Wall Street wild ride: The missing circuit breaker

Circuit breakers are getting a thorough workout on Wall Street, but they are no substitute for what is really required. Frazzled investors need to see governments step up and fiscally shield their economies from an extended shutdown in activity until there are signs that the global spread of Covid-19 has peaked.

Stemming intense market volatility and calming investor nerves requires a timeout signal. But at this juncture, it looks like a six week process at least for Europe and perhaps longer for North America. Until clarity emerges, the process of establishing a market bottom in equities and credit remains a lengthy and daunting task. The leaders of the G7 group of countries are talking big, along the lines of “whatever is necessary”, but actions speak louder at times like this. 

Not helping sentiment was the news that China experienced a much bigger economic hit than forecast in February. Having held up relatively well lately, China’s CSI 300 slid 4.3 per cent on Monday. The latest data suggest the road to recovery will take longer for China, while the expansion of shutdowns across Europe and North America will probably leave a deeper footprint. Containment inflicts high costs.

Alan Ruskin at Deutsche Bank identifies two key elements for a circuit breaker in the coming weeks.

“Does China successfully go back to work, without renewed clusters of virus outbreaks? If they can, this is proof of two crucial elements. That rigorous quarantining and isolation can work, and that the immediate recurrence of outbreaks is not inevitable.”

The second point:

“Can G10 countries show they can replicate China’s virus-infection rate inflection points, as the second derivative of new infections turns negative. Even if Q2 includes the worst two or three months of global real economy data in modern history, this can be ignored, if and only if, the above two conditions on virus stats are fulfilled.”

The danger is that the global economy will endure an extended hit. Leading global share markets set new lows on Monday, with the FTSE All-World index plumbing a level not seen since late 2016. Excluding the S&P 500 from this measure finds global equities testing their lows of early 2016.

After triggering another circuit breaker at Monday’s open, the S&P 500 pulled back from its intraday drop of 11.4 per cent to 2,400 points, not far from its late-December 2018 low of 2,351. But selling pressure returned during the afternoon after President Donald Trump warned the outbreak might not abate until August. That left the S&P down 12 per cent at 2,386, wiping out last year’s gains. While the S&P 500 has held up better than global rivals, such outperformance appears in danger as the US economy joins Europe in a lockdown.

Tobias Levkovich and the US equity strategy team at Citi expect further pressure on shares and earnings expectations as travel bans, social distancing and a health system under pressure deliver a series of “incremental demand shocks”. 

“Investors may need to capitulate on economic outlooks, earnings forecasts and hope for some perfect set of policies to reverse the damage being caused by the current pandemic. Some belief that vaccines and health responses are making enough progress to generate confidence is required as well.”

Monday’s big falls across equities and credit came in spite of central bank infusions of liquidity and rate cuts that were designed to ease dislocated market conditions. Such action doesn’t mean investors will immediately start buying stocks again. This is an environment where cash is king and cutting risk remains the dominant narrative. Gold remains under pressure, while eurozone bonds, led by Greece, Italy, Spain and Portugal, are also being sold. Such debt, it seems, clearly belongs in the risk bucket. Emerging market currencies are flagging growing distress, while the loftier areas of US credit, such as AA-rated paper, is also on the slide. 

The scale of losses for some funds such as Bridgewater show how much damage has already been inflicted. Critiquing the Fed for failing to bolster asset prices on Monday fails to appreciate the gravity of the situation facing many investors. All the Fed, through its emergency rate cut and return of quantitative easing, can do is help markets regain a degree of balance as excessive risk-taking is purged from the financial system and others reduce their expectations for growth and earnings. 

To help accomplish that task, financial markets need to stay open, a point made clear on Monday by Jay Clayton, chairman of the US Securities and Exchange Commission. The SEC is rightfully conveying concerns among retail investors if they are told the share market is shut. 

Closing markets only runs the risk of a comprehensive meltdown once they reopen should the economic shocks continue unabated during the closure. Bringing down the shutters on markets raises the question of which ones to close. The US Treasury sells hefty amounts of debt on a regular schedule and that is why the Fed has pulled out the 2008 playbook for restoring market liquidity in that arena. 

By staying open, financial markets relay the potential scope of the coming economic shock. That sends a blunt message to governments: time is not on the side of politicians and they need to get ahead of this. Governments can’t rely solely on central banks to solve the challenge posed by a pandemic. 

Indeed, Bank of America highlights the lack of fiscal stimulus to date:

“In 2008-2009, global fiscal stimulus was worth greater than 3.5 per cent of world GDP. Thus far, we have seen a paltry 0.2 per cent, with nothing from the US.”

However, there is good news. BofA adds:

“The US government has an awesome amount of fiscal firepower. At negative real interest rates across the curve, governments are effectively getting paid to borrow.”

The scales of investor sentiment are firmly tilted towards economic pain. Oil and copper prices, longstanding economic barometers, have on Monday plumbed new lows not seen since 2016. Until the global policy response is of sufficient scale, financial markets will stay volatile. But at some point asset prices will find a footing and attract buyers with a long-term view.

Michael Metcalfe at State Street Global Markets notes:

“Our sentiment metrics actually show that long-term investors did become a little less risk averse after the first Fed ease, even though the impact on prices was awash with other market participants liquidating holdings. Given the size and scope of the policy moves over the weekend, we would expect a similar reaction this week, to resist further capitulation on asset holding where possible and riding out this wave of selling, even if the price action for the moment is extremely concerning.” 

Quick Hits — What’s on the markets radar

The shape of the US Treasury yield curve provides a snapshot of broader market sentiment. This has implications for banks and other cyclical equity sectors in the coming months as the shape of an economic bounce materialises. 

Two emergency rate cuts from the Federal Open Market Committee has pulled policy-sensitive short-dated yields down to new lows and within sight of zero. In contrast, 10- and 30-year yields are lagging that decline, leaving the yield curve steeper. The relationship between two- and 10-year yields has climbed towards 0.5 per cent, from about 0.1 per cent, less than a month ago.

A steepening yield curve after a bout of rapid rate cuts is the usual pattern, as the bond market anticipates an eventual rebound in the economy and higher inflation expectations. During 2009, the relationship between 2/10s climbed from 1.5 per cent towards 3 per cent. 

Given how yields are starting from a much lower level (the 10-year Treasury note yield did not fall below 2 per cent during the financial crisis), expecting a pronounced steepening looks tough. The message from the bond market is one of limited price pressures for some time. In this context, the recent steepening suggests a deep contraction for the economy. 

That’s not much comfort for investors in equities, but any sign of a substantial fiscal loosening from governments igniting inflationary pressure down the road is a driver of a steeper curve. In turn, a steeper yield curve is a pretty good buying signal for cyclicals, just as it was in August (2/10s went from zero towards 0.3 per cent by the end of October).

Heightened volatility across markets is also a structural issue. Analysts at JPMorgan note how depth via the extent of bids and offers across asset classes such as US equities and Treasuries “is thinner than that seen in any previous high-stress period of the past 12 years” — as shown by their graphic.

US Equity and Treasury liquidity as bad as during GFC

Before the Fed’s second emergency rate cut and expansion of QE on Sunday, much of my weekend reading was about the growing fears of markets functioning poorly and casting a deeper pall over the economy. JPMorgan underscores the dramatic Sunday easing by the US Fed: 

“This condition creates and reinforces the negative feedback loop from a worsening economy to asset price declines to volatility to tightening of financial conditions and then back into the economy.”

The expansion of QE by the Fed involves mortgage and Treasury paper. Unlike other central banks the Fed has not bought corporate debt, but given the growing concerns about this sector, some do not rule this out. 

David Page at Axa Investment Managers says: 

“For now, the Fed is not authorised to purchase corporate debt. However, we will watch the upcoming press conference to see if the Fed chair suggests this might be something that the Fed would seek in the future. As it stands, we would expect the Fed to provide additional easing via extra asset purchase announcements over the coming months.”

Buying corporate debt would only enmesh the Fed deeper within financial markets and make any future effort at reducing their footprint next to impossible.