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Authored by Richard Breslow via Bloomberg,

Equity prices have continued to make their way lower. Analysts warn that they could have further to go. Yet, listening to traders talk, the preponderance of them are looking for places to buy.

It’s been a hard sell-off with a bid tone. It’s the perfect environment for continuous bursts of activity as short-term positioning imbalances get unwound because conviction within the speculative community is so very low. As it should be. But that’s not a recipe for achieving successful results.

The reality is that the current issue besetting the market is going to take longer to be resolved than the level of patience too many investors are any longer capable of exercising. We live in a world where there are long-term investors, short-term participants and seemingly no one in-between.

Markets used to derive a great deal of stability from traders with a medium-term perspective. They cared about the news. They respected price action. But, they attempted to understand the context of events and market inclinations that would get them from now until the next known known. And then they would deal with surprises by being disciplined with their trading levels and stops. They traded expectations and then attempted to avoid the event.

Did the Chinese handle the initial outbreak of the virus as well as they might have? Probably not. I dare say, not many countries would have. But they were first and scrambling. And, while the sight of the quarantined cities was frightening, it may have been unavoidable and the right thing to do. By many accounts, they are indeed having some success in bringing their productive capacity back on line. But it, unavoidably, takes time. You can’t just flick a magical switch that traders would like.

It appears that a growing number of other countries will have to deal with this problem as well. And we need to accept that it will be a slower process of recovery than anyone would like. Other than, perhaps, fiscal measures to help maintain consumer demand, there is little that will ultimately be helpful except dealing with the health issue. And time.

Everyone seems to be breathlessly waiting for the economic numbers that will start to be released in March to tell traders how these economies have been faring as they navigate the situation. As a guess, they will be disappointing. As they should be. Those numbers border on irrelevant. The only way to deal with this problem will inevitably have had adverse consequences for both supply and demand.

The economic facts that should be monitored in the short-run are whether things are starting to loosen up. We know businesses in China were shuttered. We know companies that rely on their products had supply disruptions. Some total. That doesn’t need to be proved, or be taken as permanent. The most relevant question is whether things are starting to flow again. Even if it will take time to get fully up to speed. Direction, not absolute amount matters at the moment. To get some sense of how China is doing, relying on traditional economic numbers won’t be as helpful as we would like. Asking the companies which use their products if they are getting, or even starting to get, them will be a much more informative data point. Motion is progress.

The market is salivating for rate cuts. In the U.S., futures pricing keeps bringing the expected date that the Fed acts closer.

We can debate the should they, will they question. Interestingly, a lot of advocates for a cut prefer to skip the former in favor of the latter as an easier issue to resolve. I’m not convinced that’s correct. The only thing it would accomplish is to stoke demand for even more.

A medium-term trader might accept that price action implies that the prudent thing is to position as if they will. And be out before the actual FOMC meeting. Trading on market expectations and momentum. Then skipping the coin toss. And the aftermath mayhem we’ve too often become accustomed to. The market doesn’t need to be right for them to have made money.

Yesterday, we asked “are men or machines behind the selling panic?”

This morning we are starting to get a clearer picture as men AND machines are ‘flipping’. As Nomura’s Charlie McElligott points out in a note this morning, the CTA trend model for S&P futures “triggers” on the break below 3,139…

“Flipping Short” and creating mechanical selling thereafter as the overall S&P position across all time-signals deleverages from +100% to just +15%…

And futures are below that now…

The flush was clear…

Additionally, if the S&P breaks 3,040 or so, it could rapidly extend its losses (on a Gamma flush) to 2,970…

And then look out below…

…to 2,915…

As CTAs have slashed their VaR exposure to equities…

And Risk Parity Funds are adding to the panic with their forced deleveraging…

The question is – can an emergency rate-cut do anything to stop this?

2019 was a remarkable year: the S&P’s total return was over 30% even as S&P earnings for the year actually fell. Well, according to Goldman, 2020 is set to be similarly as remarkable, because in a note released overnight, Goldman’s David Kostin writes that as of today, the bank expects US companies will generate no earnings growth in 2020, the second straight year without EPS growth despite record buybacks. This is what Kostin wrote:

We have updated our earnings model to incorporate the likelihood that the virus becomes widespread. Our revised baseline EPS estimates are $165 in 2020 (previously $174) and $175 in 2021 (previously $183), representing 0% and 6% growth. Our reduced forecasts reflect the severe decline in Chinese economic activity in 1Q, lower end-demand for US exporters, supply chain disruption, a slowdown in US economic activity, and elevated uncertainty. Consensus forecasts imply EPS will climb 7% in 2020 and 11% in 2021.

As Kostin elaborates, under his baseline forecast, COVID-19 disrupts supply chains for a prolonged period of time and weighs on US consumption (“widespread”). In sticking with Goldman’s chronic optimism, the bank then assumes that the economic weakness will be short-lived, with most of the lost activity recouped in late 2020. Our estimates are well below consensus bottom-up forecasts for 7% and 11% growth in 2020 and 2021, respectively.

Just to cover its bases, Goldman also considers alternate scenarios where the impacts from the virus are contained or more severe. In these scenarios, it assumes growth recovers more rapidly (+3% EPS growth to $170 in 2020, “contained”) or deteriorates more sharply (-13% EPS growth to $143 in 2020, “recession”).

And visually:

On other hand, if Goldman is once again overly optimistic – which it always is, recall the bank was predicting 4 rate hikes in 2019 and instead we got 3 rate cuts – Kostin gives an alternative scenario if the US enters a recession, “history suggests S&P 500 EPS would fall by 13% in 2020. If COVID-19 spreads rapidly, supply chain delays could persist, US consumer demand could plummet, and firms could lay off workers in an effort to maintain margins. Using 11 previous recessions since 1947, S&P 500 EPS typically fell by 13% from peak to trough (typically ~4 quarters). Although earnings recessions have been more severe during the past 30 years, consumer balance sheets are healthy and banks carry much stronger capital ratios relative to history. Under our recession scenario, we assume S&P 500 earnings fall by 13% from peak to trough and rebound by 10% during the subsequent four quarters.

Naturally, this scenario would be catastrophic to Goldman’s clients who were never warned about this – Goldman itself 3 weeks ago was idiotically claiming that the US is virtually recession proof – and so Kostin had to hedge that as well, predicting a just as idiotic V-shaped recovery in case the pandemic remains confined to China.

However, if the outbreak remains largely confined to China, economic activity could rebound to normal levels in 2Q and companies could rely on existing inventories. Our China economics team expects that real GDP growth in China (qoq annualized) will recover sharply following the 1Q contraction. High frequency indicators suggest that production is gradually resuming across the country. In addition, many S&P 500 companies have built inventories that can be drawn upon in the interim to compensate for disrupted supply chains. The S&P 500 inventory to sales ratio ranks in the 73rd percentile relative to the past 10 years and is even further above-average for some of the industries most clearly at risk (e.g., Semiconductors). If lost activity from 1Q is recouped quickly and average annual US and world GDP growth is largely unchanged, our top-down model suggests S&P 500 EPS growth of 3% in 2020 and 5% in 2021.

That said, best of luck with this rebound…

… considering that South Korea has now surpassed China in daily new cases.

For those who care, here is the full summary of the Goldman note:

1. Investors fear the coronavirus (COVID-19) will expand from an epidemic to a pandemic. The rapid expansion of coronavirus human-to-human infections across multiple continents has sparked a five-day 8% sell-off in the S&P 500 index. At 3116, the stock market now stands at the same level as last December but is 8% below the all-time high of 3386 on February 19th.

2. Epidemic vs. Pandemic: The World Health Organization (WHO) defines an epidemic as a sudden increase in the number of cases of a disease. “Pandemic” is defined as an epidemic that has spread over several countries or continents, affecting a large number of people. As of February 26th, WHO and CDC data indicate that there have been 82,164 confirmed COVID-19 cases across 39 countries resulting in 2,801 deaths (fatality rate of 3.4%). For context, the seasonal flu in the US infects 24-45 million people and results in 23,000-61,000 deaths representing a fatality rate of roughly 0.1%. On February 25, federal health officials at the US Center for Disease Control (CDC) stated that they expect to see community spread in the US and “now is the time for US businesses, hospitals, and communities to begin preparing for the possible spread of COVID-19.” We believe portfolio managers should also prepare for this possibility.

3. Trading the market in 2020: Consensus currently expects 2020 EPS will equal $176. With bond yields at 1.3%, the yield gap between the forward earnings yield (5.6%) and the 10-year US Treasury yield equals 427 bp. For context, the long-term average yield gap equals 230 bp. If investors adopt the view in coming months that COVID-19 will become widespread, the yield gap could widen to 500 bp. If bond yields drop to 1%, the resulting 16.7x forward P/E means the S&P 500 would trade at 2900, representing a 7% decline from the current level and a 14% drop from the all-time high.

4. US companies will generate no earnings growth in 2020. We have updated our earnings model to incorporate the likelihood that the impact of the virus becomes widespread. Our revised baseline EPS estimates for 2020 and 2021 are $165 (previously $174) and $175 (previously $183), respectively, representing 0% and 6% growth. Our reduced profit forecasts reflect the severe decline in Chinese economic activity in 1Q, lower end-demand for US exporters, disruption to the supply chain for many US firms, a slowdown in US economic activity, and elevated business uncertainty. Consensus bottom-up forecasts imply full-year EPS will climb by 7% in 2020 and by 11% in 2021.

5. Path to unprofitability. Our top-down base case assumes S&P 500 firms will report a decline in EPS during 1H 2020. Consensus bottom-up estimates imply 1Q EPS growth of +1% followed by 2Q EPS growth of +5%. The trajectory of the US and global economy is highly uncertain at this time. For modeling purposes, we assume economic growth slows sharply during 1H 2020, but rebounds in 2H 2020 and 2021. A more severe pandemic could lead to a more prolonged disruption and a US recession. Under a recessionary scenario, S&P 500 EPS would fall by 13% to $143 in 2020 before rebounding by 10% to $158 in 2021. In an upside scenario where COVID-19 spread is more contained, EPS would equal $170 (+3%) in 2020 and $180 (+5%) in 2021.

6. Lower profits, but also much lower interest rates. The ten-year US Treasury yield has sunk to the lowest level in more than 50 years. At the start of the year, the 10-year note yield equaled 1.9% but has since plunged to 1.3%. The fed funds rate currently equals 1.5-1.75%. Futures assign a 32% probability the FOMC will cut the policy rate at the March 18 meeting and an 86% probability of at least two 25 bp cuts by year-end.

7. Baseline valuation forecast: By year-end, we expect the yield gap will narrow to 365 bp and the S&P 500 will trade at 3400 (+9% above the current level). Our valuation forecast incorporates our macro model, including interest rates, the output gap, inflation, consumer confidence, and policy uncertainty. We assume breakeven inflation and consumer confidence will return to current levels by year-end and policy uncertainty will decline post-Election. Assuming bond yields climb modestly to 1.5%, consistent with futures market pricing, we forecast S&P 500 forward P/E will rise to 19.4x. We maintain our year-end price target of 3400 as lower bond yields offset lower earnings.

8. Alternative valuation scenarios: If the COVID-19 outbreak is contained and bond yields rise to 1.85%, slightly lower valuation multiples would offset the continued growth in S&P 500 EPS. In this scenario, the S&P 500 would still trade at 3400, representing a 19x forward P/E multiple. In a downside scenario, we assume bond yields fall to 0.75% and the yield gap widens to 575 bp. As a result, the forward P/E multiple would decline to 15x and S&P 500 would end the year at 2450 (-21% from the current level).

9. Sectors: Shift more defensive given slowing growth. We raise Real Estate to Overweight from Neutral, and Utilities to Neutral from Underweight. In contrast, we lower our Industrials weighting to Neutral from Overweight, and lower Financials to Underweight from Neutral. Real Estate companies generate 81% of their revenue domestically and have significant recurring revenue. Utilities have similar revenue characteristics but the historical relative valuation is comparatively more attractive for Real Estate. Industrials and Financials are both pro-cyclical so a slowing economy represents a challenge to companies in both sectors. However, Financials has the added headwind of falling interest rates, which will squeeze net interest margins for banks.

10. Themes: America First. Global economic growth is slowing but the US is comparatively better positioned than most other regions. The consumer accounts for 70% of the US economy, the unemployment rate stands at 3.6% (the lowest rate in 50 years), wages are rising, households have been deleveraging for a decade, and consumer confidence remains strong. Pandemic risk is real and our basket of firms that are domestically-oriented (GSTHAINT, median stock has 100% US sales) will likely outperform companies with a high share of foreign sales (GSTHINTL, 30% US sales).

11. Election implications. Prediction markets continue to suggest the most probable election outcome is a divided federal government. Our earnings scenarios presented above assume the current statutory corporate tax rate remains unchanged at 26% with the effective rate at 19%. However, if corporate tax reform is reversed, the 2021 effective tax rate would climb by 800 bp and the impact on S&P 500 profits would be significant. A rise in uncertainty would also result in lower equity valuations. History shows that US presidential re-election probabilities are highly dependent on 2Q US GDP growth. If COVID-19 becomes widespread and leads to a slowdown in US growth or a recession, it could alter current expected election outcomes.

The outbreak of COVID-19 in South Korea has just hit another unfortunate milestone: For the first time on Thursday, new cases in the tiny East Asian country of just 25 million surpassed new cases in China.

While few trust the Chinese numbers, the message is still clear: the global outbreak’s center of gravity is moving from Wuhan over to Daegu, and that the global spread of the virus is accelerating, putting governments and epidemiologists on edge.

On Thursday, South Korea confirmed 505 new cases, compared with 433 in China, according to China’s NHC.

Across South Korea, total cases have hit 1,766 in the 38 days since the first case was confirmed on Jan. 20. Of these, 1,132 are from Daegu, 345 from neighboring North Gyeongsang Province, and another 56 are from Seoul. A total of 13 have died.

More broadly, this week marked the first time where new cases outside China surpassed those in China. The rapid surge in cases in Daegu and elsewhere made South Korea home to the biggest cluster of cases outside the mainland as it surpassed the “Diamond Princess’s” infection total earlier this week.

So far, most of the cases have been connected to the Shincheonji Church of Jesus and its branch in Daegu, a city in the southeastern area of South Korea.

South Korean President Moon Jae-in promised to avoid the draconian crackdowns utilized by China, even as the WHO praised Beijing’s heavy handed tactics. But as the virus spreads and hysteria takes hold, with the US and South Korea cancelling military exercises for the time being, who knows what lengths the government will go to prevent the outbreak from spiraling out of control.

While nobody, absolutely nobody, cares about what happened to the US economy in the end of 2019 now that everything has changed in the first quarter of 2020 when China’s GDP is now expected to print negative, crushing global economic growth and slamming US GDP as well, moments ago the BEA reported its second estimate for Q4 2019 US GDP, and at least here there was no surprises, the number coming in unchanged vs the 1st esimtate at 2.1%, and in line with expectations.

Similar to last month, the increase in real GDP reflected increases in consumer spending, government spending, exports, and housing investment, which were partially offset by decreases in inventory investment and business investment. Imports, a subtraction in the calculation of GDP, decreased as the US imported far less goods and services. The increase in consumer spending reflected increases in goods (led by motor vehicles and parts) and services (led by health care). The increase in government spending reflected increases in both federal as well as state and local government.

The decrease in inventory investment reflected a decrease in retail trade inventories (led by motor vehicle dealers). The decrease in business investment reflected a decrease in equipment (led by industrial equipment) and structures (led by mining exploration, shafts, and wells).

Looking at the variances between the 1st and 2nd revision, these primarily reflected an upward revision to inventory investment that was offset by a downward revision to business investment.

• Personal Consumption contributed 1.17% to the bottom line GDP print, down modestly from 1.20% in the first estimate. On an annualized basis, Personal Consumption rose at a 1.7% rate, in line with expectations.
• Fixed Investment was revised lower, from 0.01% to -0.09%
• Changes in private Inventories subtracted -0.98%, slightly less than the -1.09% last month
• Net trade added 1.53%, just above the 1.49% reported last month, and contributing roughly 75% of the bottom line GDP, most of it on the back of the plunge in imports.
• Government consumption was basically flat at 0.46% vs 0.47% reported in the first reading.

The Fed got further leeway to cut rates when core PCE q/q rose 1.2% in 4Q after rising 2.1% prior quarter, and below the 1.3% estimate. Overall, the GDP price index rose 1.3% in 4Q after rising 1.8% prior quarter.

Looking at the full year data, for 2019, real GDP increased 2.3 percent, compared with 2.9 percent in 2018.

Increases in consumer spending, government spending, business investment, and inventory investment were partially offset by a decrease in housing investment and an increase in imports.

Prices of goods and services purchased by U.S. residents increased 1.5 percent in 2019, compared with an increase of 2.4 percent in 2018. Excluding food and energy, prices increased 1.7 percent after increasing 2.3 percent.

Overall, an unremarkable print, and largely meaningless now that everything has changed due to the coronavirus pandemic.

Following December’s surprise jump, Durable Goods Orders were expected to slide in January, and preliminary data shows they did but only -0.2% MoM (considerably better than the -1.4% expectation).

However, durable goods orders are still down 2.3% YoY – in contraction for 8 of the last 9 months…

Source: Bloomberg

Durable Goods Orders (ex-Transport) surged 0.9% MoM (much better than expected 0.2%), but YoY remains in contraction…

Source: Bloomberg

Additionally, core capital goods orders, which exclude aircraft and military hardware, jumped 1.1% after a 0.5% decline the prior month that was less than initially estimated

The headline durable-goods figure was depressed by the volatile transportation category, reflecting weak bookings for motor vehicles. One surprise was a surge in orders of civilian aircraft and parts, considering Boeing Co. on Feb. 11 said it received no aircraft orders in January.

Defense capital- goods orders dropped 39.8% after an 87.4% surge in December.

Of course, none of this matters as it prints before the virus impact.

Authored by Lance Roberts via RealInvestmentAdvice.com,

Over the last couple of months, there was a slight uptick in the economic data, which lifted hopes that a “global reflation” event was underway. 

As we have been warning for the last couple of months in our weekly newsletter, the ongoing collapse in commodity prices suggested a problem was emerging that trailing “sentiment” data was clearly overlooking. To wit:

“There are a few indicators which, by their very nature, should be signaling a surge in economic activity if there was indeed going to be one. Copper, energy prices, commodities in general, and the Baltic Dry index, should all be rising if economic activity is indeed beginning to recover. 

Not surprisingly, as the “trade deal” was agreed to, we DID see a pickup in commodity prices, which was reflected in the stronger economic reports as of late. However, while the media is crowing that “reflation is on the horizon,” the commodity complex is suggesting that whatever bump there was from the “trade deal,” is now over.”

Importantly, that decline happened BEFORE the “Coronavirus,” which suggests the virus will only worsen the potential impact.

I want to reiterate an important point.

The risk to the market, and the economy, is not “sick people.” It is the shutdown of the global supply chain.

China is a substantially larger portion, and economically more important, than it was in 2003 when SARS hit. As noted by Johnson & Palmer of Foreign Policy:

“China itself is a much more crucial player in the global economy than it was at the time of SARS, or severe acute respiratory syndrome, in 2003. It occupies a central place in many supply chains used by other manufacturing countries—including pharmaceuticals, with China home to 13 percent of facilities that make ingredients for U.S. drugs—and is a voracious buyer of raw materials and other commodities, including oil, natural gas, and soybeans. That means that any economic hiccups for China this year—coming on the heels of its worst economic performance in 30 years—will have a bigger impact on the rest of the world than during past crises.

That is particularly true given the epicenter of the outbreak: Wuhan, which is now under effective quarantine, is a riverine and rail transportation hub that is a key node in shipping bulky commodities between China’s coast and its interior.

But it isn’t just China. It is also hitting two other economically important countries: Japan and South Korea, which will further stall exports and imports to the U.S. 

Given that U.S. exporters have already been under pressure from the impact of the “trade war,” the current outbreak could lead to further deterioration of exports to and from China, South Korea, and Japan. This is not inconsequential as exports make up about 40% of corporate profits in the U.S. With economic growth already struggling to maintain 2% growth currently, the virus could shave between 1-1.5% off that number. 

With our Economic Output Composite Indicator (EOCI) already at levels which has previously denoted recessions, the “timing” of the virus could have more serious consequences than currently expected by overzealous market investors. 

(The EOCI is comprised of the Fed Regional Surveys, CFNAI, Chicago PMI, NFIB, LEI, and ISM Composites. The indicator is a broad measure of hard and soft data of the U.S. economy)

Given the current level of the index as compared to the 6-Month rate of change of the Leading Economic Index, there is a rising risk a recessionary drag within the next 6-months. 

This is what the collapsing yield curve is already confirming as the 10-year plunged to the lowest levels on record. Currently, 60% of the yields we track have now inverted. 

Outside of the indicators we track, Eric Hickman previously made similar observations:

“The long history (49+ years) of these indicators can be used to get a sense of timing for when a recession may begin. I have measured historically how long these indicators signaled before (or after) the start of their accompanying recession. Comparing this time-frame to when these indicators triggered recently, suggests a range for when this recession may come. The chart below shows the time ranges (minimum amount of time historically to maximum amount of time historically) in which each indicator would suggest a recession start.”

“There are a few conclusions to this. First, five recession indicators have signaled. Second, there is nothing unusual in the timing that the recession hasn’t started yet. Third, no matter which of the five indicators you use, a recession will likely begin in 2020 and the average center-point of the indicators is in March, just a little over two months away. Don’t confuse the Fed’s ‘on-hold’ stance to have any more meaning than the hope that the consumer and labor market’s strength will continue. History suggests that this is not a good bet to make.”

The problem with most of the current analysis, which suggests a “no recession” scenario, is based heavily on lagging economic data which is highly subject to negative revisions. The stock market, however, is a strong leading indicator of investor expectations of growth over the next 12-months. Historically, stock market returns are typically favorable until about 6-months prior to the start of a recession.

The compilation of the data all suggests the risk of recession is markedly higher than what the media currently suggests. Yields and commodities are suggesting something quite different.