China’s travel restrictions and business closures will still have a serious and global economic impact. The disease will probably keep spreading until a vaccine is ready, as some reports suggest even asymptomatic patients can infect others. That would mean even those who show no symptoms can still spread the virus. It is not the most deadly virus we have come across, but it does spread.

The economic virus is already in motion. The many manufacturers around the world who depend on Chinese components may find their pipelines running dry in a few weeks. Then what? Lost sales, layoffs, and it gets worse from there.

There are many ways to measure the costs of Coronavirus. There have now been more than 24,000 officially reported cases, and nearly 500 people have died, but we’d be wise not to have much faith in these figures. A report from the Lancet estimated that as of Jan. 25 the true number of Coronavirus cases in Hubei province, which includes the city of Wuhan, was not 761, as officially reported, but 75,815.

The impact on China’s economy will be considerable. Quarantine and internal border controls have been imposed, and local officials are now overcompensating in response to criticism from Beijing that they were slow to respond to the initial outbreak. Businesses and schools are likely to remain closed for weeks. Economic activity in many Chinese cities has sharply declined.

There is also the mounting economic cost for the entire global economy. The outbreak of severe acute respiratory syndrome (SARS) in 2003 knocked one to two percentage points off China’s GDP that year, which then cost one-quarter to one-third of a percentage point in global growth, according to estimates. The larger number of infections from the Coronavirus suggests the impact could be more severe this time for both China and the world. What happens in China matters more than ever for the rest of us. Its share of the global economy has surged from 8% in 2002 to 19% today, and it’s now the world’s second largest economy.

Companies in other countries dependent on Chinese supply chains are already facing a slowdown: Japan, Australia, New Zealand, Singapore, Italy, and the U.S. have all imposed travel restrictions. Asian countries will see a sharp reduction in the number of arriving Chinese tourists, an important source of growth.

Oil prices have fallen 20% over the past month on expectations of lower demand from China and reduced sales of jet fuel as flights are grounded. Press reports suggest that China’s daily crude-oil consumption has fallen by 20%, an amount equal to consumption in Britain and Italy combined. OPEC and Russian officials are now debating whether to cut oil production to buoy prices. Prices for metals and other construction materials have fallen.

This is also a hit to the “Phase 1” trade deal the U.S. and China concluded last month. China was already unlikely to purchase the additional $200 billion of U.S. goods over two years that it committed to buying. The slowdown will make that figure hard to achieve.

But the greatest cost will come to China’s reputation as a reliable trade partner. In developed countries, health care systems are quick to identify public-health risks and better able to respond to them. China’s top-down authoritarian political system makes things worse. In the early stages of these kinds of crises, local officials try to avoid blame from Beijing by hiding information about outbreaks and the extent to which health facilities are over-matched. In later stages of the crisis, they overcorrect to show Beijing they’ve taken charge of the problem.

In the process, China creates the impression that it has learned little since the SARS crisis, giving the rest of the world reason to try to reduce its dependence on China for growth and production.

The day is getting closer when it is China’s increasingly hefty economy, not America’s, that will carry the most blame for a global recession.

 

 

Gross Domestic Product (GDP)

 

Economists and investors are rightly obsessed with growth. We always want more of it. We worry it won’t come or, worse, might turn into contraction. Economists of all stripes recognize economic growth cures all manner of ills.

Yet, exactly what is growth? We think we know, but in reality, it is a sticky question. We usually measure it with Gross Domestic Product. But that’s a statistic, which is both hypothetical and subjective.

GDP growth is currently decelerating but still positive.

One of GDP’s big problems is the way it treats government spending.

Government spending is a problem and I want to isolate its effect on GDP.  Politicians want to keep the GDP number as high as possible.

A different problem emerges when government runs a deficit. That money theoretically comes from future tax revenue, assuming that the bonds the government sells to cover that debt will be paid back.

Deficits are no longer “if” or “when,” of course. They have become a fact of life and the only question is whether they are huge or gargantuan. This creates multiple problems, among which is GDP distortion; it over-weights government spending and under-weights private production.

This is a problem because GDP is key to the Keynesian macroeconomic theory on which most governments rely. If GDP is lagging, the answer is to dial up government spending, which is a direct input to GDP. Presto, growth appears.

The original idea, at least according to Keynes, was for government to run deficits during recessionary periods, thereby creating demand that would boost GDP back into growth again. Then—and this is the part we now ignore—run surpluses during the boom times in order to be ready for the next downturn. Keynes didn’t envision the permanent deficits we currently have.

Government spending is funded by either taxes or borrowing. Either is removed from the resources that the citizenry (including government employees) can spend. The citizenry can only spend money that the government is also spending, if the borrowing is from external sources, but that has its own consequences.

The current surge in outlays is not an auspicious data point for future private sector GDP growth. Nor is it going to turn around any time soon, given that Trump and the Dems are all committed to massive increases in spending, mainly fighting over who controls the purse strings and where they’ll be spending the money.

In other words, we appear to be reaching the point at which government spending overwhelms any Keynesian stimulus benefit, in part because we failed to run surpluses that would have helped cover this spending. We instead expanded the debt, raising interest costs on top of the growing entitlement and defense spending.

Worst of all, there is no painless way out of this trap. I see approximately zero chance government spending will fall, no matter how this year’s elections turn out. Whether through deficits or borrowing, government is going to suck more and more of private GDP into the Treasury, from which it will be redistributed to favored groups. What we now call “politics” is really a battle to be one of those groups.

The on-budget deficit is already over $1 trillion. Combined with the off-budget spending, the national debt will probably grow $1.3 trillion or more this year. A recession would likely increase the deficit by another $1 trillion.

This isn’t entirely GDP’s fault, but GDP’s design encourages it. Whether GDP rises or falls is important, but not as important as the policies it is used to justify.

Furthermore, federal revenues, as a percentage of GDP, declined to levels that have historically coincided with recessions.

 

 

And then there is the Fed…

During Powell’s testimony to the Senate Banking Committee this past week, he said:

“There is nothing about this economy that is out of kilter or imbalanced.”

Okay, I’ll bite.

Mr. Powell, if there is nothing out of kilter or imbalanced in the economy, then why are you flooding the system with a greater level of “emergency” measures than seen during the “financial crisis”?

 

 

The Federal Reserve now has to inject $60 billion a month to provide repo liquidity and other activity. Why? The Fed is essentially using its current QE program (although they don’t want to call it QE) to monetize over two-thirds of the deficit.

Furthermore, there is increasing talk about controlling the yield curve—another form of easing—to help GDP growth. Does it need such a boost? We can’t really know because GDP doesn’t tell us what we think it does.

Some important points on the Fed:

  • [Powell] learned little from the monetary experiences of the Fed, ECB and BoJ over the past 10 years.
  • He said, in front of the Senate, that the Fed will “likely need QE and forward guidance in a downturn.”
  • QE has proven to not be an economic stimulant, especially with rates already so low.
  • Forward guidance is bad policy and central bankers have it backwards.
  • They think telling the world that rates will stay low for a long time will engineer animal spirits. It does the exact opposite.
  • When households and businesses know rates will stay low forever, there is no incentive to act now instead of later. They just act later.
  • “Forward guidance” slows

Bottom Line: While Fed policy isn’t achieving its stated goals, it very effectively growing the bubble we see in stock, real estate, and other asset prices. The most important question for investors is how long central bankers can sustain this “success.”  Investors have been trained to disregard the “risk” under the assumption the Federal Reserve has everything under control.

Currently, it certainly seems to be the case as markets hover near all-time highs even as earnings, and corporate profit, growth has weakened. If the Coronavirus impacts the global supply chain harder than is currently anticipated, which is likely, the deviation between prices and earnings will become tougher to justify.

Conversely, if by some miracle, the economy does show actual improvement, it could result in yields rising on the long-end of the curve, which would also make stocks less attractive.

 

Good News

 

  • According to the Mortgage Bankers Association, US mortgage delinquencies as a share of total loans dropped to the lowest level in recent decades.

 

More on the Fed

 

While the economic impact from the virus is likely to be substantial, traders looked past economic realities. They focused instead on more liquidity being pumped into the markets by both the Fed, and the PBOC (Peoples Bank of China).

The PBOC decided that instead of unwinding the large liquidity provision, they would double-down on it… and that they did in size. The last four weeks have seen China supply over 2 trillion CNY (net!) into its financial system – something we have never seen anything like before.

 

 

It wasn’t just the PBOC, but also the Federal Reserve dumping tremendous amounts of liquidity into the markets which only had one place to go…equities.

 

 

While the Fed continues to deny it, current liquidity interventions are indeed “QE.” They have been clearly concerned about the potential of global instability impacting the U.S. In their most recent report to Congress, the “Coronavirus” made its appearance as the latest threat to the global economic instability.

Do NOT dismiss that last sentence lightly.

Since last October, the Fed has been injecting the financial system with massive quantities of liquidity to fix “short-term funding needs.” Each time they have tried to slow the rates of funding, the market has declined, so they extended the facility. Initially, the facility was for October tax payments. Then it was extended for the “year-end” turn. Then it was extended for April “tax payments.” The “Coronavirus” will be the next reason to extend the program into June.

 

 

The question you should be asking is: “Exactly what is going on?”

Even if the virus was cured today, the economic impact will continue to be felt over the rest of this year.

Importantly, the impact on China will be substantially greater, which will undermine any potential positive to the U.S. from the “trade deal”. That impact will result not only in the form of weaker economic growth in China, but globally, as well, due to the interlinked supply chains. This is going to manifest itself in weaker earnings and corporate profits, which will continue to make elevated asset prices harder to justify. 

The current bull market is being fueled by the Fed.  Plain and simple.  How long can this continue?

 

 

Currently, global Central Bank balance sheets have grown from roughly $5 Trillion in 2007, to $21 Trillion currently. In other words, Central Bank balance sheets are equivalent to the size of the entire U.S. economy.

In 2007, the global stock market capitalization was $65 Trillion. In 2019, the global stock market capitalization hit $85 Trillion, which was an increase of $20 Trillion, or roughly equivalent to the expansion of the Central Bank balance sheets.

How Are You Protected?

We have no certainty about when, or what will trigger the next bear market.

What we do know is that such an event will likely be far more brutal than most realize due to years of excess risk-taking, leverage, and demographics.

However, this is what our process is designed to handle:

We are ready for the anticipated volatility.

As long as the process is followed, risk can be controlled. Where the majority of investors go wrong, is by not having a process.

“Hoping” markets will continue higher indefinitely, is not a process.

 

Coronavirus Risks to Global Supply Chain

 

Reliable information on China’s Coronavirus outbreak is scarce. While some Chinese factories are starting up again after an extended New Year break, we also see some manufacturers in Korea and Japan stopping production for lack of Chinese parts.  The economic impact will keep spreading after the medical part is solved. These key points from a short report from RSM describes the challenges.

Key Points:

  • US factories received almost 30% of their imported inputs from China in 2015. The figures have only increased since then.
  • American hospitals are particularly vulnerable. The US obtains 97% of its antibiotics from China, in addition to many other products like syringes and surgical gloves.
  • Textiles, computer equipment, electronics, and non-metallic mineral products all rely on China for at least a third of their imports.
  • Wuhan, where the outbreak centers, is an auto manufacturing hub.
  • Reduced travel has pushed down oil prices, which helps Western consumers but will cause problems in oil-exporting countries if it persists.
  • Having taken drastic measures, the government can’t turn on a dime and send everyone back to work. This would risk re-accelerating the viral outbreak.
  • Local governments have imposed a patchwork of specific rules, complicating business restarts.
  • Both Guangzhou and Shanghai require companies to provide face masks, of which there is a severe nationwide shortage.
  • Beijing is requiring local governments to make plans for companies to restart operations in batches. Some sectors will take longer than others.
  • Tightly-woven supply chains can remain dysfunctional if just one link stays offline.

Bottom Line: It’s important to distinguish between this outbreak’s medical outlook and its economic consequences. Even if scientists find effective treatments and vaccines soon, tightly-woven global supply chains may not recover quickly. The world economy is already weakened from trade war and other issues. Coronavirus certainly won’t help matters.

The Coronavirus has been the biggest hit to China’s growth since the 2008 financial crisis. Gavekal believes the best-case scenario is for the outbreak to diminish and bring the economy back near full capacity by the end of February. Global disruptions will grow more severe if it drags into March.

 

Jobs

 

US job vacancies tumbled in December, with the openings rate (second chart) dropping back to 4%. The two-month decline in job openings was massive. Here are the year-over-year changes.

 

 

Oil Companies

 

West Texas Intermediate crude oil is priced at $52 right now.  At that price, MOST oil companies remain noncompetitive.  They have cost structures that can’t keep up in the world of $60-something oil… let alone $50-something oil.

In the boom years of 2011 to 2014, these companies took on huge amounts of debt that made sense in the world of $100-plus oil. Now they’re burdened with heavy debt and projects with high break-even costs.

According to Norwegian energy-research firm Rystad Energy, new oil projects, on average, require a minimum of $60 per barrel just to break even.

Of course, there are different variables across each oil-drilling project. Each project requires a certain oil price to break even over the life of the project.

The higher oil prices go, the more projects become feasible. Conversely, the lower oil prices go, the fewer projects make economic sense.

Here’s Rystad’s average breakeven price for the new oil projects.  But no one starts a new drilling project to lose money. There has to be upside with a margin of error, meaning oil has to be sustainable at prices higher than breakeven long enough to give investors confidence that a new project is worthwhile.

U.S. onshore shale projects – which don’t need ships or more specialized equipment – are the world’s second-cheapest source of oil, behind projects in the Middle East.

But they don’t come with geopolitical risk. That’s where money for new projects will go.  This will likely lead to a new round of oil and gas bankruptcies.

Leveraged companies with huge debt on their books to fund more expensive oil projects with high breakeven costs (like offshore and deep-water drilling) are in real trouble.

Companies like Chesapeake Energy (CHK) and Antero Resources (AR) are struggling to hang on… hoping for higher oil prices.

Many of these companies not only can’t make a profit… They can’t even service their debts. Many are running out of money and can’t borrow more. And one by one, they’re going bankrupt.

 

 

According to law firm Haynes and Boone, 208 oil and gas producers with a combined $122 billion in debt filed for bankruptcy from the beginning of 2015 through the end of 2019. In the same period, another 196 oilfield-services companies with a combined $66 billion in debt declared bankruptcy.

After a lull in 2017 and 2018, energy bankruptcies started picking up again in 2019 – with 42 energy producers and 21 energy-service companies filing bankruptcy.

It’s about to get even worse.

Back in the days of $100-plus barrels of oil from 2011 through much of 2014, many U.S. oil and gas companies gambled… Fueled by cheap credit, they took on huge amounts of debt – more than they could ever handle – hoping that oil prices would keep going up.

They were victims of their own success… Now, the bills have piled up. And they’re coming due within a short period of time.

According to credit-ratings agency Moody’s, $203 billion of oil and gas debt is set to mature from 2020 through 2023.

 

 

Market Data

 

  • Only 51.5% of Small cap index stocks are above their 20-Day EMA (exponential moving average). This thin participation does not instill a lot of confidence in the small-cap market.
  • Many sentiment indicators hit historic extremes of optimism in December and January. After stocks dipped in late January, sentiment reset. Now that they’ve moved to new highs, it’s being accompanied by less optimism.
  • A year of warnings. Technical warning signs triggered often last fall and started up again in recent weeks. That has amounted to a relatively large cluster over the past year.
  • Correlation concern. The correlation between daily returns in the S&P 500 and 10-year Treasury yields has neared its highest level since 1962.
  • Good growth. The ratio between growth and value stocks has become stretched
  • Auto loan delinquencies have diverged from other consumer credit markets.  A canary in the coal mine statistic.

 

 

Activity at LA and Long Beach ports, which is an indication of trade volumes, has declined in recent months.

 

 

The top two stocks are now nearly 10% of the S&P 500.

 

 

All content is the opinion of Brian Decker