| January 26, 2020 So far today it's been a quiet, lazy Sunday morning. But developments on the global scene are anything but quiet. In fact, I find the current conditions a bit confusing and highly disturbing. I have found that whenever the world starts looking a bit chaotic, my best way forward is to write about macroeconomic conditions. Somehow the process of writing has always helped me clarify my thoughts. Hopefully things will seem clearer to me by the time my writing is done. As the new decade started, I was quite optimistic about the state of the global economy. The Phase 1 trade deal meant that Chinese-American trade war was at least stabilizing into a more predictable, more manageable skirmish that was unlikely to worsen any time soon. China’s economy looked set to pick up a bit in 2020, and overall the global economy looked like it was on solid ground. Sure, there were still certain significant challenges, but at least the prospect of fresh tariffs seemed to be off the table for some months. The rest of Asia, in particular, was set to benefit from this development, and global stock markets, although extended, looked set to continue their relentless drive to successive new highs. The U.S. economy continued to look strong, and prospects for a recession seemed remote. Even the political implications of the impeachment proceedings seemed quite muted. In this environment of stable growth, low inflation, and minimal geopolitical unrest, I felt that the currency markets were likely to present some excellent money-making opportunities with “risk-on” trades being especially promising. I thought that the yen would weaken versus a basket of riskier currencies such as the Australian dollar, Canadian dollar, and New Zealand dollar. By buying these riskier currencies and selling the yen, I would earn the interest differential between the currencies and make additional profits from the capital appreciation of the riskier currencies strengthening relative to the yen. I was also modestly bullish on the British pound, although the Brexit uncertainty still hangs over the British pound like a thick cloud of fog that can’t quite lift. There were a number of anomalies which posed longer term risks to the global economy, but I chose to ignore them for the time being. For example, the negative interest rates in Europe and Japan are clearly a sign that not all is so wonderful. Last year, there was over $11 trillion in fresh debt issued at negative interest rates, which upon further examination is truly weird. I really wonder why so many people are happy to make such massive investments which are certain to have negative returns at maturity. It suggests that the asset which people are investing – MONEY – has a sharply diminished value. Perhaps I am looking at this scenario too simplistically, but I thought that the purpose of investing my money for 10 years was to earn a positive return. That is absolutely NOT what the buyers of these negative interest rates will earn unless economic conditions weaken sharply and the price of this debt rallies due to ever-dropping negative interest rates. Then the holders of the negative interest rate bonds can at least sell their bonds and make some profits. Anyway, I will write about this at great length at a different time, as the ramifications of this interest rate scenario are far-reaching and quite worrying. Surely, the monetary tools of the ECB, for example are greatly diminished. But for now, let me return to the macroeconomic scenario which is disturbing me so much right now, and the key factor which I am trying to understand – the coronavirus from Wuhan. I remember the SARS scare from 2002/2003, but it was a far different scenario at that time. The Chinese economy was $1.2 trillion, so a 1% hit to the Chinese economy was not especially important to the global economy. Today the Chinese economy has a GDP of $14+ trillion, so a catastrophe in China will have far-reaching international ramifications. Plus, SARS spread far more slowly. It took over four months to spread to 1,000 people, but coronavirus has infected more than 2,000 people in 25 days. We can speculate about whether the actual number is much higher, but even the 2,000 number is terrifying. The Chinese response – of essentially putting 65 million people in quarantine – is astonishing, and it points to the severity of the situation. That is almost the entire population of France! Clearly this is a problem that could become very nasty, very quickly, with broad repercussions for the global economy and the markets. Taking these steps during the Lunar New Year, the time of the greatest travel in China, is a dramatic move which underscores the comments of Premier Xi, who described the situation as grave. If I put on my cynical hat, then I would suggest the Xi’s usage of the word “grave” carries multiple meanings. Currently, Chinese tours abroad have been canceled. Hong Kong has declared the situation is an emergency and the government has closed schools for the next three weeks. Disney’s theme park in Shanghai has been closed indefinitely, thousands of McDonalds and Starbucks stores have been closed indefinitely, Emergency hospitals are being constructed and other extreme measures are being taken, but this scenario looks like it is going to get much worse before it gets better. Is this going to evolve into a global pandemic? Hopefully not, but the virus is spreading into many countries very rapidly. Is this going to have an impact on the global markets. Almost certainly. We saw a sell-off in the U.S. stock market on Friday, a rare occurrence, but if the virus continues to spread at an exponential rate, the sell-off in stocks could accelerate aggressively, leading to a breath-taking meltdown. The strategy of buying stocks on every dip must be avoided for the time being. Essentially, the world could shift to a risk-off mentality very, very quickly. Greed tends to take some time to develop and mature into bubbles, but fear tends to be far more immediate, leading to flash crashes. Given the sharp and relentless stock market rally since October of 2019, the magnitude of a down move could be quite fierce. Am I forecasting the end of the bull run? It is a bit premature to make such a forecast, but for the time being, the risk is heavily skewed to the downside. In other markets, as the world starts to price in an increasing risk of significant negative impacts on Chinese – and potentially global – economic performance, the repercussions in other markets could likewise be extreme. Oil prices could sell off sharply, gold could rally sharply, bond yields could drop sharply, and the risk-on currency trades could reverse into risk-off currency trades. Surely the peripheral economies such as Australia’s, could really suffer if China experiences any sort of sustained slowdown due to the steps being taken to stem the spread of coronavirus. How far can we go? Potentially these moves could turn into a rout, as the positions that need to be unwound are all crowded positions, with many speculators being positioned the same way; i.e. betting on a sanguine macroeconomic environment with solid growth, modest inflation, low interest rates, and only modest geopolitical risks. Injecting an unexpected geopolitical risk into the macroeconomic scenario is quite a shock, and many investors are going to watch this story’s development with ever-increasing levels of anxiety. My bet is that they will run for cover very quickly, resulting in the proverbial up the stairs and down the elevator scenario, with markets reversing much, or all, of the recent gains…and perhaps much more. The last time that I felt this way about an unexpected piece of news was in June of 2007 when two Bear Stearns credit funds blew up. I didn’t understand fully the ramifications of the sub-prime credit funds imploding, but I knew that the risks had all shifted suddenly to the downside. This turned out to be the first signs of the economic crisis that followed, but the Central Banks were far better armed to handle a crisis at that time than they are now. We had built up some very large risk-off exposures at that time due to low levels of volatility by buying cheap, out-of-the-money yen calls against the euro and US dollar. It paid off in a major way, and we ended up earning over 300% for our clients in 2007 and over 75% in 2008. Volatility exploded higher and the yen’s value surged dramatically. Volatility levels are currently far lower than they were in 2007, so in a way the opportunities are even more attractive now. Will we potentially have some moves that are even more dramatic than those from 2007/2008? Is this going to be a repeat performance? It is way too early to say, but it could certainly lead to the most extreme risk-off scenario we have experienced since 2018. At a minimum, I recommend that you move to a cautious stance, reducing some risk until we see how the coronavirus scenario plays out. For the more adventuresome, this can be an opportunity to start playing for at least a partial unwind of the recent rallies in stocks and the market’s risk-on currency positions. Best regards, Mr. K P.S. Did you enjoy this morning's update? Do you plan to make any trades using it? I'd love to hear your thoughts. Write me those thoughts, and any questions you might have, right here. |
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