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US Financial Markets; Will We See A Change in Regime Again?

US Financial Markets; Will We See A Change in Regime Again?

23 Mar 2020 03:36 PM

With the US stocks taking another beating last week as the scope of the coronavirus shutdown started to sink in. The S&P 500 was down 15% last week with most of that coming on Monday after the Fed’s emergency rate cuts.

The pace of economic shutdown accelerated dramatically last week in the US, making traders wonder if the stocks weren’t down enough even more. The restrictions placed on individuals and businesses in the most affected states are considered severe and extreme. For example, New York and California are currently in a “shut down status” with only “essential” businesses operating.

Consequently, the US economy is going to contract by a large amount in this quarter. The Government and the Fed have the ability to cushion the blow to individuals and businesses, but that help needs to come rapidly fast. Layoffs are moving faster than the negotiations and the longer they fiddle over the details, the greater the long-term damage will be. While many believe that the economy is going to contract in a large way regardless of what they do now. The debate now is about what happens after that contraction. If the government acts responsibly, the downturn could be short-lived; if not we could be looking at a very long recovery.

Personal income for the US is about $19 trillion annualized. Whatever passes through the US government needs to replace some percentage of that total for every month that the other US citizen and business stay shut down. But the main question comes; How much of that percentage?

There doesn’t seem to be much doubt about how all this will get financed. There is sufficient and huge demand for Treasury bills at this point as business needs a safe asset. However, taking away several trillion dollars out of the private economy is not going to stimulate anything.

Consequently, the Fed will try to finance this shortage, one way or another. One would certainly think that this will be inflationary at some point in the future but that is not much of a concern at the moment. The Fed’s bigger fear right now is deflation in a highly indebted society. With the US current debt levels, the economy need inflation to erode the real cost of paying them off. Can the Fed do enough to raise inflation expectations? Will they? the alternative is grim.

Meanwhile, the news on the Coronavirus is, as anticipated, getting worse by the day. the number of known cases is now rising very rapidly in the US and It looks quite bad. The US government are hoping that the healthcare system can handle the current stress. If the rest of the other states starts to look like New York City, huge problems the US government will in their hands. Which explains the shutdowns in states without many current cases could happen.

What traders are concentrating on now is identifying the new trends that will emerge from this catastrophe. Bear markets and recessions often mark what would be described as a “Regime Change”.

Just before the 2001 recession (bear market), the US dollar was in a strong bullish environment, US technology stocks were shining while international stocks were shunned, and crude oil fell to nearly $12-$10. The 2001 recession was fairly minor economically compared to what is happening now but the shift in the financial markets was huge. The dollar index peaked the same year and fell over more than 38% to its low in early 2008. International stocks outperformed their US counterparts by a wide margin, value stocks outperformed growth and oil eventually peaked at $120. Gold rose and peaked to over $1900.

Another shift in 2008 was created and after that the US dollar back to the strong bullish environment where growth stocks once again dominated, and commodities went begging. Gold continued to rise after the crisis but eventually fell 45% from its all-time high. Crude was most recently trading in the low $20s but even before the virus hit, it was down considerably.

Will we see a similar shift this time? Quite possibly, but if so, it will take time and all assets will not shift at the same time. In the 2001 shift, foreign stocks continued to fall with US stocks through the bear market as did US value stocks. But gold rose 21% from 2001 to 2003 as stocks continued to fall, starting a bull market interrupted only briefly by the 2008 crisis. Gold continued to rise, even as the dollar tried to find a bottom, finally peaking in 2011. The dollar index started a rally that year that carried it 45% higher to today’s current level.

Gold seems to be more sensitive to these shifts than other assets. Despite the much-noted “strong” dollar of the last few years, gold has rallied strongly. It actually made its low at the end of 2015, but it didn’t really take off until late 2018. From a September 2018 low, gold has risen 25%. It has corrected the last few weeks with everything else but less than half the loss in stocks. Now we could see if it resumes its uptrend.

In additions, the virus and its geographical impact started originally in China and later on showed up in other Asian countries. However, it appears they have done a much better job of containing the outbreak as these nationals are starting to get back to work. Unfortunately, some nations such as Hong Kong and Taiwan are still taking containment measures against a secondary outbreak driven by visiting foreigners carrying the virus.

Assuming these countries don’t relapse, they will lead the global economy out of the crisis. One would think that Europe would start to recover next with the US coming last, but it may be more or less the same time. We haven’t yet seen a peak in Italy’s new cases but the timeline for other countries has the peak around week 3 or 4, so maybe soon. The rest of Europe would presumably be later with the US on about the same timeline. That’s the optimistic view of many.


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