Can the China Coronavirus Cause a Global Recession? | The Big Conversation | Refinitiv
ROGER HIRST: Over the last week, across asset markets, prices started to decisively react to the current virus outbreak, bringing some major technical levels into play. What are those assets? What are those levels and what are their implications? That's the big conversation. In the last show, we looked at the moves in fixed income and bond markets and identified some key levels to watch on the S&P 500. Over the last few days, there have been some emphatic moves across all the asset classes. However, the PBoC, the People's Bank of China is injecting liquidity, kicking off with around about 130 billion dollars worth or equivalent of over the weekend in order to stabilize markets. Despite this, the Shanghai Composite opened 9 percent lower on Monday morning. Now, clearly, this situation is very, very fluid and the lockdowns are starting to have a significant impact on both supply and demand issues. Historically, these events have been transitory in their market impact, though there are concerns that a prolonged incident could have structural implications with potentially recessionary consequences. So what assets should we be monitoring for signs that global economies are deteriorating? Whilst many will not want to profit from pain, everyone still needs to protect their portfolios. So what are some most standout asset price moves? Well, first off, let's look at the currency markets. On the surface, when viewed by DXY, it looks like the US dollar was on the back foot at the end of last week. However, this index is heavily skewed towards the euro and that has disguised the bifurcation in price action. Safe haven currencies were rallying with the dollar/JPY pulling back from resistance. Yen strength is signified by falling line on this chart. Repatriation flows should be expected to accelerate if the outbreak builds momentum outside of China. The Swiss franc, the euro and the pound also made gains. The bigger moves, however, were in the emerging market and commodity currencies, many of which are testing key levels or have already started to break down. And it's not just in Asia, but it's also impacting many, many regions. The broad based JP Morgan Emerging Market Currency Index is retesting the lows. China's onshore currency reopened with a 1 per cent decline to test, but not decisively break its consolidation pattern. At least that was the case as of Monday when this was being filmed. And one of the first currency movers last week was the US dollar versus the Korean one, which is now breaking out of a short term consolidation pattern. Only a few days ago, it looked like this currency was significantly going to strengthen and break 1150, the neckline of a potential head and shoulders. And on this chart, the Korean Won is weakening when the line is rising. Now, the absolute level to watch for this is the super long term trend that dates back to the peak of the Asia crisis in the late 1990s. The Brazilian Real looks to be breaking the enormous cup and handle pattern that we’ve featured in previous shows. This is a bullish formation for the US dollar versus the Real. Arguably, it is breaking both short term and long term formations. The Aussie dollar is also breaking its lows, whilst the Canadian dollar is close to breaking through its four year resistance level and the South African rand is another commodity currency that has been under pressure, though none of these have as yet decisively broken down. Hence there on the watch list. In terms of equity prices, last week we identified two levels on the S&P. The first one, which should be considered a normal correction level, even if the virus outbreak was absent, was a level down 5 percent, roughly around 3160. The second level is one which the authorities may want to act more decisively, and that would be around the key support of 3030, just under 10 percent off the highs. And that is still some way off. Now, given the uncertainty, however, a relative trade may be preferable. With the move that we have seen in emerging market currencies, then emerging market equities should be coming under pressure, especially the MSCI emerging market index, which is priced in U.S. dollars and this has indeed been the case. The ratio of the S&P 500 versus the MSCI Emerging Market Index has had a significant move over the last three weeks. But is this a case of ‘horse already bolted’? Well, this comes back to each individual investor’s view, but I would certainly expect emerging market currencies to weaken further, the U.S. Federal Reserve to cut interest rates and potentially inject more liquidity if this outbreak continues to spread. And those would favour the U.S. equity market relative to emerging markets. And as a simple comparison of the potential, Cathay Pacific the airline, or largely airline company, fell nearly 30 percent during the SARS outbreak of 2003 over a very short period of time. As of Monday, Cathay had fallen nearly 18 percent peak to trough this year. It fell over 30 percent during last year's Hong Kong protests. In fact, some investors may already be thinking about when to catch the falling knife of assets, rather than considering whether this is still the right time to sell. Given the huge distortions to global economic supply and demand, it's perhaps no surprise the commodity markets have been some of the biggest movers. Both oil and copper have been under pressure, but the levels of real interest still lie ahead of us. West Texas Oil WTI front month future has a big support level around $51. If this breaks, then the focus will shift to the support in the low 40s, which is still some quite way down from here. But it forms the neckline of what could be a very large head and shoulders chart pattern. Although many think that the shuttering of huge swathes of China's industrial heartland would be an inflationary shock, commodity prices are suggesting that demand shock will be deflationary. And a knock on effect of lower oil prices could be pressure within the US high yield corporate bond market, where highly indebted oil companies are one of the largest sectors. Now this would be a bit more of a spread story, however, i.e. relative yields widening out because the absolute level of yields could fall if government bond yields continue to decline at their current pace. I think oil really needs to be breaking those lower boundaries to have a lasting effect, but the potential is there. Copper has followed a similar pattern to oil. The recent decline has left the US front month future close to testing what looks like another head and shoulders neckline. And a significant break of this level would target a price somewhere close to 180 versus current levels of around about 250 on that US front month future. Given those risks, it looks like the European basic resource sector, which is predominately miners, has been outperforming. This sector might also be forming a head and shoulders pattern. But it is a lot further away from key support than the copper futures we just mentioned earlier. On the other side of this risk profile is gold, but it’s not so much the flight to safety factor that will drive it, but the collapse in real yields. Gold, as you may recall from previous programs, tends to be inversely related to US real yields. US real yields are retesting their five year lows and a break of this key support would target the lows that were achieved in 2012. And recall, real yields are nominal or actual yields minus inflation expectations. And what should we expect nominal yields to do? The big level to watch is the one we pointed out last week, which is around about 1.4% for the US 10-Year. The ultimate low is closer to 1.32%. We've touched these levels on two previous occasions. A break here would suggest the response to the virus, rather than the virus itself, at least at this stage, is having a deflationary or disinflationary impact on global sentiment where sentiment remains the key word. If US yields are falling, then we'd expect similar moves in other core bond markets such as the German Bund and the UK. Gilt yield curves would continue to flatten. This is why we've seen banks come under pressure both in the US and in Europe. And the other fixed income instrument mentioned last week has also been on the move is the Eurodollar December 2021 contract rallying. 98.92 is still the previous peak to watch for and this target remains in place. Overall, these levels, particularly those big ones on commodities and bonds, should be considered as key levels to watch rather than actual targets. The framework we've laid out in previous programs is one that has been defined by central bank liquidity, which has kept asset prices soaring even whilst global manufacturing growth was lethargic and global trade was in contraction. And as mentioned earlier, the PBoC is not hanging around. They're also cutting rates and this may be setting up for an even bigger injection in coming weeks. Now, arguably, global growth was actually about to receive another liquidity boost anyway that could have created the impression of reflation. Now, however, that liquidity could be diverted. 2019 was all about central banks and particularly the Fed fixing the mistakes of 2018. If, however, the big levels on bonds and commodities are breached in the coming days or weeks, then central banks will be fighting the first true slowdown since the commodity shock of 2015. And the big question is, will those same tools still work? While there's obviously a lot of chatter about the spread of Corona virus, there's also a lot of chatter about the expected impacts with some of the potentials of this current outbreak outlined in the previous section. Now, it may seem premature to think about when to buy assets, but for many investors, this will be the key topic of conversation. Sentiment and price action go hand in hand, or at least they did in a world where assets were dominated by active managers i.e. people like you and me. Whilst many algos will still be programmed to trade off sentiment and headlines, the rules based multi-asset funds will be using things like measures of volatility and income to allocate capital between bonds, equities and others. But if we assume the sentiment does matter, and I think that's certainly true within emerging markets, then what should we be looking for? A company called MarketPsych Research combined with Refinitiv to create a series of sentiment indices. Financial asset returns are highly influenced by media and public sentiment and the Refinitiv MarketsPsych Indices provide sentiment time series from 1998 through to the present day. Data derived from global news and social media are condensed into indices such as the Human Infectious Disease Index, Fear and sentiment indexes. Tiago Teodoro of Marketpsyche looked at a number of past events, including SARS of 2003 and Ebola of 2014. These indices, the number of media stories about an event are calculated as a percentage of all the stories at that time. In Hong Kong in 2003, the first SARS stories, as indicated by the yellow vertical bars on the chart, had little impact on the price of, for instance, Cathay Pacific, the airline company. Once the human infectious disease index saw the percentage rise to 10 percent or higher of all stories, then the share price started to plummet. And the fall of the share price, not surprisingly, coincided with a pickup in the level of fear and a decline in sentiment. And these are derived from two exponential moving averages, the eight day and the 21 day. When the short term average is above the longer term, this was a period of peak fear or rising fear, and when the long term average was above the short term for sentiment, this represents a decline in sentiment and both these are indicated by red on the lower sub chart. And can be seen, the peak fear and a trough in sentiment occurred well before the number of stories, as a percentage of the total, peaked and then a few months after, the share price of Cathay Pacific bottomed and started to rise. A similar pattern was also experienced during the Ebola crisis of 2014. And here, news stories were taken from the US, where Ebola was perhaps not as all consuming as SARS had been in Hong Kong in 2003. Therefore, the percentage of all stories that focused on Ebola was much lower, peaking at 4 per cent on this occasion versus 20 percent of all stories during the Hong Kong SARS outbreak of 2003. But the fear and sentiment indicators did follow a very similar pattern. Fear peaked and sentiment troughed about the same time that the price of airlines troughed, which was again before the peak in the percentage of news stories on the subject, but it still remained a hot topic for at least another couple of weeks. So I guess the key question now is what are these indices showing today for coronavirus? Well, firstly, the number of stories on the subject as a percentage of the whole is far lower than the experience of Hong Kong. Even though the data is taken from the Chinese media. And we can probably put that down to the difference between free Hong Kong press 2003 vs. regulated press in China today. Now, watching the global news today, I'm sure you'll all agree it certainly feels like there is a very significant coverage of this outbreak. The Marketpsych fear and sentiment indicators have gone into that red phase that was typical of periods that immediately preceded the trough in airline stocks, during those previous outbreaks. But it also looks like this is only the first leg lower in sentiment and higher in fear. The red phase on both those other two occasions lasted from two to three weeks, maybe a little bit longer. So far, the red phase this time round has lasted barely one week. It's also notable just how quickly this has reached the fear phase. On the other two occasions, they were very much slow burners by comparison. And perhaps there is the key. These indicators will be coincident with price because it is sentiment that drives price. It certainly looks premature to say that it's worth trying to catch the falling knife. Indeed, on both previous examples, it was worth waiting for the turn in fear and sentiment indicated by flipping into green on those charts. Whilst you may have missed the exact bottom in the stocks, you'd still have participated in the upside. Clearly, no one knows how big this event will become and how quickly it will spread or what will be the size of the response from the PBoC. Copring Cathay today to previous examples suggests there is more downside. But have we reached peak hysteria? It's anyone's guess, but it would be foolish to try and catch the falling knife. The UK is finally out of the European Union, but no one really noticed. It was just as wet and windy as it always is in good old Blighty. And the question really is what happens next? In reality, very little. Everything is still in place and will remain so until the new trade deal is negotiated. Now, this has been optimistically scheduled for the end of 2020, though this should be considered something of a negotiation trick and not as a hard deadline, despite the protestations of British Prime Minister Boris Johnson. The UK's banks have been underperformers versus the broader FTSE100. But this is a trend that's been in place for most of the last 10 years. It's not due just to the impact of Brexit, But, with the prospects for a fiscal stimulus and further deregulation of the UK financial sector, the outlook for UK banks looks better in many ways than that of the broad European banking space. Banks are currently under pressure everywhere because of the flattening effect of yield curves due to the recent rally in bonds. But the overall prospects for UK banks should benefit even if the negotiations run into a few trouble spots with Europe. And in fact, one of the sticks that the UK can use is extreme liberalisation of the banking sector to make it significantly more competitive than its European neighbours. For the overall UK market valuations look cheap, but generally the UK has traded at a discount for much of the last 10 years as well. And that's never really been a strong reason to buy the UK market. The FTSE350 has also underperformed vs. many of the global benchmarks, and this is an index that combines the FTSE100 large caps with the FTSE250, which is generally the middle and small caps. THE FTSE250 does have slightly more domestic exposure, though the difference between the FTSE100 and FTSE250 is not quite as large as many people think in terms of those exposures. And in some ways the FTSE100 can be classed as a global dullard, full of staples and pharmaceutical companies. But it does have a cracking dividend yield that gives the FTSE100 total return index a much better performance than the headline index suggests. So overall, the UK looks attractive today on a relative basis, but that attractiveness has very little to do with Brexit.