CORONA-VIRUS AND OPEC COLLAPSE IMPACT ANALYSIS

If you invested $100 in Oct’18 in India and left it to market forces, they would still be the same today.

The markets flash-crashed and tested year lows and major supports. Looking closely, these events unfold a truly historic juncture, as it reshapes the complete financial landscape. Things went south every day, with just a hope for the next day to tick green. There were bits and parts of short covering which bought respite but couldn’t hold the bears long enough until the S&P 500 hit its 7% circuit. The virus breakdown was further deepened by the geopolitical tensions over the collapse of the OPEC, in a bid to break the ‘Energy Dominance’ status that US commands in the oil markets.

Initially only the epicenter of the virus, China was affected, but soon as cases started to ripple across European countries, it became a mayhem and the south east Asian offices reported complete shut downs. This raised panic among companies, countries and was gradually priced in by all the markets over 2 days. But yet this was just the tip of the iceberg. Only when the markets were seeming to be cheap for an entry, there came another wave of shock from the middle-east, with the OPEC collapse and spur a price war in the oil market. This event was considered akin to the 1990 gulf war, as ICE Brent Crude Oil nosedived to $30$/ barrel and the Saudi kingdom, regained its monopoly status in the energy market. This was a clear attempt to flatten out the highly leveraged US Shale and Russian producers off the market, as the Saudi producers could still manage to expand their bottom line with these prices unlike others.

Q. So, when did it all start and why?

The first sign of lock downs in China triggered worries about the supply chain disruption in the world largest manufacturing economy. The markets reflected their angst first on 17th Jan, and global cues seemed under control until the virus wasn’t tested positive outside South East Asian countries. The first case in Iran was reported on 19th Feb, when the world declared it as an epidemic, and the markets welcomed this with a red carpet spread across major indices. Since then, there have been transitionary recoveries but couldn’t really upbeat the sentiment. Major equity indices have swept off year and multiyear gains over weeks, some even tested bear market regime (20% fall from peak to trough), as the ambiguity about future cash flows increased and international trade and travel came to standstill. Things went so bad, that a survey showed that the SMEs in China could survive just for another 3 months, if things didn’t improve.

Q. What was the impact across major asset classes?

Equity:

Equity markets are considered to be the first movers, and a very good leading indicator of the overall economy. Yet this time again, we saw them appraise the trade collapse with a sense of utter urgency. There was colossal flight to safety, and investors just shed their risk assets to hold primary claims on the liquidation, i.e, government debt. Though initially the story was limited to auto, airline and travel sectors, but after the oil breakdown, it had a snowball effect on all the industries, specially for the oil exporting countries. Banks, the key to every project saw bleak future amidst demand scarcity and sentiment disparagement. Volatility index, aka fear index, soared to its highest levels since the 2008 crisis, while at the same time the Put/ Call ratio of VIX Option surged too, as investors expected it to subside, over a month. A lot of commentary about this massive fall also revolves around the overvalued markets, which sought correct valuations. We saw a remarkable recovery from the Chinese markets, as it emerged victorious in containing the virus and soon setting its industries back to work.

After the oil crash, highly leveraged mining and exploration companies credit spreads widened to levels higher than 2008 crisis, and that took a toll on the banks. While it was doomsday for the oil companies, the petrochemicals, paint and pharmaceuticals rallied the expectation for cheaper materials.

Takeaway: Due to the recent market turmoil and the combined drop in the US treasury rates, the ratio on the Dividend yield to the treasury rates has surpassed 2008 crisis levels, so if we don’t see this rout affecting the long term dividends of the companies, we can surely bet on non-cyclical companies with good reserves.

FX:

Last couple of trading sessions have led to blizzard of headlines proclaiming the wildest of market swings in years, from JPY inching to its 5 year highs to oil currencies tumbling because of OPEC collapse. Panic and fear made the global investors to sell all foreign holdings and buy USD treasuries. This led to rampant selling in the EM currencies, irrespective if they were net exporters or importers of oil. This becomes a challenge for them to honour their dollar denominated foreign borrowings at a time when they need to expand deficits for fiscal stimulus. JPY anchored its safe haven position and even after bleak growth expectations in Japan, investors clinged to the haven. Though during turmoil, USD shows strength, but this time, fear of losing share in the oil market, raised concern over how profitably they could set their 13 million barrel per day oil production to use. Norwegian Krone, one of the worst hit currencies, touched its 35 year lows, as it has one of the highest oil extraction costs, and a major pie of its trade is oil.

Australian Dollar observed the highest volatility amongst the G7 currencies, as the Chinese trade lock down vanished all hope for future business expansion. As the Australian business activity is highly linked to the Chinese optimism, they went lackluster.

Here we see that JPY rode further more than how much USD slumped. USD has fallen by nearly 2% but JPY strengthened by 6%. As Japan is a net exporter, this appreciation hurts its global competitive stance.

Commodities:

One a safe haven, other a global growth index. Yes, I am talking about Gold and Oil.

Gold touched its 8-year highs, peaking at $1700/ounce. Market fallout led to margin calls, and this led to the price friction upwards as we observed some selling to meet the margin requirements, but soon the panic aided its rally.

Metals, energy and Industrials saw one of their worst weeks from the 2008 crisis. As mining feasibility is on mercy of the Saudi, the market for industrial equipment has weakened. The Bloomberg Commodity Index is making new lows every day, as the fear around the virus shook the demand forecast for fuel, food and raw material. Furthermore, commodities act as an inflation hedge to the portfolio, but given weaker consumer sentiment, cheap money and raw material, it seems redundant to have an inflation hedge in our portfolio.

Oil- In times when typically, OPEC should have cut its production to meet the fading demand, it burst open a price war after Russia disagreed to cut its production. Saudi has one of the highest fiscal breakeven price of $83/barrel, but the lowest extraction cost. The kingdom is aggressively opening its taps to flood the market with cheap crude, at times when the demand is highly uncertain and dispersed. This looks like an attempt to punish the US Shale producers for its repeated sanctions on Russia’s energy interest. It was virtually a Black Monday for the energy markets, with Global benchmark Brent crude plummeting more than 31% shortly after the open, the most since the Gulf War in 1991.

Interest Rates:

There was a time when the US investors and banks were sitting on a $1 Trillion short position on the treasury rates, that’s massively insane levels of panic and haven buying. The rates have frenzied to abnormally low levels, with the whole yield curve floating below 1%, for the first time ever. This is a double whammy for the banks, as this squeezes their net interest margins and loans get refinanced to lower rates. Furthermore, due to the oil price slash, it might have a huge crackdown impact on the banks that financed those oil plants.

10 year US treasury came as low as 40bps, and the 30 year to about 70 bps. Even after the sudden 50 bps rate cut announced by the Fed on 3rd March, expectations didn’t strengthen, and perhaps there is a further expectation of another 75 bp cut in the coming 18th March meeting. Even strong jobs report for February didn’t wither away the risk aversion, and yields continued to drop. Chasing higher duration, investors flocked to longer tenors, as we can see a tremendous 190 bps fall in the 30 year notes over 2 months.

We uncover some interesting charts from the mayhem of this $100 trillion bond market:

Given the wildfire buying in the treasuries, the question is lies on can we really trust the US Treasury on trillions of debt, as there have been instances in the past where sovereigns have defaulted too.

The tax free municipal bonds too, were left aback by the flight to safety theme. A ration of the tax exempt yields from muni bonds to the taxable returns from treasury gives us a good idea of the relative valuation. This ratio broke barriers and went north to prove supremacy to the municipal bonds.

As the panic rose, so did the CDS spreads amidst rising anxiety for potential future defaults. Spreads widened to 9 year highs as the price for protection increases during turbulent times. Investors are highly wary of the huge pile of debt at the edge of the Investment grade, BBB rates companies, and as the debt and demand conditions worsen, they can bubble out a debt spree.

Q. Will the Central Banks be able to achieve target inflation, in times of falling crude and benchmark rates?

Over the last couple of months, central banks across the world have slashed interest rates and added liquidity aiding to global growth inching year highs. With staled business confidence, sluggish consumer sentiment, falling crude prices and even cheaper money, will the central banks be able to outshine the deflationary theme triggered by the events over last couple of weeks.

Benchmark rates testing near zero levels, central banks will have to device an innovative blend of monetary and fiscal policy to maintain a balance between widening fiscal deficits and deflationary fears. The Trump administration is drawing up an economic package to blunt the fallout from the coronavirus epidemic. In Germany, Europe’s largest economy, said it would invest an additional 12.4 billion euros and introduce changes that will make it easier for companies heavily affected by the virus to apply for aid. Meanwhile, France’s finance ministers said Europe should prepare a “massive and coordinated” fiscal stimulus in response.

Takeaway: The problem with throwing vast sums of money at a problem is that you're not sure where it will end up. Big venture checks enriched founders but didn't always create great businesses. Fiscal stimulus packages might've saved the global economy back in 2008, but they also helped pay out banker bonuses.

The latest global crisis has made it easier for big venture investors to conclude that maybe throwing good money after bad isn't such a great idea. But it's clear that governments don't have that luxury.

These milestone developments and events leave us with some questions:

1. Which sector or country will see the fastest recovery and what policy stance does that central bank take?

2. How well can the business adapt to these crude levels, who can magnify their bottom line from this opportunity.

3. Will cheaper money transmit to increasing consumer spending and revive back economies?