Premia Partners - “Perfect Markets” Meet Perfect Storm

Premia Partner’s Simon Say Boon Lim describes the state of the global markets in the face of the fallout of COVID-19, discussing whether the virus can be blamed for the current trends being witnesses globally.

By Simon Say Boon Lim, Senior Advisor, Premia Partners

• The sharp pullback in developed markets could see 10% knocked off the S&P 500
• The correction was due to a more complex mix of factors than just COVID-19
• A rebound could emerge on monetary stimulus hopes
• But deeper problems of overvaluation and negligible earnings growth will remain to trouble markets later in the year

US markets have been in technically overbought territory on daily charts since early February. This correction was overdue and we should see a total of 10% knocked off the S&P 500 from the recent peak, before this is over.

Notwithstanding the headlines, this is less about COVID-19 than about a market being jittery because it is priced for perfection. Newspaper headlines and market commentaries often reflect a search for neat, convenient “reasons” for market moves which often reflect messy and inconvenient underlying factors. COVID-19 makes a better headline – and satisfies the need for neat answers – than “there were more sellers than buyers.”

The bigger worry for developed markets is what happens on a medium-term basis, beyond the coming rebound on the S&P 500 from around the 3,000 level? If the S&P 500 and the Euro Stoxx 50 daily charts have been technically overbought for 3-4 weeks, the weekly charts have been technically overbought for 3-4 months. Beyond the coming rebound, there is a deeper malaise which may show up on markets later.

Was it COVID-19 or markets were just plain old “tired”? I reckon the latter. As written here a few days ago, “US markets are technically overbought and fundamentally expensive, both short-term and medium-term. The Euro Stoxx 50 also looks technically overbought. The underlying trend for the developed markets – particularly the US – is they are at the tail end of their bull moves. They could edge up a bit more but the risks are biased much more on the downside.”

Daily charts for the S&P 500 and the Euro Stoxx 50 were both signalling technically over bought for weeks. Conversely, the CBOE VIX had hit oversold levels by mid-February. This was going to happen anyway. Another tell-tale sign was how market breadth had lagged the S&P 500 since the start of the year. This usually foretells fatigue.

In the 24-hour news cycle, editors and TV producers demand headlines – simple (simplistic even) explanations. Oscillators, momentum indicators, or worse, wave counts will never make it to the headlines. “Markets plunge on COVID-19” is a lot more compelling than “Markets plunge because they were tired.”

What happens beyond a rebound? The same indicators that signalled a short-term correction are also telling us a deeper, medium-term correction is looming for Developed Markets. Here are three reasons why a more painful correction is looming for DM.

• Talk of an economic revival had been exaggerated – the global economy was fragile to begin with. The Euro Area economy has been steadily slowing through the course of 2019, from 1.4% growth in 1Q19 to 0.9% by 4Q19. There was some cheering a few days ago when the Euro Area Composite PMI picked up for the third consecutive month to 51.6 in February, from 51.3 in January. Underlying that was a stable reading for services. However, new business growth slowed and employment grew at its slowest rate in more than a year. Importantly, Manufacturing PMI at 49.1 in February was still contracting. In fact, that would be the 13th consecutive contraction.

The US – the “star” of the global economy – is slowing very significantly. GDP growth was at 2.1% growth 2H19, which was a fair way off its 3.1% in 1Q19. But the Composite PMI fell into contraction at 49.6 in February. The manufacturing PMI had been easing anyway since November last year. But the Services PMI fell sharply into contraction at 49.4 in February, from 53.4 in January.

The Japanese economy, which contracted by a whopping 1.6% q/q in 4Q19, had its worst quarter in six years, and was already staring down the barrel of recession even before COVID-19 hit.

Bottom line: The much-vaunted rebound in the global economy in 2H19 was starting to fade anyway before COVID-19. The epidemic (likely soon, pandemic) will exacerbate the slowdown.

• Stock valuations are priced for perfection. “Perfect markets” may have met the perfect storm. As I noted late last year here, the Shiller CAPE ratio was at levels “similar to that seen just before the Great Crash that marked the beginning of the Great Depression, and only historically exceeded by the CAPE seen just before the Nasdaq Crash.” And if you think the longer-term, CAPE ratio is too academic, I also noted in that article that the S&P 500 forward price to earnings ratio was at 19x, compared to the 5-year average of 17x. Against that, I noted that US corporate earnings were stagnating. Well, 4Q19 earnings reports suggested earnings growth of around 3%, hardly inspiring given a forward PE ratio of 19x.

• Monetary stimulus will be even less effective in the face of a pandemic. I wrote late last year about the dubious efficacy of more and more monetary stimulus here. In particular, I noted research by Princeton University economists Markus Brunnermeier and Yann Koby which suggested that ultra-low interest rates eventually trigger a “reversal” of its intended effect on the economy by damaging banks’ profitability and capital, hence limiting their ability and willingness to lend. This “reversal rate” comes in sooner (at a higher level) with quantitative easing.

Yet, that won’t stop central banks from cutting rates and buying bonds in attempts to offset the economic impact of COVID-19. That could give markets reason to stage a near-term rebound. Indeed, the decline in the US Treasury 10-year yield from January is already pricing in those rate cuts. But apart from the long-term, self-destructive economic nature of excessive monetary stimulus, there are also near-term limitations on how monetary stimulus might work if supply chains are gummed up, and how you get the “wealth effect” of monetary stimulus (via asset markets) to work if consumers can’t get out to spend.

View the article on Premia Partners’ website HERE.