This post is going to be about the tightening of financial conditions as evidenced by a rush to safe haven assets and bond market spread-widening. But I want to start with how I am thinking about the economic impact of the Covid-19 virus outbreak and how government officials are handling it.
Doing the right thing
Let’s start with a recent piece penned by Greg Ip over at the Wall Street Journal under the headline "Fear of Coronavirus, Rather Than Virus Itself, Hits Economies”. He writes:
The body’s immune response to infection is often more painful than the infection itself. The same is true of epidemics and the economy.
As with terrorist attacks and financial crises, epidemics generate widespread uncertainty and sometimes panic. Government authorities and private individuals often respond by drastically reducing exposure to the shock, amplifying its global economic impact.
The stock market’s steep drop on Monday reflected fears that as the coronavirus spreads to other countries, the reaction may be as draconian as it has been in China.
Based on health impacts alone, the coronavirus shouldn’t be that big a deal for the global economy. As of Monday it had killed 2,618 people, mostly in China, where the rate of new infections appears to have peaked. By comparison, the Sichuan earthquake in May 2008 killed 69,000 or more without leaving any noticeable trace on Chinese growth.
The difference is that the breadth and severity of an earthquake’s damage is much more confined and clear than a virus. And in this case, Chinese officials are taking no chances. They have locked down 60 million people in Hubei province, bringing economic activity to a virtual halt.
This is how we want public health officials to act. It’s important to say this because the draconian measures the Chinese are taking are designed to save lives. And by not taking those actions, they would risk the outbreak being more severe and potentially much more deadly. So I would describe this less as ‘fear' of coronavirus hitting economies and more as 'justifiable caution' hitting economies. In my view, fear is what we would see if authorities didn’t do anything and the virus spiralled out of control as a result. People would really be afraid then - and the economic consequences would be even more severe.
For example, just today we learned an Italian doctor vacationing in Tenerife, Spain contracted coronavirus and the immediate response of authorities was to put the hotel he was staying in into lockdown. Lombardy is the region in Italy where the virus has spread and that is also now in lockdown. Isn’t the hotel lockdown measure what we want to see, rather than the hotel guests going back home and potentially spreading the virus even further around Europe. The Spanish are doing the right thing. And it’s measures like this that prevent fear, rather than add to fear.
The financial impact
Nevertheless, lockdowns cause economic disruption. And if that economic disruption lasts a long time, there is some economic activity that is lost forever; we get a U- or an L-shaped recovery instead of a V-shaped one. Markets are now reacting to the greater possibility that this - the U- or L-shaped recovery - is the eventual outcome for the global economy. And it has meant a risk-off environment for investors until we get greater clarity on how severe the impact will be.
Now, yesterday I questioned how much policy makers could do to mitigate the disruptive impact of lockdowns, quarantines and lost economic activity as people avoid public venues. And certainly, one or two interest rate cuts isn’t going to have a measurable impact there because interest rates are an instrument to ease financial conditions, not deal with supply and demand disruptions.
Nevertheless, interest rate policy has to come into play now because we are seeing financial conditions tighten relatively aggressively here. For example, earlier this morning the Wall Street Journal reported that yields on 10-year Treasury bonds were on track to breach the July 2016 record lows over coronavirus concerns. They did, in fact, breach those lows before bouncing back. Right now we see the 3-month to 10-year spread at -17 basis points, a level associated with recession in the past. The 2-year to 10-year yield spread is still over 11 basis to the positive. So, I take the curve inversion as a sign of expected aggressive rate cuts rather than an outright harbinger of recession per se. The inversion is now 29 basis points from 3 months to 3 years. That’s steep and it demands Fed action sooner rather than later.
As I told you a few weeks ago in a post about the corona virus, tail risk and policy error, "the contagion risk goes from coronavirus to lower oil demand to lower prices to an energy sector bear market to a rout in the US high yield sector, where energy firms are big players.” That’s where the tightening of financial conditions matter. And what we’re seeing now says the tightening has begun in earnest.
For example, just a week ago, European high yield bond yields had dropped below 3% for the first time ever. A day later, both investment grade and high yield bonds were trading at their lowest yields ever. That was indicative of the risk-on environment prevalent after the initial coronavirus market fears subsided. But since then, things have really fallen apart. High Yield CDX has fallen the most since June 2016. High yield spreads have gapped out 85 basis points. And high yield energy bonds closed yesterday at a near 4-year high yield. Energy high-yield spreads are at their widest since 2016, when the shale meltdown was in full play. This is not good.
The Oil Patch
What’s more, even the good names in the energy sector are feeling the pain. Here’s Bloomberg:
The most obvious symptom of coronavirus’ spread in the energy sector is the slumping oil price. The less obvious, but equally serious, signs can be found in the financing market for oil and gas producers.
Exxon Mobil Corp., that haven of havens in oil, just saw its dividend yield spike above 6% for the first time since the merger that formed the modern company more than 20 years ago. If you want true stability among Big Oil in stormy seas these days, you have to go to Saudi Arabian Oil Co., or Saudi Aramco, which yields a mere 4.2% (prospectively). Then again, the remarkably subdued price moves and turnover in Aramco’s stock amid the turmoil rather underscores how its IPO was quarantined already from the wider world long before that behavior caught on elsewhere.
Exxon’s fall from grace is roughly inversely correlated with its counter-cyclical investment binge; the sort of thing that worked better with investors when they (a) trusted oil majors to spend money wisely and (b) trusted oil demand to never stop going up. It will be interesting to see if the messaging on strategy has shifted at all when Exxon faces analysts in 10 days’ time.
The really vulnerable crowd, however, is those oil and gas producers who had compromised their immunity with excessive leverage, exposure to natural gas or both. As I wrote here in November, E&P stocks with higher debt have performed notably worse than less encumbered peers since last spring. Coronavirus’ impact on commodity prices and sentiment in general has exacerbated that. Since the start of the year, low leverage stocks in my sample are down about 16%; not great, but better than the very-high leverage index, which has fallen more than 40%.
The really eye-catching action is in the bond market. The rush to safety in Treasuries has widened an already gaping risk premium on high-yield bonds for energy issuers. The option-adjusted spread for the ICE BofA U.S. High Yield Energy Index ended Friday at 772 basis points. That’s up from 650 points at the start of 2020. But another way to look at it is that the gap between the energy index’s spread and the spread for the broader CCC-rated bond index — the junkiest end — has narrowed sharply. Indeed, this spread-of-the-spreads is now narrower than at any time since early 2016, the very depths of the oil crash
This is trouble. Will a couple of Fed rate cuts end the trouble? Probably not. But, the Fed’s sitting on its hands as this unravels would certainly be a policy error that increases tail risk. So I think we are getting close to the point where we are likely to see rate cuts. The next Fed meeting is in mid-March. Does the Fed wait until then or cut inter-meeting? I think they wait. And we will just have to see how much worse financial conditions get before then.
For Trump, this is bad news, of course, because much of his campaign rhetoric is premised on his handling of the economy and the rise in the stock market. If these factors come unstuck, his advantage in November on that score goes away. My worry is that he doesn’t do the right thing for fear that it will hurt the economy. Read this thread on this very possibility. The worst thing that could happen now is that the US prioritizes making things look ‘under control’, causing the coronavirus to spread much more rapidly - and then real fear and panic set in. Let’s hope it doesn’t get to that.