The U.S. market finally started to see hints of panic selling as the S&P 500 fell from 3280 all the way down to 3230, breaking the key 3250 level whereby the negative gamma positioning reverses, forcing dealers to sell more futures as it goes lower rather than buy (a technical derivative set up).
Emerging markets (as seen by the iShares MSCI Emerging Markets ETF $ (EEM) ) are down 10% since the Coronavirus outbreak started to cause real concern. The iShares China Large-Cap ETF $ (FXI) is down 12%, which triggered a 9% drop in the Shanghai Composite this morning as markets reopened post Lunar New Year holiday period. This has now become a real demand threat, as cases seem to appear worldwide with China having confirmed 17,205 cases by the end of Feb 2 with the death toll rising to 361, according to China's National Health Commission on Monday.
When we look back to gauge what caused markets to collapse in 2020 or possibly even trigger a recession, one will almost certainly blame the Coronavirus, but we all know correlation does not imply causation. Just because one event leads right after another, it does not necessarily mean one caused the other. The markets -- and specifically risky assets -- had been propped up since Q4 2019, when the Fed started to aggressively increase its balance sheet to stimulate economic growth and shore up repo market instability. This will, of course, never be admitted by the Fed as they still seem to think that balance sheet expansion has no connection to asset prices. Clearly they need to be shown some charts.
Over the past decade, central banks -- especially the Fed -- have kept coming to the market's rescue each time to support any downside risks. This has fuelled an even bigger debt bubble across the globe to the point where one wonders when this can and will end. We know the broader global economy is tethering on the edge, if this experiment blows over. This was witnessed in 2018 when the Fed was raising rates on auto-pilot and normalizing its balance sheet. To put it simply, the world and asset markets cannot live with higher-dollar interest rates, and the Fed knows it. Demand has been delicately balanced and propped up vs. supply, which together with record cash on company balance sheets have allowed them to buy back their stock aggressively.
Five firms -- Facebook $ (FB) , Microsoft $ (MSFT) , Apple $ (AAPL) , Amazon $ (AMZN) and Google $ (GOOGL) -- make up about 18% of the S&P 500 market cap, the largest share since 2000. Focusing just on the S&P 500 is misleading, as the Technology sector is leading its performance more than other sectors and dynamics. Goldman has defended this sector by suggesting valuations today for the 5 largest stocks trade close to 30x P/E as opposed to 47x in 2000, and EV/Sales at 5x today vs. 10x in 2000 -- so they are not expensive. They have all reported excellent numbers and beat earnings per share expectations, but what about Q1? Clearly there will be some supply chain risks and sales slowdown, given Apple has shut all its stores in mainland China from Saturday through February 9 due to the virus outbreak. Businesses, restaurants, tourism, consumer goods -- all have come to a standstill until this virus is contained. There is a risk that China's GDP can print much lower than 5% even, despite the fake in-line PMI prints we keep seeing.
To combat this uncertainty, China unexpectedly lowered interest rates on reverse repurchase agreements by 10 basis points today, 7-day repo down to 2.4% from 2.5% and 14-day repo down to 2.55% from 2.65%. In addition, the PBOC also injected a total of 1.2 trillion yuan (~ $174 billion), but this was offset by 1 trillion yuan in short-term reverse repos schedule to expire, so it was a net injection amounting to about $27 billion. China's industrial profits fell 6.3% year over year to 588.39 bln yuan in December vs. the previous 5.4% gain. It is worrying that the massive stimulus boosting efforts in Q4 2019 only managed to stabilize the economy, as opposed to boost it as it did in the past.
Make no mistake, Chinese demand is coming to a screeching halt, not just a slowdown, in a short period of time. According to a Bloomberg note, the region accounts for 90% of copper smelting, 60% of steel production, 65% of oil refining, and 40% of coal output, and firms have been told to delay restarting operations until at least Feb 10. It was also reported that Chinese oil demand has dropped by about 3 mln bpd; 20% of total consumption and probably the biggest hit to oil demand since 2008-09 Global Financial Crisis. Hence, it is not surprising to see copper down 12%, oil down 17% and the respective equities down ~ 25% in some cases, especially the more-levered ones.
There is no doubt both copper and oil are getting to extremely oversold levels -- and stocks very attractive, if you believe this virus will be contained and demand will run back up. It is hard to tell, as cases keep increasing and the death toll rising, so there is a chance that businesses remain shut for longer. Also, a point of debate is how much the Fed can do now, as it used most of its bullets back in October 2019. Presumably it will wait until the S&P 500 really falls, as everyone thinks U.S. economy is immune to Chinese slowdown -- a big misconception. There is much better value in select names, but we need clarity or confirmation of some sort of stability before diving in. Once it settles, authorities no doubt will try to support the economy with more liquidity -- and we can see a sharp bounce back in demand as we did post SARS.
The one thing that is different this time is that all markets and asset classes are very closely linked, delicately balanced with cheap liquidity and debt, which has been a growing concern. If this carries on further, as the U.S. yield curve is showing with 10-year rates back down to 1.5%, we can trigger a bigger correction, asset classes have been holding up like a Jenga tower. If the wrong piece or pieces come out by mistake, could this be the straw the breaks the camel's back?