I want to present two sides of the argument that equities are putting in a bottom. I think there’s no doubt that equities are trying to put in a bottom, simply because equity markets are deeply oversold after the massive downdraft in shares. But, at the same time, the question goes to how much of the coronavirus situation is already ‘priced in’. Just because we are seeing a near-term bottoming doesn’t mean there isn’t another leg down here.
The case for bottoming
As I write this, futures markets for US shares show expected gains of well over 2% when US markets open at 9:30AM EDT. This comes after a day when all three major US indices closed in the green, but not excessively so, as they have done in previous snapback rallies. And European equity markets are all well into the green today, following a stellar trading session in Asia.
It looks to me like we are seeing a near-term bottoming process, with the first (and perhaps) final wave of selling over. This comes after a massive spate of news on the fiscal and monetary stimulus front. The idea, then, is that, while policy makers arrived late in their response, they came with guns blazing and that has changed the psychology of the market, which was hurtling into a financial crisis.
Moreover, if you look at how equity markets have responded as they ticked up recently, there has been outperformance on names that you should think would outperform. The Nasdaq has outperformed the S&P500 and tech names like Amazon, which are more leveraged to the virtual world have outperformed the Nasdaq as a whole. If shares are bottoming, then, perhaps this outperformance is suggestive of investors bidding up shares where where the most future upside potential is available.
Finally, while shares were rallying yesterday, Treasury bond prices fell and Treasury yields rose. As of yesterday:
The $16.9 billion iShares 20+ Year Treasury Bond ETF, ticker TLT, has slumped more than 15% since March 9. That’s sent it to a 1.7% discount to its net asset value on Wednesday — a chunky gap for a fund that historically has barely budged from the price of its underlying debt.
The Treasury curve is now fully upward-sloping from 3 months to 30 years. The 2-year Treasury is more than 30 basis points higher than the 3 month Treasury. That is consistent with a situation where, after a brief but severe recession, policy normalizes over time, perhaps as soon as two years down the line.
The case for bottoming then is one where the economy takes some massive hits and we experience a recession, but where all of that is priced into the rapid 30%+ decline in shares. And with a policy stimulus safety net in place, we can be assured that the worst for the markets is behind us.
The case for more to come
I am sceptical of this scenario for a number of reasons. First, from a macro level, built into it is a best case economic outcome assumption. It’s one where we experience a V-like U-shaped recovery, if you will – one where the recessionary drop is steep but not long lasting. Second, it also assumes that even in this scenario, a 30% decline is enough of a discount to mean this best case outcome is priced in.
When I discussed this bottoming yesterday on Real Vision’s Daily Briefing, my colleague Roger Hirst noted that bear bottoms do not tend to have previous market leaders outperforming on the way up. For example, as the 1990s tech bubble burst and bottomed, it wasn’t the tech darlings who rose from the ashes most. They languished as old economy companies recovered first. It could be that this is just an intermediate bottom, with more selling waves to come.
As I write this, Treasury yields are plummeting and the same is true for government bond yields right across the developed world. The UK 10-year is down 14.4 basis points. The Italian, now ECB-backstopped, is down 17.3. The Swiss is down 14.3. And the US one is down a relatively paltry 11.9 basis points by comparison.
If the bottom is in, why are government bonds rallying? Isn’t that suggestive of a continued dash for safe haven assets?
Look at the corporate bond space as well, for example. Bloomberg’s Lisa Abramowicz noted this morning that “US junk bonds keep getting pummeled, with March’s losses of 16.5% poised to be the worst monthly decline on record. The entire $1 trillion market is being treated as if it were close to default, with average spreads now less than 25bps away from being considered distressed.” That doesn’t sound like a bottoming.
Investors have yanked money out of high yield funds for the fifth week in a row. And investors have pulled a record $5.3 billion out of high-yield municipal bond funds too. Investors even pulled $35.5 billion out of investment-grade bond funds in the week to Wednesday, an all-time record by a 3 to 4 times order of magnitude. And the Bloomberg article I quoted above in the case for bottoming also notes:
That pain has spread to investment-grade corporate bonds, with the $28.2 billion iShares iBoxx $ Investment Grade Corporate Bond ETF, ticker LQD, dropping 15.7% in the past week and a half.
My view
I look at this from a real economy perspective first. For example, Goldman Sachs is projecting that jobless claims for this week through Saturday will rise to 2.25 million, that’s up from 281,000 last week and more than triple the record. JPMorgan Chase sees -4% annualized for US GDP in Q1 and another -14% annualized drop in Q2. That gives you a sense of the scale of this.
Share prices reflect a longer-term view of how the real economy is likely to do. And I think that the real economy will fare poorly over the medium-term. 30% down for equities is just about right for a middling or garden variety downturn. A severe downturn, like the one I think we’re in is more likely to see shares fall further. And a Depression would see shares fall further still.
On a different note, I was doing a social distancing walk through the neighborhood with my wife yesterday. That’s where you walk around town and say hi to people in the neighborhood, but all make sure to keep your distance from one another. We ran into a neighbor who’s daughter used to be a classmate of our son. And she told us that she had dumped her equity positions and moved to cash to hide out because she couldn’t take the news flow anymore.
How common has that been in this bear market? Money market funds gained a massive $249 billion of inflow in the week to Wednesday. So, I think it is fairly common. This is exactly what you expect to happen before the bottom is in. You need to shake out the ‘weak hands’ so to speak.
In the previous market upturn, especially with the rise of index funds, retail investors have been told to ride out market downturns and buy the dip. That’s been a stabilizing force that has prevented downside volatility. But, at some point, the market will fall so much and the situation will be so volatile that ‘weak hands’ throw in the towel. And then, that will precipitate a secondary and tertiary wave of selling. Is that what’s already happened or is it what awaits us going forward? I don’t know. But I think it’s a key question to answer in assessing whether the bottom is in.
There is considerably more negative economic news flow to come. And I am starting to re-consider my view that lockdown will remain in place until the coast is reasonably clear. The economic pain may get so severe that we see lockdowns reversed just to gain a sense of economic normalcy. But that’s much further down the line. In the next few weeks, the news will be about the exponential rise in coronavirus infections and deaths and the measures needed to arrest that trend.