Month: March 2020

Submitted by Peter Garnry, Head of Equity Strategy, Saxo Bank

Summary:

The energy sector has lost extraordinarily $1.15trn in market value this year as oil prices have plunged to almost unimaginable levels.

In this equity update we provide investors with different ways to play the havoc in the energy sector. We also take a look at earnings this week with especially Carnival earnings being the most interesting to watch as the cruise industry is in a severe crisis due to COVID-19.

Lastly, we focus on consumer credit and the apparent weakness observed in China and how that could be a forewarning of what to come in the US and Europe. As a result we recommend investors to add Mastercard and American Express to their watchlists.

The global energy sector has been punched in the gut by first a slowing economy last year and then this year by an oil price war between Russia and Saudi Arabia. Making things worst the sector is now experiencing an abrupt 20% oil demand reduction equivalent to 20mn barrels a day or the entire consumption of the US. The oil futures curve is in steep contango as the active contract in Brent today went below $23/brl and stories have recently surfaced that physical oil is being transacted at $8/brl and oil storage is running out of capacity. As we talked about on our Market Call this morning the constraint on physical storage and ongoing demand destruction could push the front-end of oil futures down even further.

The current oil price creates extreme shareholder destruction with the MSCI World Energy Index losing $1.15trn in market value this year.

High yield bonds in the energy sector have seen their option adjusted yield spread to Treasuries widen to the highest levels on record and implied default probabilities are rising fast. But how should investors play the energy sector from here? One way is to buy call options on ETFs tracking the US or European oil and gas industry preferably with expiry during the second half. Another option is to get long-term exposure through single stock but here we recommend opting for only the highest quality names (see table below). The most risky strategy is to buy into those names that have the highest bankruptcy risk when the market rebounds, but here we recommend traders to apply some short-term filter (moving average or the like) to get confirmation during the rebound phase.

This week many Chinese companies will report earnings such as Geely Automobile and Air China, but also outside China interesting names such as Dollarama, Carnival, Walgreens Boots Alliance, CarMax, H&M and Constellation Brands will report earnings hopefully providing a picture of the demand situation in the US and Europe as these geographies are impacted by strict lockdowns due to COVID-19. With Carnival shares down 75% from this year’s peak in January and the trouble regarding many cruises during the last two months related to infected passengers with COVID-19 there will be a lot of focus on Carnival’s earnings. The main question is whether the cruise industry can stage a comeback and survive this serious threat to the industry.

In past couple of weeks we have highlighted many times on our Market Call podcast that investors and traders should watch oil, USD and VIX for guidance on market temperature. We have had focus on credit as well but with central banks stepping in the bleeding has stopped for now, but in other parts of the credit market outside corporate bonds there are now cracks happening.

Especially consumer credit in China is weaker as the weaker employment is spilling into repayment ability and is likely an indicator of what is coming for the US and Europe. So we recommend investors to put Mastercard and American Express on their watchlists.

In China loans to households have risen by 22% annualised and our worry is that at some point this credit expansion will lead to an abrupt halt like we saw in 2008 in the developed world.

Neel Kashkari, famous for coming out several days ago and giving one of the most bizarre 60 Minutes interviews of all time (an interview in which he claimed that the Fed had “infinite” cash) is now out giving life-lessons about when and how the American people should be worrying about moral hazard.

In an op-ed written late last week in the Washington Post, Kashkari made his argument that throwing as much money at the problem as possible, even if we don’t have a complete understanding of where that newly-printed cash is going, is the solution.

In other words, we’ve got the cash and so now, we can be the moral authority as well.

Kashkari stated: “If there is a principle policy makers need to keep in mind going forward, it’s this: Err on the side of helping as many workers and businesses as possible rather than on prudence. This is not the time to worry about moral hazard or whether people are incentivized not to work.”

He continued: “When the Covid-19 crisis is behind us, if our biggest complaint is that some workers and small businesses got help when they didn’t really need it, that would be a wonderful outcome for our country.”

Kashkari seemed to make the argument that since the Fed was already printing unlimited amounts of cash, they might as well use it to shore up as many liabilities that existed prior to the crisis anyway: “Policy makers should use the full authority Congress grants to immediately make sure that states have the health-care resources and equipment they need, that businesses have the wherewithal to preserve their staffs, and that individuals and families can make ends meet until the virus is contained”

“The highest priorities must be to enable the health-care system to catch up and control the spread of the virus — and to maximize the number of jobs saved. It is far better to spend taxpayer money to help small businesses retain their workers than to spend the same money helping workers after they’ve been laid off,” he continued.

Recall, during Kashkari’s 60 Minutes interview a week ago, Kashkari, when asked if the Fed would just “literally print money”, admitted: 

“That’s literally what congress has told us to do. That’s the authority they have given us, to print money and provide liquidity into the financial system. We create it electronically and we can also print it, with the Treasury Department, so you can get money out of your ATMs.”

Kashkari’s God complex continued when he was asked: “Can you characterize everything the Fed has done this past week as essentially flooding the system with money?” 

To which Kashkari responded simply: “Yes. There’s no end to our ability to do that.”

Gov. Andrew Cuomo is delivering his latest press briefing…NY’s case count has climbed by 6,894 cases to 66,497…

At the Javits Center in New York City giving a briefing on #Coronavirus. WATCH: https://t.co/Zx7b6P8wag

— Andrew Cuomo (@NYGovCuomo) March 30, 2020

Submitted by Nick Colas of DataTrek Research

While Donald Rumsfeld may not be one’s go-to guy for decision making paradigms, his 2002 mention of “unknown unknowns” is worth considering just now as an investment framework. The idea here is that we all make judgments based on a tripartite spectrum of available information. Specifically:

Known knowns (entirely baked into asset prices):

• COVID-19 both spreads easily and is sufficiently harmful to require countries to limit economic activity dramatically in order to contain the virus before it overwhelms their health care systems.

• Policymakers have responded by providing large scale fiscal and monetary stimulus in the hopes of tiding over economies during the worst of the outbreak.

• Medical researchers are working on improved therapeutic treatments as well as vaccines. Testing is becoming faster and more widespread.

Known unknowns (partially baked into asset prices):

• The exact duration of national lockdowns around the world and their impact on labor markets.

• The pace of economic recovery once the immediate danger has passed/possibility of reinfection during a restart.

• The size and timing of further fiscal/monetary stimulus (NY Governor Cuomo highlighted this in his press briefing today with respect to state budgets, an important source of US fiscal spending).

Unknown unknowns (not in asset prices and near-impossible to assess today):

• Inflation rates over the next 1-3 years, a push-pull of fiscal/monetary stimulus and uncertain consumer/business confidence.

• Any change of personal/corporate tax rates to stabilize government deficits (both at national and state levels).

• The political implications of COVID-19 on the November US general election. Worth noting: President Trump’s latest Gallup approval rating out on March 24th were the highest of his presidency and may have helped boost stock prices last week.

• The effect of exploding deficit spending around the world on the cost of capital.

• How emerging market economies with large dollar-denominated debts will handle a slow global economic recovery or how the European banking system will deal with a sharp recession in its most vulnerable countries.

• Just as the Great Recession did lasting damage to younger job seekers, will the current global downturn affect those finishing/just out of college right now?

You probably have many other “unknown unknowns” you could add to this list, but that’s exactly the point when considering how well US equities have held up; the S&P 500 at 2541 implies:

• No structural damage to US large cap earnings power. We’re trading at 20x the trailing 10-year average S&P earnings of $122/share, not the 10x we saw in 2009.

• Confidence that visibility into that $122/share earnings run rate will be there in November 2020 (near term equity prices tend to lever off 6-month forward economic/profit conditions).

• That the CBOE VIX Index over 60, even on large up days, is only a sign of near-term potential volatility rather than a sign equity prices are fundamentally wrong.

• That markets will continue to ignore bad economic news or disappointing corporate profit reports because either they are temporary or they will spur further monetary/fiscal stimulus.

As for how this is playing out in our 2008 Playbook construct, once again using September 29th 2008 and March 9th 2020 as starting points (the first +5% “crash day” move in each sequence):

#1: Because policymakers now both “own” the COVID-19 Crisis (unlike Q4 2008 when there was a US election pending) and learned from 2008 to go big/early (both in fiscal and monetary policy), the damage to the S&P 500 has not been as bad in 2020 as it was in 2008:

• The index is down 7.5% from September 29th, 2020.

• In 2008, the S&P was 15.0% lower on October 17th from September 29th, the same number of trading days as we’re including in the prior point.

#2: From this point in 2008, for the next 19 trading sessions the S&P 500 was in a very broad band but went essentially nowhere.

• The index closed at 940 on Friday, October 17th 2008.

• 19 trading days later, the S&P closed at 911, down 3.1% from that 940 level. In between October 17th and November 13th the index had an +11% day (October 28th) and four +5% decline days (October 22, post-election November 5/6, and November 12).

#3: The real crack for US stocks in 2008 came right after this waiting period, happened very suddenly, but bounced back relatively quickly:

• After holding the 900 level, the S&P went to 752 in just 5 trading sessions (November 14th to November 20th), a 17.5% decline. The headlines at the time centered on which financial institutions/auto makers would receive TARP funding, and how much.

• The S&P then came roaring back over the last 27 trading days of 2008 and closed at 903 with just one +5% crash day (-8.9% on December 1st).

This experience is emblematic of how markets behave when “unknown unknowns” shove their way into asset prices, and it continues to serve as our template for what to expect now. Specifically:

• Markets think they have a solid handle on the known knowns and the known unknowns. That should make for a period of notionally stability, even if the day-to-day price action feels otherwise.

• When economic events outrun policymaker’s responses, however, there is a sharp (18% in 2008) decline that doesn’t last long but creates an investable crisis low.

• Yes, the S&P did not really bottom until March 9th 2009 but you would not have wanted to sell at that 752 low on November 20th given the sharp bounce back through year end.

Bottom line: the 2008 playbook says we should see volatile but generally sideways US equity price action this week and next. Should there be a sudden shock from an unknown unknown that creates a +15% decline (2100 on the S&P, in round numbers), that would also fit with the 2008 playbook. Buying that new low would feel awful, but it would also be a signal to policymakers that they will need to take further steps. In the end, that’s why we lean on the 2008 playbook so much: in periods of crisis capital markets drive policy response.

Perhaps the only major non-coronavirus story to briefly grab international headlines over the weekend was North Korea’s firing off of two short-range ballistic missiles into the Sea of Japan. “The missiles were fired from the port city of Wonsan, flying about 140 miles to the northeast before landing in waters between North Korea and Japan,” The New York Times reported of the Saturday launch.

It came a mere week after Kim Jong-Un received a letter from President Trump offering to assist in the fight against the coronavirus pandemic.

Pyongyang officials confirmed the launches Monday, described as a test of a new “super-large multiple rocket launcher” which state media reported as going off without a hitch.

Official state news agency KCNA said the test was overseen by governing party vice chairman Ri Pyong Chol, suggesting that Kim did not personally attend the launch.

“The operational deployment of the weapon system of super-large multiple rocket launchers is a crucial work of very great significance in realising the party’s new strategic intention for national defence,” Ri was quoted as saying during the test. “The test-fire was conducted successfully,” KCNA said.

It’s the sixth such short- and mid-range missile test within the past month, after a three-month respite from testing which went from late November to early March.

The resumption of testing has provoked anger from South Korea, which slammed the drills as “deeply inappropriate” given the world is currently battling coronavirus pandemic. Leaders in Seoul said they had “urged the North to stop such acts immediately.”

#NorthKorea confirms test launch of “super-large” MRLS

But seemingly without Kim Jong-un pic.twitter.com/oL4FFwbQqG

— Joseph Dempsey (@JosephHDempsey) March 29, 2020

South Korea’s government-funded Yonhap News Agency notes military officials are analyzing photographs of the launch:

The military is scrutinizing photos North Korean state media released earlier in the day of the super-large multiple rocket launcher tested Sunday as the system looks different from the North’s existing weapon of the same name, a JCS official said.

It looks more like the large-caliber multiple launch guided rocket system unveiled in August, he said.

One of the photos showed a projectile being fired from a system with six tubes, different from the four-tube system North has disclosed in its previous super-large multiple rocket launcher system test-firings.

“According to the photos released by North Korea this morning, (the rocket system tested Sunday) has similar characteristics with the one unveiled on Aug. 3 last year,” Joint Chiefs of Staff of the Republic of Korea spokesman Kim Joon-rak told a press briefing.

Pyongyang ramped up missile launches and testing this year after stalled de-nuclearization talks with Washington at the end of last year, after Washington insisted Kim must dismantle his nuclear capabilities before sanctions relief is on the table.