It is incredible how much fear of missing out there is within the trading community when just a 3% pullback is a green light to go guns blazing, charging into "buy the dip."
After all, we did just witness a 15% rally off of October lows when the S&P 500 just took a one-way trip to Euphoria land without a single down day till the coronavirus outbreak.
After the Fed's communique that they would do whatever it takes to solve the quarter-end and year-end "plumbing" issue in the repurchase agreement -- repo -- market by pumping in copious amounts of liquidity daily, including buying U.S. Treasuries at a rate of $60 billion a month, investors took that as a green light to reflate risky assets, especially commodities. It is now Jan. 29. and the Fed is still conducting daily repo auctions in the order of $35 billion to $45 billion with no justification or end in sight as to why or how long this will last. Clearly something is broken and the Fed refuses to accept nor acknowledge it.
As seen by the latest Bank of America Fund Manager survey, funds had been overweight in commodities coming into January 2020. After years of underperformance, the sector finally saw inflows as central banks pumped liquidity into the system -- including China trying to jump start its growth after the dreadful trade war had put a damper on things. It was an all-go for commodities, especially likes of copper and oil, of which China is the majority driver of growth and faces short supply within a short window of time. Copper is a market that is in perennial deficit with flat demand as supply-side seems to disappoint always. The oil market had seen the Organization of the Petroleum Exporting Countries push through aggressive cuts that will now be extended through to June, helping support the price. All in all, there was good reason to bid up these two sectors where stocks were trading on decade-low discounts in some cases. The stars were aligned perfectly for the long commodity, long reflation trade. Then came the coronavirus outbreak in Wuhan.
Every trading system and institution is so used to the "buy the dip" mentality, which in their defense, has served them well over the past years. But that "regardless of an outcome" logic does not prevail. The SARS outbreak saw markets retreat around 10%, but rebound sharply higher after. Investors fearful of "missing out" stepped on the wagon and stared buying the first dip as the S&P 500 touched 3250. Oil is trading close to $59 a barrel and copper at $5,700 a ton; there is no doubt that these are super cheap levels, given a conservative assumption of demand and supply for the foreseeable future. But cheap can always get cheaper. That is the problem for commodities. It trades on "expected" demand outlook based on a given level of supply. The latter is easy to forecast at any given time, but the former can change on back of exogenous shocks. This is why commodities sensitive to demand areas get hit much harder and faster than logic expects.
China is a majority of 50% of demand growth for metal demand, especially copper. With 56 million people in quarantine, and flights to China -- not only Wuhan but Beijing and Shanghai as well --being cancelled by major airlines like British Airways and United Airlines (UAL) and more, this will have a big impact on jet fuel demand. Travel tourism and air travel cutback will hit oil demand hard. It is hard to quantify how much until we know "when" this virus is contained and normal travel and business resumes. Whether banks try to call it a $3/bbl. hit or less, it is just a number for now, until we know exactly how bad it really is. This morning China said that it expects first-quarter GDP growth to be below 5%. That is an extremely harsh assessment of GDP, given that we are only three weeks into the new quarter. And we all know that when China gives us a number, we need to take it with a pinch of salt as that figure is probably closer to 3% or lower even.
Now we have the Federal Open Market Committee meeting, where we expect to hear what the Fed has in store for its "non-quantitative easing" QE and balance sheet levels. Most expect the Fed to come in and save the day. But with its balance sheet closer to $4.17 trillion, it seems they have less wiggle room for now. The market is almost expecting a dovish outcome given what the Fed has done over the past year. This meeting will set the tone for risky assets and the dollar for the rest of the quarter.
The S&P 500 is clinging onto the 3250 level, where it first bounced off of after the first big down day this week. This level is important, because below this the derivative structure of the market also changes whereby dealers get extremely short "gamma." What this means is that if the S&P 500 breaks below 3250, the move down to 3180 or lower can be quite severe as dealers will need to sell futures to hedge themselves.
Bond and commodity markets are not buying the dip, just yet. Equities are always eager to bounce on any uptick in fear of missing out. We shall wait and see what the Fed has in store. But investors will be better served to wait till this coronavirus settles and is contained to assess real demand damage before bidding up either commodities or cyclically geared stocks for now.