Can Covid-19 derail the biggest source of equities demand?
Sentiment.
The sentiment in investment markets of late is being driven by the perception of a large (but difficult to quantify) hit to corporate earnings. This time, from Covid-19.
The VIX (or the fear index) went a little berserk last week, reaching its highest level in 8 years. On Friday it closed at 40.1, roughly halfway up to its GFC peak.
U.S. equities have been belted significantly in 3 of the last 5 sessions.
Here’s a few price movements about 3 hours into last Tuesday’s trading session.
Much press has been written about the hundreds of billions wiped off various equities exchanges last week, so I won’t rehash that here.
Whilst it’s clear that negative news flow from Covid-19 has been a catalyst for the market correction (which might still continue), it’s not the only reason. There are others.
Investment thesis for equities.
QE has inflated central bank balance sheets (Fed, ECB, BOJ, & PBOC) by around 300% since immediately before the GFC.
This expansion and flow on effect through the trading banks, plus interest rate cuts (some now negative, which I have often written about) has provided an almost endless amount of investment capital for equities.
My proposition continues to be that until interest rates and central bank balance sheets are normalised, money by default will continue to flow into equities to earn returns not seemingly available elsewhere.
What’s interesting though, is that social and economic disruptions from Covid-19 including social distancing, quarantines and perceptions of worker shortages, etc., together with hindsight of the late-2002 to mid-2004 SARS pandemic, are casting enough doubt to weigh on earnings and c-suite sentiment.
Last week you would have seen a myriad of companies around the world lowering their 2020 earnings guidance.
This panic and fear is understandably more pronounced than during the SARS outbreak because China now makes up a significantly higher share of global GDP.
China is of course a major manufacturer, but much of its basic inputs are sourced through complex offshore supply chains, including countries in respect of which the virus has spread.
Covid-19’s war on QE likely to be fought in the buy-back arena.
Major central bank QE programs have increased the volume and deflated the value of money. When almost free and definitely easy money is around, the cost of capital falls and share buy-backs are a no-brainer.
The U.S. corporate tax cuts of 2017 (when 35% became 21%) plus the cash repatriation amnesty sidecar, left even more money in companies to undertake buy-backs - which has been all the craze since QE started immediately following the GFC.
Late last year Goldman Sachs released some research on net US equity demand (see below).
What the chart is saying is that for the past 4 years, Corporations through share repurchases and buy-backs have been by far the largest net buyer of equities - fueled of course by QE.
Households have ridden those share price gains, whereas funds and hedgies have ridden (long and short), cashed in and churned into the next deal.
In 2017, the domestic c-suite bought roughly the same amount of equities as foreign investors and households together – whereas in 2019 they bought (net) 3 times more than households.
Effectively, most of the QE rocket fuel has been utilised by the c-suite and tipped into their own companies (and incentive bonus/share schemes).
Could this key source of equities demand fall away if the virus becomes a pandemic?
Perhaps that’s what the market is thinking.
That is, what if the c-suite decides to keep a cash buffer to cushion the real and perceived effects of Covid-19 on labour shortages and overall demand and trade, i.e., earnings – and forego or curtail bay-backs?
Could this also be a signal that the market questions the meaningfulness of the phase one trade deal and/or thinks that maybe there’s something to Bernie Sanders’ campaign?
Two or more of these factors acting together could be enough to convince the c-suite to pullback the buyback – and households to run for the survival shelters with baked bean cans stacked to the roof.
If that occurs, we can expect a full funk market recalibration.
However, on the other hand, once signs of the outbreak start to turn positive (and there is no telling when) and assuming interest rates are still low at the time and the central bank balance sheets are as large as they are now, if not larger; buybacks are likely to start up again, given the lower share prices under that scenario will make buybacks even more attractive.
The pendulum never really stops swinging.
China, Japan and the U.S., stand ready to inject more shots of liquidity into the market, whereas the EU needs to start thinking about fiscal measures.
But this will be extremely difficult as populism continues to spread. Given the make-up of the German ruling triad and the yellow vest issues Macron is having in France, an agreed ‘austerity’ is unlikely to happen.
And, what of Mario Draghi’s so-called fiscal instrument to take some of the weight off monetary policy, in the event of another crisis?
Silence. But his successor, Lagarde, needs better ammunition – asking Germany to spend hard in Germany is unlikely to help other countries because there is a lack of fiscal integration amongst the trade bloc.
Most likely monetary policy is the only weapon the ECB will be able to default to, even though negative interest rates are making it harder to justify pulling that lever. Politics usually wins.
Is the likely default solution part of the ongoing problem?
Recent comments from the IMF indicate global growth forecasts are likely to be revised down, as a result of Covid-19.
Recent metrics out of China suggest that last year China grew at just over 6%, making it the slowest rate in nearly 30 years.
Bad timing to say the least.
Many other countries are suffering from China’s slowing growth, and recent shutdowns in several regional markets due to health concerns are evident.
The solution? China has said it will use special loans to small and medium banks and conduct open market operations, standing loan facilities, and medium-term loan facilities to boost liquidity to combat the economic drag from Covid-19. This perked up Chinese markets last Thursday.
Recent comments from US Fed Chair Jerome Powell indicate that he is reasonably happy with the level of interest rates:
"However, the coronavirus poses evolving risks to economic activity. The Federal Reserve is closely monitoring developments and their implications for the economic outlook. We will use our tools and act as appropriate to support the economy."
Maybe that’s why there was a bounce in U.S. equities in extended trading after the bell on Friday. Expectation of lower rates, again, or was it the U.S. deal with the Taliban to withdraw troops from Afghanistan?
But, are these measures a good thing, or are they a way to kick a larger can further down funky money road?
So, the question becomes whether Covid-19 (with some help from an unfinished trade war) can significantly curtail the main source of US equities demand, or, will likely interest rate cut responses win out?
Furthermore, what about all of the unlisted companies looking to IPO? Potentially they have the luxury of remaining unquoted and riding out the dip. In some ways, unlisted equity may provide a level of defensiveness during this dip.
Some final thoughts.
Attribution: Market Watch.
What really happened in the market when SARS broke out in November 2002? Understandable panic.
Economically, I lived through it, even with several deals in the market at the time.
But with most of these outbreaks, the first month is ugly, and you will notice that generally and on balance, the market performs well in the months after.
By 2003, and even whilst SARS cases were still being announced, market returns (refer chart above) were around 21% over that 6 month period. Markets, other than for in Asia, didn’t even feel the Avian Bird Flu and the Swine Flu was muffled.
The six year bull market only stopped for around 6 months due to sub-prime in 2008, and then continued on to create the longest bull market in modern history - a double up on the pre-GFC peak - courtesy of, you guessed it, QE!
The market performed poorly six months after an outbreak in only three of the charted cases, namely in the immediate aftermath of AIDS, Ebola and the Pneumonic Plague. Zika was nearly neutral.
That said, history is not always a good predictor of the future and the above reactions may or may not repeat if Covid-19 is far more severe than the charted outbreaks.
Yes, valuations are high and the market has been looking for an excuse to recalibrate. Perhaps Covid-19 is it, and whilst it looks nastier than previous CoVs and the Chinese economy is more prominent than it once was, history is still being written for Covid-19.
The c-suite is watching. And so too are politicians and central bankers, with jawboning tweets, interest rate scalpels (and potentially money printing presses) at the ready.
Mike.
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