The financial markets have been under much pressure, volatility and uncertainty since COVID-19. At the end of February 2020, the global equity markets were in a freefall. Many are still doubting the severity of this quickly spreading disease, but as these bottom buyers are finding out, the big picture still views this uncontained epidemic as not seen through.
This timely blog on Perspectives explores the virus’ impact on global financial markets from a regional perspective.
What has happened?
Referencing financial data, current and historical, we see that the pace that COVID-19 is spreading much faster than prior epidemics (SARS, swine flu) in a limited time frame. The timing of this contagion has also been an issue to deal with. China has been working to see an economic recover from a tepid 2019 and the first wave of trade negotiations with the U.S. were just underway.
The effect of imports to China have directly affected the export economy of countries around the world. This has an immediate effect within oil, LNG, agricultural goods and metals. In oil, we have seen demand from China, the largest net importer of crude oil, take away nearly ten percent of global demand in January. In 2019, China was bringing in a total of 10.12mm b/d, so far this year we have seen this number fall to ~7mm b/d in January and February. The International Energy Association’s Fatih Birol has been quoted as saying the revision for 2020 oil demand will numerate to the lowest in a decade.
The longer-term effect may be detrimental for environmental concerns as well, because China is a major supplier of battery materials. We have yet to see the financial results of these complications, but they do not bode well for Q1 or Q2 results for manufacturers, producers and their respective country economies.
What is happening?
As anyone in the financial markets will tell you a moment in time is an eternity when the markets are moving.
We’re obviously watching the markets roiled as updates come along. To date we now have seen the US Federal Reserve come into the market with a 50bps interest rate cut, in which a cut was anticipated. What wasn’t anticipated was the way this was announced.
Days after we were reassured from President Trump over the weekend that this was not a time for panic, the Fed acted. This marks the first time the Fed has acted outside the normal Fed meeting announcement and with such a large cut (50bps) since the financial crisis in 2008. To add, there have been statements from President Trump that more cuts should be considered.
The goal is to be proactive and action needs to be taken sooner than later. This brings us to the other area that we viewed with concern last week, OPEC. In this Perspective I note that OPEC should have acted as soon as quarantines were in effect in China. China is not only the second largest economy behind the US, but they are the world’s largest oil importer, in 2019 Reuters estimates that China imported an average over 10mm b/d. China took over this mantle from the US in 2017 when the US averaged 4.5mm b/d vs. China 7.5mm b/d (source EIA).
With China at a near standstill on imports as well as a decline in exports, the need for oil was severely diminished yet OPEC stood pat. It wasn’t until today, the first week of March that OPEC has announced a cut in production of 600K b/d. This falls short of market expectations in timing, but also in volume. Most thought OPEC would be preemptive and announce a 1mm b/d cut in production. Oil markets have since been in decline and it’s likely that we will continue to see this move lower until further actions are executed.
Much lies ahead, but I remain steadfast that the best way for investors and corporations to stay ahead of the developing situation is to stay well informed. Reliability of data and news are the keys to keeping calm in the waves of volatility.
What may happen?
In 2002 to 2003, we had dealt with the SARS epidemic. That started the beginning of 2002 with a peak in fatalities and cases coming by June. As mentioned earlier, this outbreak has climbed rapidly and we’re only two months into the move. The number of cases reported are moving quickly above 80k worldwide with the fatality numbers topping 2,700.
As this continues to make its way through quarantines and economic isolations, the impact seems to be rising at a compounded rate. The most important part of this epidemic and its financial and social implication, is that people need to be aware. There is a high chance that this continued pressure and spreading contagion will push the global economy into recession. In the oil markets, it’s possible that we see oil prices drop to lows seen in 2015 under $30 a barrel.
With a focus in the financial and commodity markets, the keys to maintaining balance is to stay informed. Watching currency markets are as important as covering import and exports of commodities. There is no way to predict such a ‘black swan’ event, but we can compare prior markets as they make their way through these critical anomalies. As everything in this world is a new news event, everything follows a cycle that is familiar.
The deepest cut to the Asian regional economies remains with China. Japan continues to find solid footing and this outbreak has pushed it off course. For what it’s worth, Japan continues to fall upon unfortunate timing, as it was looking for a boost from the 2020 Olympics. South Korea’s recent rash of cases poses another threat to the once strong oil and natural gas market. Taking China out of the equation has been bad enough, but to see the other main importing energy countries, Japan and South Korea in the mix, it becomes a dilemma.
Focusing on the China stock market and its relative indexes, it seems like we’re seeing some flattening out from the decline. There has been a recognizable bounce off the lows in late January, but we seem to be far from the end of this pandemic.
One must approach all of this with an open mind and think of all possibilities. To think that the China markets are operating as normal might be a bit gullible. Behind closed doors, it’s possible that China is limiting exposure to open trade. After the Chinese New Year, as investors returned to the markets, short selling interest in the stock market was limited by the Chinese Securities Regulator. It is possible that these regulations are still in place but enforced behind closed doors.
Another concern about the Chinese stock market and its true purpose is to understand who is trading. China’s stock market is made up mainly of retail investors. These investors dominate the money invested in the market, by some accounts, up to 75 percent. With many people sick or quarantined, it’s likely that these investors are not trading as normal. This raises the question: Is the bounce in the market really holding at these levels or will there be more volatility and downside exposure to come?
It is easy to pull China data out and see the major impact on commodities. If we only consider the impact this has had on the recent trade negotiations with the U.S., we scrape the surface of how this cascades into all commodities imported and exported from the second largest economic nation in the world.
Imports of crude oil have hit a wall that will take months to recover. Local Chinese refiners are seeing credit lines pulled in fears that they will not be able to make payments. OPEC has not budged over the past month and any movement from them will take weeks to affect the depressed market.
To be brief when we are talking about commodities, this is complex and understandably a situation that will take time to be repaired. The commodity market impact is well beyond oil. The agriculture trade will continue to see significant issues. The metals market will come under pressure. Consider that copper and iron ore have already seen a slump from declining demand in China, and this will continue. Battery components may be the one commodity overlooked. With a significant amount of minor metals sourced from China, markets for computers, mobile phones and EVs will feel a crunch.
That of course is only a review of China’s market. Keeping to the broader view, the loss of South Korea and Japan is a considerable loss for the energy industry. These countries make up for large imports of crude oil and LNG. As they start to feel the effects of this pandemic, their respective economies will slide also.
As we move through other regions in this paper, it’s important to state here that this is not only an opinion of what still may happen, but also a paper on the preparation of another pandemic that will likely happen. In these past 20 years, we have had several outbreaks of unknown diseases that have caused panic, quarantine and fatalities. The lesson that we should learn from all of these is that they are never easily solved. Most take at least a year to reach the end stages of an outbreak. It is important to remember that we need to learn from historical cycles. Although not indicative what will happen in the future, but a guide to what we know can and will happen coupled with a large dose of the unknown.
The last week of February has been the most significant decline in the U.S. stock market over the past four years. Unlike most swings in the stock market these past few years, the reasons behind this move is well defined. From my collection of traders and analysts, there is still an optimism that the market has overblown the sentiment. Even President Trump has expressed confusion and anger over the U.S. stock market declining at such a rapid pace. Unfortunately, the decline continues as COVID-19 cases continue to rise.
The concern that we should be having is not about this current market, but the future earnings of the companies in the U.S. indexes. The effect of lower imports and exports to the major economies in Asia are going to show up in Q2 and Q3 results. We have started to see the U.S .Fed take these things into consideration and talks of an interest rate cut are starting to come to light.
When we start to think about an interest rate cut at this time, it may be a good thing for the U.S. and help shake off the weakness, but it’s not going to solve global trade. A weaker USD may seem an attractive option for trade, but it puts pressure on competing countries also affected by weaker trade. The result may become an all-out currency battle that will need some economic strength somewhere to counter the issues at hand. This seems an unlikely scenario with this pandemic still in early stages. This is where we must remember the basics of economics; cause and effect.
We have started with a focus on the U.S., but we’ll shift to Canada and Latin America to start our commodity outlook. We want to begin with Canada and the burden of its crude oil supply. With the recent issue concerning Teck Resources, it’s a compounding issue within this country. The CEO of TECK mentioned that Canadian regulations are a difficult hurdle to get over but seeing the overall standing of crude oil supply globally may have had some effect on this decision.
Since the U.S. lifted the crude oil export ban in 2015, the U.S. has become a major global oil supplier. This has been a difficult issue to deal with in Canada as it has always looked to the U.S. as its major consumer. In recent years, Canada has worked to figure out ways to move its oil out to the global market, but transportation costs have been a detrimental impact to margin.
With the outbreak of this virus, we’re seeing crude oil supply accumulating globally. This cannot be a good sign if barrels are waiting to leave the U.S. Gulf and Canadian barrels become landlocked. It is possible that the biggest impact on crude oil will not come down on OPEC+ or the U.S., but in Canada.
There may be some hope for the commodity market in Canada. We’re once again likely to see a safe haven trade to gold. During times of uncertainty and instability, gold has been a winner. The investment into this commodity may bolster production and mining in the country as well as in Latin America.
Latin America has always been a strong trade partner with China, but it’s been a diverse group between oil, grains, softs, livestock, and metals. Most countries in Latin America can continue to maintain economic stability if the U.S. remains viable. If there is an outlier to this, one must think about the suffering economy of Venezuela. Losing China as a trade partner and perhaps as a once solid backer of credit, the country may fall quickly into an economic collapse.
Moving to the U.S., it comes down to the current trade negotiations. The U.S. was in the top 10 of oil importers into China in 2018 ($6.8B). This accounted for about 25 percent of the oil China imported in 2018. As we moved into 2019 and China put tariffs on U.S. oil, U.S. crude oil quickly dipped to about 5 percent of their import in 2019. Perhaps this was a saving grace after the demand decline from COVID-2109, but there remains a lot of supply in the global market. The recovery of demand is not likely to come quickly and absorb the overhang. If the global economic picture continues to decline because of this virus, there will be more supply and a much longer wait to absorb the oil.
A commodity that is taking the biggest blow in the U.S. from this crisis is LNG (liquefied natural gas). Natural gas prices in the U.S. have been under pressure for the past year and this now puts it under more stress. One of the hopes for this commodity has been the shift to more LNG exports.
In South Korea, the U.S. increased its LNG imports by 5.5 percent in 2019. That accounted for 18 percent of that country’s LNG imports. The recent wave of COVID-19 outbreak in South Korea will likely influence all energy imports from the U.S.
The one that matters though is natural gas. Losing any ground now, the U.S. natural gas market will come under more pressure to cut back on production and increase storage. Not an easy thing to do when there is still a significant amount of associated gas from oil production. This also does not bode well for companies that have been focused on building out LNG export terminals. The demand will return, but these projects now must consider a revised budget and forecast.
Agriculture in the U.S. will feel the effect of weaker demand from China, but again the recent trade wars have already stemmed the tide. One would have never had the foresight to predict that learning to cope with weaker trade because of tariffs would mitigate the pressure brought on by this pandemic.
What now remains is to see how long the U.S. agriculture producer can hold without China’s demand. There is hope that Japan may make up for some of this loss with the upcoming 2020 Olympics, but that is a large question mark on how it unfolds. We have seen this virus off to a fast start, but containment is key. If brought back to manageable levels, we should see enough time for Japan to prepare for the Olympic economic boon. That should be enough for the U.S. to pull through these tough times in agriculture.
This may be one of the few areas that have not seen significant economic implications, but with cases rising in Italy and Iran, all eyes are on the area.
As we started 2020, one of the main focuses in this region was dealing with Brexit. Although it’s moved out of the spotlight for now, this may become an important issue for the EU and the UK down the road. We have heard from the EU Commissioner during the last week of February and he has stated it is too early to tell about the economic effect from COVID-19.
What we have been reviewing through this whole paper is that we don’t expect to see much more around the immediate effects, but we do expect the future effects to compile. Germany has recognized the possibilities and is slipping into stagflation. It has noted that if the virus outbreak continues to affect other major economies, it is likely to suffer as well. It’s a hard thing to pull a country’s economy out of recession, inflation or stagflation. It’s is obviously much more difficult to do so under pressures from a global virus outbreak.
Major countries such as the U.S. and China deal with major trade agreements. In other countries, trade deals may be of a smaller amplitude, but these minor deals are also those that are susceptible to being affected the most. Major cities such as Wuhan may favor trade with easier-to-deal-with countries. If this holds true, shutting down Wuhan will have a major financial impact on those trade partners. Since they are smaller trade partners, they are also more dependent on these deals. That leaves a large amount of exposure that we may not see in the major stock market moves, but something that is going to evolve over time.
This area depends a lot on how the current outbreak in Italy progresses. The global progression is quite important, but if there are other cases in Europe, it may cause concern over major shipping areas for commodities. Obviously, the ARA (Amsterdam-Rotterdam-Antwerp) area will be the focal point of concern. This port area accounts for more than 25 percent of Europe’s crude inflows and is a major point for turning this crude around into refined product exports.
Shipping will be at risk the most in this area regardless. We’re seeing shipping rates in steep decline (~80 percent) to end the month of February and those may continue. It’s hard to imagine how the shipping industry is surviving several blows to rates over the past few years. This one could be one of the most detrimental to date.
The Middle East has the most at risk when it comes to oil and China. The Saudis and OPEC have refused to act during this outbreak, but it’s likely that talks with Russia may have played a part. The Saudis are the second-largest importer of crude oil to China behind Russia. If Russia is not willing to cut its production and supply to China, the Saudis are not going to make a move either. That in turn leaves OPEC without its leader to lead any cuts in production.
This will not bode well for oversupply in the global markets and if this virus continues to evolve, we will find the oil supply in a point of no return. We have seen a similar predicament back in 2015 when OPEC refused to deal with the U.S. fracking boom. That resulted in a major supply glut and saw prices drop from over $100/bbl to under $25/bbl. Lessons are expected to be learned from past mistakes, but we are a stubborn society full of optimism in stable economic times.
In 2019, I made several presentations to various groups in the financial and commodity markets. All these presentations focused on the same thing, ‘The Unknown Unknown’. I was directly quoting former U.S. Secretary of Defense, Donald Rumsfeld. Most of the time I had a chuckle in the audience, but the truth is I was right. It was this ‘unknown unknown’ that created one of the biggest global financial crises we’ve seen since the Great Recession.
This is an important thing to note. For those that still look at the global stock markets as overdone to the downside, there is a lot that we still don’t understand. A lot that we don’t know and more that we cannot know.
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