So, traders will pivot from the other Wars, Trade and Iran, and into the “WARS” zones of another kind, the Wuhan Acute Respiratory Syndrome zone, where the latest travel restrictions now confine nearly 60 million Chinese.
Traders who would be typically discussing the weekend football results are now sadly focusing on mortality scores this morning. And trust me, absolutely no market professional likes making money off misery, but we all have a job to do to protect client’s savings. So, risk profiles need to be adjusted as the Wuhan frenzy factor kicks in, and risk markets enter the fear zone, a highly pandemic place in its own right. Even more so after President Xi calls the rapid spread of the virus a grave situation.
So defensive strategies will be priced at a premium out of the gate as investors shed China and global risk proportionally to the mounting reports of confirmed Wu- flu cases worldwide. Suggesting the market risk lights could start flickering between amber and red.
While much of the focus has been on the usual suspects’ luxury, travel, and tourism, just calculating the number of canceled tourist trips, declines in retail trade and similar factors are not sufficient to get a full picture of the impact of “WARS.” The structural changes to the global economy complicate the economic analysis of this because there are linkages within economies, across sectors, and across international trade and capital flows that need to be factored.
The biggest threat to the global economy is not just because the disease spreads quickly across countries through networks related to global travel. But also, because any economic shock to China’s colossal industrial and consumption engines will spread rapidly to other countries through the increased trade and financial linkages associated with globalization.
Unlike 2003 where SARS was less impactful on the developed world market, the rest of the world could feel the pinch this time around. And if the virus stunts China’s domestic economic growth in an echo of the SARS epidemic nearly 20 years ago, the falls could be even more precipitous than projected. And there are two reasons why: 1) consumption is now a more substantial part of China’s GDP, and 2) China’s overall growth trajectory. In 2002, retail sales accounted for 34% of nominal GDP; this share is now over 40%. And since China has been at the forefront of the global economic recovery this year, mostly driven by consumption, there could be a massive knock-on effect globally as China’s pivot from a brick and mortar economy to a services powerhouse means they import much more from abroad than they ever did
There has already been a significant markdown in China exposure and leisure stocks – as positioning had been extremely consensus in both. But not only could we see a multi-sector ASEAN equity market fire sale unfold, but a massive chunk of the nascent great global growth trade of 2020 could unwind. After all, a possible one percent haircut to China’s GDP is not a trivial matter, and indeed, when China sneezes, the world catches a cold.
According to the IMM commitment of traders, equity futures long positioning has continued to rise to new records, call volumes have surged to the highest since October 2018, and sentiment indicators are at the top of their historical band. Over the last three months, equity funds have also seen inflows of $75bn, the strongest since early 2018, with cyclical sectors being big beneficiaries, especially Tech, Financials, and Industrials. Indeed, the market’s fear factor has given way to greed, which could leave current positions precariously perched. Pullbacks of 3-5% in the S&P 500 have been typical every 2 to 3 months historically, but now we’re stretched to about 3.5 months, and if a significant Wu-Flu risk wobble occurs, we could see more profound positioning unwinds as a pandemic panic ensues.
There is nowhere that China’s economic influence is more on display than in Asia. The key driver of ASEAN’s steady growth over the past decade has been the rapid growth in bilateral trade with China. China has been ASEAN’s largest trading partner in the past ten years, with two-way trade reaching $292 billion in the first half of 2019. And thus, makes the rest of Asia extremely vulnerable to a China economic slowdown.
And although I have the usual assortment of crazy trade ideas going through my head, unusual for me, I’m starting to think cash is the right place to be for the next few weeks instead of trying to stand in front of the Wuhan freight train. It’s too early in the year to go into a trading hole.
Oil sold off aggressively last week on concerns about the impact on China’s economy of the outbreak of a SARS-like virus. Brent was down close to 6% on the week as trader moved to price in a worst-case scenario around Chinas travel and transportation demise. But now traders are left with the impossible task of factoring in the global demand impact as the outbreaks are getting reported worldwide, not to mention a potential 1 % hit to China GDP. Given the extremely tight linkage between China’s economic growth and its appetite for oil, there’s no place to hide for oil bulls and as we saw last week, taking a bullish leap of faith proved to be a fruitless exercise in frustration.
Since the Wu-Flu incubation period is estimated at between 5 days and two weeks, we’ll need to assess the true extent of the damage after the Lunar New Year holiday, so I suspect the balance of oil markets demand devastation risk remains on the wobble until then.
Gold is performing well in large part because of the slump in US yields since the new year. This fact seems to be offsetting the impact of a strong US dollar to a more considerable degree. And with the Fed on hold, so a risk-off induced break lower in yields could be relatively unobstructed, which would be very bullish for gold.
Also, the details of Friday’s US PMI report were a little downcast. New business did rise, but at a slower pace. Both manufacturers and service providers recorded a more gradual expansion of new orders than expected. And new export orders placed with US private sector firms dipped into the contractionary territory at the start of 2020. Which supported also provided a fillip to gold priced on Friday
But a Wuhan flu triggered sell-off in equity markets will likely drive gold demand out of the gates today, and long-term strategic buyers could compound the move higher as they start to position for the Wu-flu to spread at a faster pace in the coming weeks. The more rapid pace of contagion will represent another significant headwind to global growth. Given how early we are in the newfound growth cycle, more policy easing will be needed to support growth, which could be viewed as bullish for gold. A policy response from the PBoC is a given. But the big question is if the Feds need to react at some point down the road. All of which would be bullish for gold
Still, the effects on the US economy are a long way’s off as trade flows between China and the US have been reduced to a trickle due to tariff wars. And with only two, at this juncture, reported flu cases stateside, it’s not going to have a significant impact on US consumers, but its the fear factor that’s impossible to gauge. None the less at this stage of contagion the Wu-Flu is unlikely to have a material effect on the FOMC policy.
But in case you needed more reasons to buy gold this week, all eyes and ears will be honed on Chair Powell’s FOMC presser. Still, more specifically, Powell will be grilled about the financial stability risks created via the Fed’s liquidity injection due to balance sheet expansion.
There’s no blueprint for unwinding the balance sheet without some element of risk. But the fear heading into this FOMC meeting is a communication misstep. At some point, the Fed will need to communicate a temporary pause in the Fed’s repo activities as it can’t go on forever. Still, a misstatement could easily trigger a huge adverse market reaction. This in itself demands some protection either via long gold or downside USDJPY structures.
ASEAN currency markets
Depending on how widespread the outbreak gets, we could see more shifts in the market long ASEAN axes with tourist-heavy THB and the global growth-sensitive TWD as most vulnerable in this case.
The preferred way to trade this through FX is THB – with the economy dependent on tourism, the loss over China New Year will weaken GDP and weigh on the Baht, precipitously.
The THB remains the most exposed to the new coronavirus outbreak as Thailand is a top destination for Wuhan tourists. Analysis of seat capacity on flights by OAG shows that the two largest international markets are Thailand, with nearly 107,000 seats and Japan with 67,000 seats available.
Coronavirus – Tracking Down the Bug (OAG)
Other analysts estimates suggest a 3% haircut to tourists during the Lunar New Year holiday week.
But if the virus stunts economic growth in an echo of the SARS epidemic narrative and triggers a deeper slowdown in China and weakens the RMB. Then the Yuan correlated basket of KRW and MYR have the most to lose so we could see a further unwinding of capital market risk in South Korea and Malaysia this week.
G-10 Currency Markets
G10 FX vols are holding in for now in though spot markets will be quiet in Asia due to the Lunar New Year holidays across the region. Implied levels are already low, and concerns regarding the new coronavirus outbreak continue, so market makers do not want to be short vol just in case fear escalation. If the virus outbreak continues to expand, it could significantly impact the currency market where the safe-haven JPY and CHF should shine while the USD will attract its lion share of safe-haven flows. I don’t like either of those trades mind you 1) due to Japan’s economic proximity to ground zero, and 2) the SNB doesn’t care about the US Treasury currency manipulators tag.
The Euro continues to struggle even in the face of a moon shot on this week’s ZEW data, and while hints of a move towards a symmetric inflation target are a small positive within the context of the ECB policy review. Still, without a more supportive fiscal policy input and a bounce in rates, the Euro could languish.
But the Euro has been a critical funding currency of the “carry trade” this year, especially into the ASEAN basket. Hence, as local currency bullish bets unwind, it could add some support to the underlying EUR risk as those shorts get covered.
As for the market short dollar narrative, the US dollar will undoubtedly be a big talking point during the US presidential election, and the Fed is likely to end up cutting rates following the strategy review. But these events are later in the year, and for now, it’s hard to fight safe-haven US bond driven currency inflows.