Equity markets ended last week with a positive tone by rallying into the close. And this is despite some ambiguous words of support from Fed officials on Friday. The fact that equities rallied, ostensibly on the prospect of monetary support, tells you that conditions were oversold. And this morning, soothing words from the Bank of Japan have had a similar impact, changing a negative tone into a mixed one as we start the week.
A relief rally is probably the best we can hope for at this juncture. Bond yields are still plummeting, showing both risk-off sentiment and an expectation that monetary easing is coming For example, the market is now pricing in with near 100% conviction a 50 basis point cut by the Fed later this month. The Fed had better deliver or we may see panic as traders realize the Fed won’t be there to bail them out.
As I write this, the US 10-year Treasury is trading with a yield just under 1.07%. The curve has the 3-month at 1.155%, sloping down to 2-years now, instead of 3, at 0.765%. The 3-year is trading just above that at 0.769%, with the curve sloping up to the 30 at 1.631%. The biggest bogeys to watch are 1.00% for the 10-year and 1.50% for the 30-year, both within striking distance.
I still see the steep inversion at the front end as reflective more of the Fed’s cutting than of a recession, particularly as that inversion has shortened from the three-year Treasury to the two-year. But, we are still in at a deficit for information. And the tone might change if the data worsen.
The data everyone is most concerned with now are the infection and death rate count of the Covid-19 outbreak. The recognition that this is a global outbreak is pretty much universal now. The question is how bad it gets and what sort of impact does it have on the economy. We saw horrific PMI numbers out of China at the weekend. The manufacturing PMI was 35.7 for February, a record low below the 38.8 in the 2008 financial crisis. The services PMI was even worse at 29.6. So, that gives us a sense of how far things can drop.
With the Chinese now attempting to return to normalcy though, the emphasis is on how well they can achieve that and whether there is pent-up demand that makes the return more of a U- and less of an L-shaped recovery. To the degree this goes well in China, it will have a positive impact on market tone, even if infection rates and death counts rise exponentially outside of China – as it sets the bar for how long this outbreak can last.
The sense I get now is that the under-preparedness in the US is pretty severe. The cases of Covid-19 in Washington state point to a virus that has been circulating freely for at least two or three weeks without being detected. And the percentage of people actually tested in the US is far below what we see in Europe or Asia. Likely, we are going to see a massive increase in infections in the US. And that means school closures, large spectator event cancellations and the like. It will also mean some lockdowns and a lack of travel. How much this impacts the economy remains to be seen, of course.
Overall though, I am of the wait and see mindset. I am not going to jump to conclusions about worst case outcomes, either for markets or for the economy. Right now, I feel we have some room for relief. But when the actual virus data start to deteriorate, we will get another leg down in equities and bond yields.
How does that impact the Democratic Presidential Primaries? Will voter turnout be affected? Do people want to go to Trump rallies and risk getting infected? How will voter sentiment be impacted by news flow related to this epidemic? All of these are relevant questions. In general,
I tend to think the virus and concomitant negative impact on the economy is bad news for Trump. And that’s because many voters are ‘holding their nose’ in support of him because of the economy. If that talking point goes away, his position is weakened. And recent comments by Trump and his surrogates blaming the media and Democrats for fanning the flames of fear suggest he understands this.
Ultimately, Trump will judged on outcomes irrespective of how he tries to position events. A declining economy and poor preparedness hurt him.
We are through the first wave of market turmoil now. And the mood feels a bit more stable as we begin the week. My sense is that people are waiting for the other show to drop and for a huge coordinated response if it does. Until either of those things happen, we’re in a bit of a wait and see phase, with most of the risk to the downside for risk assets and to the upside for safe assets. Only if it becomes clear that a global recession is unavoidable do I think we move from market correction and volatility to generalized bear market and panic.