Peace for Our Time
Even if there were a vaccine for coronavirus today, production would have to get to a scale to meet demand. We don’t just need the vaccines for the 60 thousand active cases already diagnosed, we would need enough for the expected exponential rise in the number of cases, which on the current trajectory soon will reach hundreds of thousands if not millions.
The already-terrible human impact of coronavirus clearly has the potential to become tragic, but the economic impact will be significant even if its progress can be impeded. Our estimate is that China’s Gross Domestic Product (GDP) growth for the first quarter could be slashed to -6 percent annualized from an already slow 6 percent in the fourth quarter. That could shave about 200 basis points off of global growth relative to its recent trend.
At the same time that China is being forced to shut down factories and quarantine workers, interruptions to the supply chain in the United States and Europe have yet to be felt. By most estimates, if the Chinese extend the lunar new year by two weeks it would not meaningfully impact the global supply chain, but if it went beyond two weeks then we would start to see problems for materials and consumer goods outside of China. Even if the virus does not turn into a pandemic, to think it isn’t going to impact what’s going on in the world is irrational.
The impact of all this on corporate profits and free cash flow will be dramatic. The effect on oil and energy prices could be even more extreme. Right now, excess oil production in the world is an estimated one million barrels per day, so as demand dries up from repercussions, oil could plunge to $25 a barrel unless OPEC or other producers decide to cut production.
Also, we cannot forget that the published numbers related to the coronavirus may be understated. Many experts are confident that as bad as the numbers are, the Chinese are underreporting.
Yet as a major economic problem looms on the horizon, the cognitive disconnect between current asset prices and reality feels like the market equivalent of “peace for our time.” The average BBB bond yields just 2.9 percent. A recent 10-year BB-rated healthcare bond came to market at 3.5 percent and subsequently was increased in size from $1 billion to $1.7 billion due to excess demand.
For those investors who perceive the disconnect between risk assets which are priced for a rosy outcome and the reality of the looming risks to growth and earnings, any attempt to reduce risk leads to underperformance. It is a mind-numbing exercise for investors who see the cognitive dissonance. The frantic race to accumulate securities has cast price discovery to the side. In the world of corporate bonds and asset-backed securities, issuers are launching deals and then tightening spreads to Treasurys by 25 basis points or more relative to where the last similar new issue was priced just a day before. They are also upsizing deals, as it has become common to see new issue bond underwritings ten times oversubscribed. The giant flood of liquidity is driven by virtually every central bank in the world injecting reserves into the system. And many investors today don’t even buy individual bonds, they purchase a basket of bonds that can be traded versus an exchange-traded fund (ETF). The quality of the bond doesn’t matter; no one is actually negotiating a rate or a price. In the ETF market, prices are set by pricing services that frequently use stale data when no price discovery has occurred. The result is a non-market price determining where a security is trading and there is no additional price discovery, meaning nobody is negotiating individual bond prices. If it is in the index, buy it! This is what price discovery has become.
This will eventually end badly.
guggenheiminvestments.com |
