Pricing in a Recession

The long feared recession which would make investors bearish is here.  There is no doubt about it.  The coronavirus will plunge the world into a global recession, as reduced consumer spending, job cuts, and reduced production will overwhelm any kind of fiscal response, which is usually a dollar short, and a day late. 

Contrary to what the so-called bond experts believe, the move in Treasuries over the past few days is not irrational, but a swift realization from the most efficient market on Wall Street that a recession is coming, and the Fed is going to zero in a hurry.  The emergency 50 bps rate cut from Powell was a screaming signal that the Fed is panicked and will cut aggressively to zero.  And bond investors remember how long it took for the Fed to go from zero rates to their first rate hike (7 years).  That is one of the reasons the yield curve is not steepening, the bond investors are chasing yield by going out further out on the to 30 years, the only part of the curve yielding above 1%. 

We are pushing forward a bear market due to the coronavirus economic shock, which is going to be in many ways, just as bad as 2008, but instead of financial danger, it is physical danger that people will have to deal with.  And that is something that hasn't happened since the Spanish Flu in 1918.  This coronavirus should be named the Wuhan virus, because it is the Chinese who have probably released the virus from their biological weapons lab, either through human infection or lab animal viral transmission.  Of course, there will be no concrete evidence or news coming out of China to reveal the truth, it will just be assumed that it came from wild animals at some wet market, which is hard to believe. 

Anyway, we finally have headlines and news which are going to more impactful than what Wall Street expects.  That is a rarity in an age of chicken little investors that get frightened by Iranian missles, small tariff hikes, and a little repo rate volatility.  The coronavirus is the real deal, it cannot be overexaggerated enough, because people are underestimating how easily this virus is being transmitted, with many passing it on to other without having symptoms.  It appears that China has gifted the world with a new viral disease that will have to dealt with on a permanent basis, as the characteristics of this virus make it hard to completely eliminate. 

The U.S. government approach of reluctant testing and trying to paper the problem over with tax cut proposals and rate cuts doesn't get to the underlying problem of virus containment.  This presents longer term and more severe economic problems where more draconian measures of quarantine and people staying home will be necessary (like what Italy is doing) to try to contain the spread of the virus. 

The longer governments wait to control the problem, the harder it will be to contain the spread.  This coronavirus economic shock will be long lasting seeing how easily it is spreading and with a lethality about 20 times that of the ordinary flu, which kills plenty of people as it is, even with a vaccine available.  When people stay at home and avoid crowds, stop going to the mall, movies, sporting events, concerts, traveling, etc, that has a huge impact on the velocity of money and the unemployment rate.

Short term, it looks oversold and with the ECB meeting Thursday and FOMC next Wednesday, there will probably be a equity market bounce in the coming days, but I would use that bounce to either get short SPX or long Treasuries, even at these very low yields.  And the only way I would be playing the SPX on the long side is to wait for extreme oversold conditions to buy.  It will be easier to play the short side at least for the next few weeks. 

Stock market investors have forgotten what a real bear market is, expecting this to be quick and easy just like fall 2018 deep correction, or an August 2015-February 2016, or an August-September 2011 correction.  I just don't buy it.  The valuations are too rich, the yields are already too low, providing no risk parity benefits for long bond holders, and the economy will be much weaker than anything you saw in 2011, 2015-2016, or 2019. 

I will be trading with the assumption that we are now in a bear market, and that requires different rules.  It is something that most investors have forgotten or never experienced before, and I am sure will catch a lot of traders off guard in the coming months.   I'll get into that at another time.