Saxobank: “We Do Not Want To Advocate Panic” But “This Has Clearly Been A Huge Mispricing Of Risk”

Submitted by Eleanor Creagh of Saxobank

Summary: The COVID-19 spread outside of China has sparked concerns the outbreak is evolving into a global pandemic, despite the WHO saying it is too early to re-classify. This has triggered a reassessment of downside risks which has seen a wave of selling wash across risky assets.

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The market flipped very suddenly from outright complacency to all out panic and risk assets were offered across the board as investors woke up to the realities of what has clearly been a huge mispricing of risk. Risk assets had been remarkably resilient in the face of a double whammy demand and supply shock ready to hit economic activity, with investors taking an optimistic view that the virus outbreak would be contained within China and an impending cocktail of fiscal and monetary stimulus would serve as a cure all. It is far from clear how effective monetary stimulus and tax cuts will be whilst people are quarantined, factories operate at reduced capacity and uncertainty prevails. As investors have reassessed the real impact of COVID-19, the simultaneous unwind in positioning has been violent, given the complacent positioning prior to the sell off and the increasingly stretched valuations which left the market over extended and vulnerable to larger falls as positioning flipped.

Although the move has been swift and sharp, to put the selloff into perspective, markets are still trading at elevated multiples and the ASX 200 is just back at levels last seen in January. No doubt the pandemic fears are a catalyst, but is difficult to attribute what proportion of the move is due to extreme complacency being upended vs. the virus spread.

S&P 500 futures are pushing back into the green this morning, not because investors are suddenly optimistic about the containment of the COVID-19 outbreak or the hit to economic growth and earnings, the ultimate impact remains entirely unknown at this stage. And uncertainty is the enemy of conviction. But following a near 8% drawdown from the Feb 19 intraday high for the S&P 500, the initial panic selling is subsiding and shorts are being covered.

Even though further downside risks remain, US equities on some measures posted the worst 2 days in the entirety of the current bull market, and after 4 consecutive days of selling the initial panic is abating and the door is open for some sort of bounce. It is important to remember that when volatility picks up larger trading ranges are driven by falling liquidity and the expansion in trading ranges is not only to the downside, but to the upside as well. So even falling markets witness fierce upside rallies.

That being said, the S&P 500 is not oversold, despite the violent price action over the last few days, and there is capacity for a continued corrective move. Buying the dip is not such a sure thing against the current backdrop (unless its gold!). The state of play is currently unprecedented and we do not have a good analogue to replicate, so the outcomes and ultimate impact is going to remain a moving target. We are not epidemiologists and don’t pretend to be experts on viral outbreaks, so we stay focussed on the data and until we see some sort of containment and verifiable recovery in economic activity we continue to advocate a more cautious stance.

This as the Fed continue to sit on the sidelines, recent musings from Dallas President Kaplan have laid rest to an immediate incoming Fed put that markets have become so accustomed to. Whilst we think that the market has the Fed over a barrel and they will be forced to take action, whether it is the right antidote for the induced damage or not. In a market so detached from fundamentals that has been accustomed to central banks caving to liquidity demands, the limited reaction at present removes (albeit temporarily) a pillar of support.

Price action will continue be highly susceptible to virus related headlines as fears ebb and flow. We simply do not know how elevated the tail risks are at this stage and cannot rule out another wave of panic selling. The spread of COVID-19 beyond China now means more transparent reporting from countries like South Korea, Croatia, Switzerland, Spain, Austria and Italy which could further heighten volatility and risk aversion. And as the number of countries testing for the virus mounts, we can expect the case count to follow. The Italian Prime Minister said it best, “the surge of Italian cases only reflected Italy’s casting a wider net in terms of testing”. As the CDC has “warned Americans to prepare for a coronavirus outbreak”, according to experts at the CDC it seems that it is only a matter of time before cases are reported in the US, a potential trigger for another wave of selling. Although we can’t help but wonder if incoming tweets “the vaccine is close” from a certain President allergic to any stock market falls may soon become this year’s equivalent to “the trade deal is close”.

As equities face up to the facts, South Korea being an important supply chain centre and key logistics hub remains on high alert level, intensifying the already ongoing regional supply chain disruptions. And pandemic or not, the spread to Europe bound by open borders and the free movement of people presents a heightened risk environment particularly as the Eurozone can hardly afford another hit to Germany’s languishing manufacturing sector and the tentative green shoots that had begun to spring across the continent. Particularly as the Eurozone’s services economy, which has kept the continent out of recession, is heavily exposed to China. 

The virus also appears to being spreading fast in the Middle East, with cases emerging in Iran, Iraq, Afghanistan, Kuwait and Bahrain, with many of these countries lacking the infrastructure to adequately contain further spread. The jury is clearly still out on what the ultimate impact of the COVID-19 outbreak will be. But what is clear is the SARS outbreak in 2003 is not a good analogue and any forecasting dependant on such modelling will be void. This means the disruptions to supply chains and will be larger than most analysts have forecast to date, and the corresponding recovery will be increasingly protracted.

As several provinces in China are lowering their emergency response level and factories in China are being urged to resume operations, amongst other real time indicators like traffic congestion and coal consumption, we are tracking the return of migrant workers from rural areas back to large cities. The problem being many factories still don’t have enough workers to resume at full capacity, despite the relaxation of quarantine measures. Activity data in China continues to point to an economy running well below usual levels and calls for a rapid recovery are premature.

We expect price action to remain volatile as the toll of COVID-19 spread mounts and begins to materialise in hard data and company earnings over the coming months, particularly as US political risk steps up a notch. As the contagion picks up outside of China, increased measures to control the outbreak lends the potential for the anticipated recovery and ripple effects to be much more drawn out than was expected by previously complacent markets. Measures to control the spread of the COVID-19 outbreak will significantly disrupt economic activity and ultimately impact economic growth and earnings. The ensuing supply disruptions and production bottlenecks, in particular non-linear supply side effects, are the real wildcard in terms of further downgrades to growth, earnings and longer term disruptions. The impact on company earnings and activity is therefore unknown at this stage but larger than is currently being accounted for, putting any previously forecast earnings recovery in jeopardy. We do not want to advocate panic, but stress that a more rational approach does not underestimate the impact on economic growth and earnings as the story evolves.