what should be on your radar, because financial assets can be manipulated, if you want to see how bad this is getting in the real economy, the real economy is things like oil is things like copper. So it's those break down and fall dramatically again. Then we know that this is a much, much bigger issue. And even if we get the bounce in financial assets, we may want to take those opportunities to sell into that strength because the real economy is still on the downside.