From the HRA Journal: Issue 317
Ugly, ugly, ugly.
That didn't take long. We went from all-time high to bear market in record time. And so far, we haven't been getting any love for gold stocks, junior or senior, even though gold is one of the best performing asset classes.
I don't know where the bottom is for equities. The only thing I'm comfortable is that it should come fairy quick, even if it's much lower. Covid-19 will clearly get worse before it gets better but, even here, the impacts should start to lessen after a couple of months if we don't screw it up.
The only positive in this horrible situation is that I expect the gold sector to be the ultimate winner. We've got some of the best conditions for a long-term gold rally we've had in many years. Gold producers should be making a ton of money and the market isn't pricing anything in. If we can survive the bear market, there should be a lot of gains to be had for everyone in the gold space.
Keep a close eye on the credit markets. They are still behaving strangely. There may still be a nasty surprise in store from that side of the market.
And make sure you take care of yourself and your family. That's the most important thing. There will always be another trade, but people are irreplaceable.
March 10, 2020
"...Saudi Arabia says, 'Oh, there's too much oil.' They - they came back yesterday. Did you see the report? They want to reduce oil production. Do you think they're our friends? They're not our friends."
– Donald Trump
Anyone who enjoys irony enjoys Donald Trump. He's an endless source of it. The quote above is a few years old. Trump is a staunch ally of the Saudis now. And he may not complain about the idea of the oil price cratering. The Saudis have decided to start another oil price war after Russia refused to cut production along with OPEC. Russia was expecting the move. Reliable sources in Moscow say Putin's decided it's time to try bankrupting the US shale oil producing sector.
The average American drives a big vehicle and will love the drop in gas prices they're about to see. But the US is a net exporter now, so the cumulative impact on the economy won't be as rosy. And, frankly, I think many people view the oil market devastation as just more evidence the economy has rolled over. Which I think it has. Unless someone comes up with a miracle covid-19 cure tomorrow, I'd say the odds of a 2020 G7 recession are about 100%. It probably will be measured as starting last month, or this month at the latest.
Likewise, a bear market on Wall St is also baked in the cake now. Yes, the Fed can cut rates more, etc., but I'm not convinced that will change the trajectory. The Fed should have cut harder or not at all last week.
I'm in the minority that feels they shouldn't have cut. The market wouldn't have been happy about that, but it was pretty bloody unhappy already. Cutting rates "not enough" only convinced traders that the Fed was seeing the same bad stuff as them but wasn't taking it as seriously as it should have. Or worse yet, that nothing the Fed does will matter much. That would be an historic change of mindset for a market that's depended on the "Fed Put" for years.
Better to either cut enough to generate shock and awe, or tough it out and go for the "keep calm and carry on" play. Not saying that was guaranteed to work, but a 50 bp cut was almost guaranteed not to.
Before moving on from oil, I want to highlight the High Yield Bond index (HYG) above. Horizontal drilling and fracking is very capital intensive and many of the larger producers have been using the debt market to fund production growth. A number of other companies with "stretched" balance sheets have debt in this index, but oil producers are a big part of it.
Note that this is a "price" not a "yield" index. Higher price means lower yields. HGY rose through 2019 and into 2020 as all yields fell, then reversed hard a couple of weeks ago, even though yields were falling even harder. Why? Risk aversion. Traders have gone from chasing yield to worrying about whether companies in the index would go under. Expect to see it dive harder in coming days. The riskier end of the bond market is likely to freeze up for a while.
A lot of frackers are highly leveraged and need to access the bond market often. Some of those companies will be in big trouble, fast. I think Putin will get his wish and we'll see US oil production decline, though it won't happen overnight. That will lead to higher oil prices -at some future point-but not before a lot of pain in the sector.
The oil market decimation was just another nail in the coffin of the 10-year equity bull market. Recall my recent comments about black swans. They are defined as much by the backdrop they occur in as the event itself. A 30% drop in the oil price would have impact anytime, but probably not generate another panic in a "normal" market. This bull market has been a balloon in search of a pin for some months now, however.
That brings us to the SPX chart above. The index suffered one of the worst one-day declines in history Monday, followed by an impressive (to some) bounce the next day. It has since fallen well into bear territory. All the indexes are extremely oversold and due for another bounce. I'm not convinced that bounce will be the last one. I'm pretty sure there are more new lows before we see a lasting bottom At the Monday after hours low, the index was 20% below its recent all time high. In terms of scale, the decline is well beyond the late 2018 drop you can see on the left side of the chart.
The late 2018 drop was mainly caused by tightening monetary conditions and reversed when the Fed backed off and delivered more rate cuts. You can see a small dip in the 10-year yield on the left side of the TNX chart below. It's barely noticeable on this weekly, log scale, chart because of the recent mayhem. The 10-year yield fell as low as 0.4% during Monday's minicrash, before bouncing back to about 0.8%. It's important to appreciate just how crazy things are out there. I've been flagging Treasury yields as a danger sign for a couple of months, and the evidence just keeps getting stronger.
Normally, if the word "normal" even applies any more to markets, you'd expect a positive response from Wall St to a dive in rates. Not this time. Equities and yields fell together, and both fell hard. The current move, when you look at the SPX and TNX together, looks nothing like late 2018. Don't get sucked into that Wall St bull narrative. Late 2018 was "we need looser monetary conditions", 2020 is "shitstorm dead ahead".
Bonds were surging and reflecting the effect of the cut before it was announced, and they kept surging after the announcement. We only saw Treasuries sell off a bit after Washington started floating the idea of massive fiscal stimulus in the form of payroll tax holiday for the rest of the year. But, in the scheme of things, the Selling in the Treasury market has been minor. The bond market clearly sees bad stuff now, and worse stuff coming.
So far, the 50 point cut is a clear fail, but I've been wondering if the Fed didn't have a broader agenda in mind. Several FOMC members were quoted as saying they didn't think a rate cut was needed immediately before it happened, and yet, the vote for the intra-meeting cut was unanimous.
I think the G7 central bankers tried to come up with a coordinated response to covid-19, and there may have been discussions about weakening the $US. Its strength isn't just an issue for US exporters and Donald Trump. It's a big problem for emerging markets and other heavy $US denominated borrowers. It's in everyone's interest to see the Dollar lower. That may be hard to engineer in a crisis, given the Dollar's safe haven status, but it looks like someone's been trying.
You can see from the chart above that the USD was moving lower for several sessions as traders priced in lower bond yields and a smaller spread between US and offshore rates. Unsurprisingly, it dropped even faster once the Fed made its announcement. It may be telling that the ECB has yet to make significant cuts of its own. It's got less room to maneuver than the Fed, but a bigger (current) covid-19 problem. The ECB leaving its rate alone while the Fed cuts shrink the rate differential and helps weaken the USD. I think The ECB will cut rates again, but that that the Fed will cut more, partially because it still can.
This is historic stuff. Its fear buying and the expectation of a deflationary event that's driving this. Be very clear about that. The Fed is not driving the bus here, it's sitting in the back row while bond traders take the wheel. Yes, there was a dump in yields after the Fed made its announcement, but the 10-year yield was already at 1.2% when the Fed cut the discount rate from 1.5% to 1%.
In terms of the bond market at least, the Fed is reacting, not acting. And odds are high it's going to do it again. Even after the recent bounce, bond traders have already priced in another 50bp cut at next week's FOMC meeting. And that's a quarterly meeting with press conference and additional material like dot plots being distributed. If the FOMC is going to announce something imaginative, that would be a good time to do it. And Wall St isn't going to be taking "no" for an answer. Unless we see a big positive reaction to fiscal stimulus measure Trump is talking about before the FOMC meeting, traders will NOT be happy if the Fed doesn't cut again. If the Fed doesn't cut at least 50bps, expect another new low on the SPX immediately after the meeting.
Stimulus talk gave Wall St a stick save. That, combined with extremely oversold levels for all risk assets, could give us a more extended uptrend. Make no mistake though, I view anything near term as no more than a bear market rally unless we get great news on the virus. Don't expect rallies to last long.
Traders have been wise enough to react skeptically to most positive economic news, like last week's non-farm payroll report. You should be too. As I've said repeatedly over the years, when you're in a period of economic inflection, and we certainly are right now, you need to be very cautious about trailing economic data. When you're heading into a downturn, those sorts of readings will always look better than the current reality, because of built in lags in the data.
Relative to most of the world, the covid-19 situation in the US is still in its early stages, though its hard to get accurate info due to lack of testing. Things are clearly going the wrong way however and moving fast. There's no reason to think areas of North America won't be reporting the sort of exploding case numbers we're seeing now in Italy and Iran. As bad as the virus may be, it's the reaction to it, and effects of containment measures, that will have the greatest economic impact.
Keep in mind that the US, and the rest of the G7 for that matter, are economies dominated by service sectors. Think of things like travel, leisure activities, dining out, etc. That's precisely the sort of thing most people will cut back on first if they get worried, both to save money and avoid mingling with a bunch of strangers.
And if things go the way they have in Italy, the distancing won't be by choice alone. Major events are getting cancelled already, airports and cruise ship terminals are turning into ghost towns. Its quite possible we see government orders to cancel all large sporting and cultural events that haven't already taken it upon themselves to do it.
Consumer spending dominates all the G7 economies. Think about it. How much cutting back does it take for GDP growth to vaporize? Yes, there will be some pent-up demand when things return to normal, but services are hard to hoard. Lost sales tend to be lost forever. We're late in Q1, so growth for January-March may still be (slightly) positive. I think contraction for Q2 is pretty much baked in the cake now though, and Q3 will suffer the same fate unless things turn around fast.
I don't see how the Fed cutting interest rates has the slightest impact on that. It will cheer up traders but that will be transitory until we get better news on the virus.
Unless something happens to lower the general level of unease across the developed economies, the odds of a G7 recession this year, at least a mild one, is close to 100%. Wall St is edgy but given how overvalued it was a couple of weeks ago, the drop we've seen so far doesn't come close to pricing in a couple of quarters of zero or negative growth in the US. The chart below shows SPX valuation, in terms of P/E ratio, for the past five years. When traders get pessimistic, they start marking down prices in terms of P/E as they assume forward profits will fall. Currently, Wall St is still priced well above the P/E levels of late 2018. Traders are scared, but not scared enough. If we're entering even a mild recession, I'd expect the total drop from all time highs for the SPX to be more like 40+%, not the 27% we have currently.
The chart above was put together by bond strategist George Gonclaves. The chart of the Dow during the financial crisis is labelled with the many, many announced bailouts and stimulus programs through that period. While I don't expect 2020 to be as severe as the GFC, it's worth remembering just how much fiscal stimulus and bailout programs it took to calm the market down. Keep that in mind as programs are rolled out in coming days and weeks. Those announcements may generate rallies, but bear markets don't end until traders are afraid to buy and capitulate. They haven't done that yet.
Last, but not least let's talk about gold, and where it might be going. There are a lot of disappointed goldbugs out there right now. Gold has traded well compared to just about everything else, but not as well as hoped. And gold stocks haven't shared in the gains at all. What gives?
To help answer the question, I've added the S&P and gold charts below as a "compare and contrast". The top two six-month daily charts are the current period. The bottom two daily nine-month charts cover the worst of the GFC. As you can see, gold's already trading a lot better than it did in the early stages of the GFC. That is partially due to the higher interest rates prevailing at the start of the GFC.
We're already well into negative real interest rates currently.
Traders were freaked out by drops in gold and gold stocks on the market's worst recent days. I wouldn't overthink that. I think there were some heavy margin calls on the day gold really dived. If I had to guess, I'd say hedge funds. The early stages of steep declines heading into a bear market feature a lot of flat-out, fear-based, hunt for liquidity. If it could be sold, it was sold.
And keep in mind what's happened to volatility. The VIX index, the proxy for volatility, has exploded. "Short vol" was a popular trade among hedge funds and algo traders through last year. Anyone who didn't get out of that trade would have been killed in the past 10 days and scrambling to cover margin.
Gold bugs enjoy viewing themselves as a persecuted minority. Yeah, gold isn't in enough portfolios, but the gold market, especially the futures market that drives the spot market, is large. You can push a lot of money through the gold market and that's exactly what traders will do on days of multi-percent down moves. That will peter out over time, but I'm not promising we won't see a couple of bigger drawdowns for gold before this is over.
The main takeaway from the compare and contrast charts is that gold is performing very well compared to equities, but gold stocks aren't-yet. During the early stage of the GFC gold stocks got sold like, well, stocks. The same thing is happening this time.
And keep the time frames in mind. Things have been so crazy lately that its easy to forget we're only thee weeks past the market top. A lot of the gold move happened before that. Gold is only up about 4% since the SPX peaked.
We're still in the "fear of illiquidity" phase. Traders are scared and exiting, and cash is king. That could go on for a while longer, though this market seems be moving faster than any previous cycle. The drop into bear market territory from the all time high is the fastest in history. If the market's downward slope seems steep, that's because it is.
We're already entering the leading edge of the "fear of insolvency" phase. Oil producers, airlines, cruise lines and hotels/restaurants all look like they're in trouble they will only come out the other side of when the worst of the virus threat has passed. Governments are cutting interest rates and coming up with fiscal stimulus plans that will be large. If the US follows through with its plan to cancel payroll taxes for the year, that plan alone will double a federal deficit that was already going to be $1 trillion. I expect similar moves from other G8 countries. The printing presses are back on and working overtime.
The reaction to rate cuts and repo market injections have been weak so far. It seems inevitable "QE Whatever" is on the way, and much larger fiscal deficits too.
Real US rates are now negative out to 30 years on the yield curve. That something you never really expect to see. I don't think it's ever happened before. Negative real rates are the best predictor of higher gold prices I know. We'll see more rate cuts. Negative real rates could e with us for a while. If the economic paralysis from covid-19 continues to spread, we'll be seeing A LOT of fiscal stimulus to match the monetary stimulus.
The markets are giving us a rough ride, and it will probably get worse before it gets better. The good news is gold companies should exit the bear market hard and first. With current gold price, energy costs and interest costs, gold producers should be among the most profitable sectors this year. None of that is priced in yet. I don't expect GDX and GDXJ will be underperformers much longer.
Gold will continue to have big swings along with everything else, but I'm more comfortable even than I was late 2019 that we've got all-time-high gold prices, coming in the next 12-24 months.
There are comments about how you might play things at the start of the Update section. Bear markets suck, but we'll get through this. First and foremost, stay safe and stay healthy and look forward to a much stronger gold sector coming soon to a market near you.
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