Trading in Coronavirus Times: Trading Covid-19

Coronavirus Trading

I don’t play it tactically when it comes to trading with COVID-19, wondering how stocks, bonds, and other assets and asset classes can pass. I’m not an epidemiologist, virologist, immunologist, or any kind of medical professional, so I don’t have experience or informed opinion on how it’s likely to be played out.

I just want to make tactical bets on things I think I have information and/or analytical advantage on. And keep the size of each individual bet low to keep sensible risk controls in place.

If I have nothing worth pursuing (i.e. future “alpha” opportunities), then I sit in beta and patiently wait.

The Tempo

Contagious disease before coronavirus was not high on the list of concerns for traders. No disease has affected the global economy in the way Covid-19 has since probably the Spanish flu of 1918.

Ebola had a very high fatality rate. But it affected a relatively small portion of the global population for the same cause and did not spread worldwide.

Normal seasonal influenza infects millions each year and kills hundreds of thousands of people every year. But those seasonal diseases are common enough and have sufficiently low mortality rates to be considered a part of the normal course of events.

The coronavirus is of a type in which it is contagious, with the time of incubation and virulence making it more deadly than the normal seasonal flu. This makes it especially difficult for governments and health officials. It has made it more challenging for economists and investors to assess its impact on capital flows.

It’s hard to gauge the impact on the economy and markets. The best we can do is look at analogs from the past. But if past events are not very good models for the present or the future, then this is a very flawed approach.

Investors tend to exploit recent past events to inform the future. Investors obviously used the SARS outbreak to hone their focus on the coronavirus. Yet SARS was a different kind of virus and when it broke out almost 20 years ago, China was a much smaller part of the world economy as well. It led to complacency because it was an obvious heuristic. As stocks drew down about 10 percent during the outbreak of SARS before rapidly recovering as the epidemic burned out. But the reference to SARS has been more confusing than insightful.

At the same time, the Spanish flu of over 100 years ago happened so long ago that comparisons are difficult to draw.

Markets reacted when the virus hit the airwaves in mid-January. Although, it was nothing like the 15 percent plunge we would see in late February. A consensus arose from the 2-3 week period past mid-January that China had taken enough aggressive steps.

Market participants interpreted this as assuming that the spread would be contained and that the economic effect would be mainly limited to the Chinese consumers’ lost demand. Countries exporting to China, such as Australia and Brazil, saw their currencies retreat. While countries importing from China more than they export; (e.g., the US and Mexico) saw their currencies increase relative to the renminbi.

Some even suggested that lower Chinese domestic demand could make these products cheaper for importers of Chinese goods. Leading to lower inflation, lower bond yields, higher chances of monetary easing, and hence higher stock prices. In the second half of January, stocks did fall but rebounded to create new highs.

But the narrative shifted rapidly when February 19 came and went. Cases started to appear across the globe. It was no longer deemed a regional problem. International health organizations’ reaction has been uncoordinated. Different countries are treated differently. Some got worried about restricting the spread. Others have focused more on reducing mortality.

For example, Japan initially was more concerned with limiting mortality. The decision was made to avoid overburdening their care system. After that, further action has been taken to close schools and restrict spectators attending public events in a more containment-focused attempt, similar to China and Italy. China has lightened its constraints and people are getting back to work. We can see some of that in alternative data, such as traffic in Beijing.

It requires a trade-off. Strict quarantines will reduce economic activity and see recessions created globally, and a deeper downturn in the markets for risk assets. If the virus is contained, however, then the growth bounce would be faster.

If countries opt for more of a treatment approach, then a longer, but more modest, drop in growth could be expected.

Since each area has its own strategy, a mixture of both is likely to be present. Growth will decline and possibly lead to a wider downturn in growth (at least we will see a significant Q1 and Q2 impact).

Usually, demand recedes first when it passes, while supply lags behind. Stimulating demand is typically easier than adding power, or new investment.

Markets are generally more concentrated on the disinflationary elements, and it may take some time before the inflationary elements take hold. And that doesn’t automatically mean that a spike in inflation would occur either. Oil plunged more than 25 percent over the weekend, leaving headline inflation low.

During the past economic cycle, we’ve had a lot of inflationary factors thrown at the economy, like low-interest rates and asset buying. But inflation hasn’t significantly gone up because what they’ve done is actually ignored deflation. Which had as a result high-income debt.

Breaking the Covid-19 Effects Into 3 Categories

There are different angles to the Covid-19 that make up the whole:

  1. The influence of the coronavirus itself – i.e. health outcomes
  2. Economic ramifications due to the consequent impact on health and business (hence on economic productivity), consumer trust, and the consequent government response.
  3. The capital markets response due to economic consequences

Health Results

Occasionally, a virus from another species jumps to the human race and we are not all well prepared to deal with that. This is what made the coronavirus a human concern, and why it’s a part of the normal course of affairs and unlike other influenza strains. We’ve come up with an immunological way to deal with them.

There is a phase of adaptation that has to be between the virus and the host. We are in that period now.

Sometimes, it passes by, people adapt and the virus dies off. H1N1 was a virus that frightened many people (it went from birds to humans). It was the same type of strain as Spanish flu in 1918, but very quickly disappeared. Many times, especially in this one, they are extremely destructive.

The fatality levels associated with coronavirus are linked with age (specifically 65 +). Along with those with pre-existing respiratory problems, based on the data we have seen. That’s good for the world because it’s not serious in its lethality but it’s not insignificant.

The statistics below pit Covid-19 against Ebola, MERS, smallpox, SARS, and seasonal flu.

The statistics below pit Covid-19 against Ebola, MERS, smallpox, SARS and seasonal flu

While I don’t know what the final health impacts will be, what’s likely to happen is that the virus will be a temporary inconvenience. Even if it turns out that the human cost is high.

It is also possible that the ability to contain the virus would vary materially, based on location.

Countries that are better equipped to deal with any epidemic will have strong centralized leadership to quickly implement decisions. A workforce that is efficient in implementing those decisions. A populace that is responsive to government orders, and has the medical infrastructure in place to combat the virus.

There’s a certain pacing level involved, too. If a government quarantines too rigorously, that will minimize the outbreak but can put the brakes on economic activity excessively. Every outbreak needs to be properly quarantined to prevent it from spreading, while at the same time easing should be done as the spread declines.

If this is not done well, the problem can get worse and cause it to persist, leading to negative effects on economies and markets.

Because of its global reach, and the forthcoming extra tests that are likely to boost reported numbers of infected people, this is likely to increase the amount of fear on the markets. This goes for the States, too.

Those who have come down with the flu will get more testing. You tend to find it when you’re testing for it. This will increase the numbers published, and may also threaten the resources available to hospitals.

Nobody really has a knowledge advantage when it comes to COVID-19 trading and most trading is actually powered off the scare-related headlines. There’s a psychological component around the world and a high level of anxiety that’s pouring into asset prices.

Although some of them are grounded in intuition (bad health outcomes or worse potential health outcomes -> poorer economy -> more market volatility), most of the activity is causing wash-outs for some market participants due to idiosyncratic cash-flow problems.

The whipsaws often generate emotional effects that can have a lasting impact. For instance, when bad things happen in markets, investors sometimes need a while to recover their trust after getting burned in the past.

The spontaneous decisions are taken by some countries and various health organizations (public and private) in choosing which activities to conduct, which to postpone, what kind of travel should be done, who can go to work and who can’t, and so on, have created a menagerie of different issues that have made the ultimate effect difficult to forecast on economies and markets.

Accordingly, we should certainly expect this to last a while, with an upcoming slew of negative data that will hold market uncertainty elevated and be a persistent drain on stock markets.

Countries in the southern hemisphere are thought to be moving stronger through the outbreak at this time of year due to the hot weather.

Economic effects

The coronavirus is economically unique in that it is an adverse shock to both supply and demand.

The shock of short-run supply is primarily a result of the effect of the virus on global supply chains.

Because the prices of goods, services, and labor differ all over the world, this allows many companies to be able to get the most bang for their buck for offshore aspects of product and service production to various countries.

For instance, to make the iPhone, Apple will have to pay numerous companies to purchase the components to complete the device and ultimately have it assembled and delivered internationally to the different parts of the world it’s sold in.

A rundown of where the chips and different components are produced:

– Samsung (South Korea) produces the processor for memory and applications.

– Texas Instruments and Micron (both US-based) make the touchscreen and flash memory controller, respectively. The audio controller is rendered by Cirrus Logic.

– Dialog Half-conductor (UK-headquartered) renders the components of power management.

– Infineon (Germany) makes components of the telephone network.

– The accelerometers and gyroscopes are made by ST Microelectronics (Taiwan).

– The Bluetooth and WiFi components are made by Murata (Japan).

In Shenzen, China, assembly takes place, by the Taiwanese supplier Foxconn.

China’s economic growth and rising labor, land, and energy prices could also push Apple’s margins and incentivize the company to produce offshore elsewhere in the future.

Below is an Apple-captured value map on iPhone 7 for 2016:

Apple-captured value map

Effective supply chains are like a well-thought-out system. But it carries with it the possibility that if one or more of such ties is unproductive, it may present risks to the business at large. In the event of a natural disaster (which is what the virus really amounts to) or an installation accident, having supply chain redundancy and overcapacity can help to reduce risk. But this adds cost to a dynamic economy. Backup supply chains don’t always operate either. Any excess inventory will last just so long.

Falls in China’s manufacturing PMIs and a decline in China’s South Korean imports indicate supply chain problems. Survey-based data in the US, such as the Fed’s Beige Book and ISM surveys, show issues with the supply chain are already visible.

Supply shocks are inflationary, holding everything else on a par. Lower supply bids the price of the goods and services, holding a constant competition.

Nevertheless, there is also an element of a demand shock. Decreasing demand is disinflationary. That is expressed in lower 10-year Treasury yields and reduced forecasts for inflation by the CPI.

Ultra bond futures (mirrors the US 30-year bond price) are up almost 25 percent from the start of the year (or $44k per contract) – a huge move for a fixed income product.

Ultra bond futures
(Source: Interactive Brokers internal charting)

Below is a stylized example of the economic trend in terms of supply and demand, and price impact.

Why Covid-19 will test policymakers
(Source: Moody’s Analytics)

Monetary policy can not do much for a supply shock – reducing interest rates does not do much to bring supply chains back on track. It can help to tackle demand, but only to some extent.

When there is a combination of supply and demand shock this in some form requires monetary and fiscal policy action.

Monetary policy options

On the monetary policy front, the Federal Reserve may try out a number of maneuvers:

– Forward guidance (assert that rates would be kept low for a prolonged period)

– Further rate cuts (near to running out of room)

– Quantitative easing (also near to max, but far less successful than during the period 2009 to 2014)

– Easing credit deflation

– Temporary lenders relief under the Community Reinvestment Act (CRA)

– Yield curve regulation (keeping rates low while staying steep in a portion of the yield curve to maintain a healthy lending spread to help the health of the banking system)

– Restart investment in mortgage-backed securities to achieve lower interest rates on mortgage markets; this will promote refinancing

Much less likely in the near term but possible in the future:

– Fiscal and monetary policy cooperation:

  1. Fiscal deficit monetization and/or
  2. Omitting the constraints of the increasingly yield-less cash and bond markets and bringing money directly into the hands of spenders and savers and connecting it to spending opportunities

Fiscal policy

Fiscal policy can be slow, particularly when there is a growing bifurcation of the ideological distribution between the two major political parties. It’s hard to get people to agree on a lot, and there are short-term pressures that prevent certain things from getting done more generally at certain times (e.g., major policy changes in a presidential election year).

Congress made an Early March agreement of $8.3 billion for emergency funding. Compared to the form of relief offered for recent natural disasters, this is smaller.

Government aid programs are intended to provide wages and other financial support to residents and businesses affected – for example, medical and health care, unemployment insurance, state and local government funding, paid sick leave, tax breaks. In addition, some funding is being given to help develop a vaccine.

In broader economic terms

It is almost certain that quarantining and lack of travel would cause a substantial decline in economic activity and will create a V-shaped recovery once the fear is over. The virus is unlikely to have a long-term material effect.

China’s economic performance already showed a bottom in activity in late February. Does this carry on?

Now other economies, including South Korea, which later became contaminated, are seeing a more direct hit and a similar rise in the disease that China had once seen. In terms of quarantining and keeping the disease under control, will they follow a similar direction to China?

It is critical how individual countries approach the problem and how those arcs play out.

The 1918 Spanish flu comparison

One of the biggest demographic shocks in history was the 1918 Spanish flu. It took as victim up to 50 million lives (the total number is unknown) and infected 500 million people (then about 27 percent of the population of the world). The pandemic came in three waves, before vanishing.

In the US it began in January 1918. It first appeared in Kansas, not as you would expect at one of the coasts, particularly if it was imported.

It was a serious case of flu in this first wave but then it burned out.

Through step two it emerged in Europe as World War I was still raging in the early summer of that year. But it went away as well.

The third was the worst wave. It returned in October and November and this period is what caused the largest demographic shock in modern human history.

Around the same time, amid the chaos, it was actually essentially gone by 1919 and 1920. The most deadly viruses appear to die out the quickest; they kill the host, then they die themselves.

It did not generate a prolonged downturn in the world economy given the large death toll. In respect to the coronavirus outbreak in 2020, we can’t say that for sure, but this is how these outbreaks have worked out before.

Prognoses

Wall Street Journal on March 2 wrote on the subject, stating that S&P Global estimates that the U.S. economy will fall to an annual growth rate of 1% in the first quarter from a rate of 2.1% in the fourth quarter of 2019, with a half percentage point due to coronavirus. The impact would be modest over the full year, shaving off one or two-tenths of a percentage point of production. But that prediction assumes the effect is predominantly overseas.

Speaking to Wall Street Journal, Jamison [UCSF Emeritus Professor] said such a scenario could still force U.S. businesses and schools to close down, shut down transport networks, and cut down half a percentage point from year-to-year economic growth. That’s enough to slow the economy but it doesn’t cause a recession or two straight quarters of economic contraction. He expected that any event would not last longer than several months and that a sharp increase in economic activity would follow.

We have all the ingredients for an economic activity disruption here, Northern Trust chief economist Carl Tannenbaum said, adding that it highlights the importance of what’s happening, since a month ago’s expectation that this will blow over at this stage is not an appropriate stance.

Market results

A degree of resemblance to other shocks can occur when it comes to trading the coronavirus. At first, they seem to be under-discounted and in the end, too-discounted. When looking back it’s always easy to find this. You don’t know where the “top” will be when you’re in the middle of it. It makes the idea of actually trading the COVID-19 hard to do.

Furthermore, as the virus spreads internationally, in Chinese markets we see less of a sell-off and more of a sell-off in global markets. Since it expanded beyond Chinese borders and regulated the number of Chinese cases (i.e., lower growth rate), we have actually seen Chinese markets outperform world markets.

Right now, with stocks dropping, we know some of this is a drop in earnings expectations and some of it is a rise in risk premiums (i.e. investors seeking more risk compensation).

Based on how much we think an incremental rise in risk premiums is, the market expects a decrease in earnings between 20-35 percent. Perhaps the 35 percent is too steep, and a higher risk premium is some factor.

This is a big influence. And when you talk about coping with the coronavirus, if you want to trade tactically, you also have to talk about what has already been discounted in.

Markets are pricing in the coronavirus mainly as a shock to the market. Consequently, we see both lower growth and lower expectations for inflation. It is bad for stocks (which are doing poorly in such an environment) and good for sovereign debt on the developed market (which is doing well in such a scenario). If it were, in fact, just a supply shock and net inflationary, we would have seen stuff like government-linked bonds and gold do well.

Until the coronavirus broke out, and after it reached the airwaves in mid-January but was largely dismissed by mid-February, market positioning in equities was highly leveraged. This exacerbated the dynamic on the way down due to other technical factors, such as volatility shorting (i.e., short OTM puts).

The fifteen percent fall in equity markets has been the highest in modern history. From February 20-28, the S&P 500 plunged to a high of 13 percent:

Hao Hong, BOCOM International, a Bank of Communications subsidiary stated that the market collapse over those two weeks has been truly historic: the likelihood of its occurrence since 1896 is ~0.1 percent; the pace of the fall and the VIX rise is the highest recorded; the 10-year [US Treasury yield] is at an ever-low point.

Dean Curnutt, Macro Risk Advisors explained that this stress episode is now one of the most severe in the last 25 years, joining an elite group that includes Asian Contagion (1997), LTCM (1998), WTC (2001), [Enron, Worldcom, and Tyco] Accounting Scandals (2002), Financial Crisis (2008-2009), Flash Crash (2010), Eurozone Crisis (2011-12), and more.

All of these developments caused large drops in volatile markets at the moment but produced major gains following for those who kept on and/or bought assets at more attractive prices.

Fixed income

The 10-year US fell to a yield of less than 0.5 per cent, an all-time low.

With a 10-year period of US Treasuries, all it takes is about a 5-bp upward change (i.e. + 0.05 percent) in interest rates to wipe out its entire annual yield. If inflation averages 2 percent per year, your actual, adjusted return on inflation is negative.

So, you have the risk of duration which means the risk of price. And even if you were to hang onto that bond for 10 years (which basically removes your price risk, assuming you are always holding enough cash on hand to cover any losses), you are losing money in real terms.

If we want to get even more nitty-gritty about the long-term prospects for US sovereign debt, governments will have to sell a lot of bonds to finance those budget deficits. Much of the existing US sovereign debt stock, up to 25 percent of GDP, will need to be rolled over in the coming years. In the private sector, most of the cash for buying the bonds will not be feasibly available. Instead, to buy the excess supply, it’ll have to come from the central banks.

Lower spending and higher taxes are a choice but this ability is limited and controversial from a political perspective. You can’t cut spending a lot because many people rely on that income and you can’t raise taxes a lot because you risk tax arbitration and capital offshoring behavior. Only before they vote out those governments can people take so much in extra taxes and cuts in welfare programs that benefit (or could potentially benefit) them. Therefore, there is some limit to inflation and how much extra income can be obtained.

Even if the funds are not sufficient to meet all government commitments, it is highly unlikely they will be defaulted on. In the developing world, loans are denominated in domestic currency, ensuring they have the tools at their fingertips to handle them (e.g., rising interest rates, adjusting maturities, and raising which balance sheet it is on).

To buy it, central banks would literally have to be “printing money.” This makes it highly unattractive for investors to buy such bonds because they would be worried about what it means for the US dollar as that supply stream needs to be driven into the market.

Although foreigners are most concerned about the currency when buying foreign bonds, domestic buyers bear much of inflation to gauge their true return. As we said, both of these variables (currency and real return) are on the downslope, which has been compounded by the coronavirus (bad for the dollar and bad for yields), meaning the Fed’s balance sheet will have to take on a lot of it to keep the rates under control.

So, though during the coronavirus epidemic Treasuries were the ultimate safe haven, owning them is becoming increasingly less desirable as time goes on. (Gold is also a popular safe-haven alternative. It has the downside of being more volatile than short- and medium-term treasuries, and is less liquid.)

Equities and other risk assets

Because of the amount of assets acquired on leverage, market dynamics can be risky for purchasers of equities and other risk assets.

Central banks, as part of their quantitative easing initiatives to lift asset prices, have low cash and bond returns to allow investors to move into equity. This should, in principle, generate a “wealth effect” that gives households and companies more spending power and greater creditworthiness.

And, as equity prices have gone up, their forward returns have dropped. In addition, investors who need a certain return on equity to make themselves satisfied and their clients have simply increased their leverage to raise their returns.

It continues to sow the seeds of its own downfall because the markets are becoming more leveraged and more likely to turn in the opposite direction.

In some situations, you almost want to do the opposite of the crowd (or sit it out) when you see this happening (i.e. purchasing risk assets on leverage), even though the timing may be poor in the short- and intermediate-term.

When the market shakes out, most investors are likely to concentrate more heavily on the effect on sales and earnings and concentrate less on how it may affect companies with weak balance sheets – particularly those with a lot of debt coming due in the near term and might not have enough cash on hand to weather it.

Owing to reports impacting consumer confidence, the travel and leisure sectors are the most adversely affected sector-wise. Within this setting, industries with more stable cash flows tend to outperform others.

A firm with plenty of liquid reserves and little short-term debt is likely to weather the storm well and be hit in a way that is out of proportion to its fundamentals.

This is causing more intense and volatile market activity than natural. Investors are being washed out of their positions to raise cash.

Many styles of traders do have some other stuff against them. Most traders sold OTM and deep OTM placed options into more stable periods thinking they could simply receive the premiums. Now they have to either liquidate these positions or hedge against them dynamically (e.g., short-selling the underlying securities) as an avalanche of selling bears down on them.

This opens up opportunities for those with cash to come in and find quality opportunities, particularly for businesses with high earnings and cash yields without debt (especially short-term) problems.

Will actions by central banks help?

Like other central banks, the Federal Reserve has announced an emergency rate cut to help raise the prices of risk assets and help certain businesses cheapen their liabilities to help offset decreases in demand.

Into the March meeting, we now see another 75-100 base points of cuts priced:

75-100 base points of cuts priced
(Source: CME Group)

Yet rate cuts can only do that much. It will not encourage further purchasing and operation by those who have agreed to cut their discretionary spending.

Monetary policy is out of position in industrialized Europe and Japan, in terms of lowering interest rates and buying assets. The United States is now almost at the same level, having to spend its “powder” coping with the outbreak. Fiscal policy is a method of political making.

So there can be little stimulus from central banks because cash and bond yields are already small and reflect the discount rates at which equities and most other financial assets are off-priced.

A lowering of interest rates will normally help to increase the prices of assets accordingly. But the decline in expectations for profits is far beyond the decrease in interest rates, contributing to a continued fall in prices.

More falls will have to be balanced through a mix of monetary and fiscal policy cooperation. In other words, for it to be most successful, it will need to be aimed at especially distressed institutions rather than the usual wide-ranging networks of increasing liquidity (i.e., short-term interest rate cuts and asset purchasing).

Changes in the central bank rate and stimulus are good and can work to some degree. But the disease’s ultimate economic impact is unknown. So we can not have indiscriminate faith in the power of the financial levers of government to combat it.

Depending on what is currently priced in the curve, after March, the US will be practically out of any more room to cut interest rates. The typical recession needs cutting to about 500bps. Europe and Japan will need to step in the direction of alternative approaches, and the US is now mostly in the same mode.

This makes the issue of whether the economy and markets will hold up more of a mystery during the next recession than has already been the case, for which central banks are still largely unprepared.

On top of this, despite the political hurdles, fiscal policy is weak and policymakers have come to delay monetary policy on these matters on a regular basis.

Conclusion

It is likely that whether the coronavirus becomes a chronic economic issue will depend on whether its effects spill into the credit system.

The virus is likely to remain a matter of public health for some time. Some of this is due to the virus’ own characteristics, such as its long incubation period. In other words, people are sick before symptoms show up, which allows them to go about their daily lives and infect more people before they have to hunker down to deal with the effects of the disease.

The virus will have human and economic costs, although we are likely to see a V-shaped (or at least U-shaped) rebound in production once it finally passes (and is likely to pass, though we don’t know when).

Markets will remain volatile, and volatility will remain high. As reported in March 2020, we are now 17 percent off the all-time high of the U.S. stock market. Trading the Covid-19 is hard because no one really has an advantage of the knowledge and is trading in response to rumors and news flow.

Is the future outlook of the US (and global) business 17 percent lower than it was a few weeks ago in terms of its future earnings and cash flow trajectory?

This is not simply thought that stocks have undervalued themselves. We might argue that the stock market was already overvalued and just got less overvalued. Or perhaps it has been overvalued and “fairly valued”. When you regularly create a balanced portfolio and rebalance, then perhaps it is time to recycle some surplus cash into equities.

You don’t want to go on a buying spree, taking advantage of all our cash simply because it could be a great buying opportunity. Things are cheaper, but definitely not cheaper than in 2009. Price-earnings ratios in US stocks are currently around 17x-18x compared with about 10x in 2009. At the same time, what earnings ultimately come in as uncertain, which is causing a major downward change in their values. Market prices are increasing confusion by expanding bid-ask gaps and lower traveling.

It could, however, get worse before it gets better. Countries are still in the early stages of testing their coronavirus and Covid-19 populations (the disease that the coronavirus produces). Accordingly, as research progresses, we are likely to continue to get higher published numbers, and more are eventually discovered, exacerbating headline-driven market movements.

If it comes to forecasting the future, we have to live with not understanding and recognizing that the unknown will always be greater than the number of items that can be predicted and place ourselves as such.

While some businesses have become very attractively priced with high cash yields and no credit issues, we aim to maintain a diverse portfolio that can perform well in various environments and be largely exempt from what we don’t know.