‘The Good News Is, It’s Not Severely Out Of Hand’

Friday saw bearish follow-through in Asia from Wall Street’s dramatic Thursday rout, but European and US equities will look to rebound and close the week on a high note.

Standing in the way is Texas, and specifically Houston. The city may reinstate a stay-at-home order and is preparing to activate an emergency hospital set up at NRG Stadium. “We may be approaching the precipice of a disaster”, Harris County Judge Lina Hidalgo remarked late Thursday. “It’s out of hand right now. The good news is it’s not severely out of hand”.

If that’s what counts as “good news”, you’re in a bad situation. It’s not clear how much weight any new lockdown order would carry in the face of Texas governor Greg Abbott’s executive order reopening the state. Donald Trump visited Dallas Thursday to chat with religious leaders and law enforcement. Some top officials for the city and county were not invited. Texas hospitalizations fell for the first time in four days Thursday, but were still above 2,000.

Speaking of things are “out of hand” but not “severely out of hand”, US equities’ dramatic declines on Thursday may have been more about simple profit taking than anything else after the huge run – perhaps it’s not the start of something worse.

One happy consequence of US stocks’ three-day selloff is a falling RSI. Colloquially speaking, the tea kettle isn’t screeching anymore, although that doesn’t preclude further losses, especially in the event other major metropolitan areas start talking about reinstating stay-at-home orders, just as New York City is reopening.

“The overall move for S&P 500 wasn’t that extreme versus what we saw over the last several years — or even the last several months — but the move in MSCI ACWI yesterday was considered as one of the top 20 worst daily moves for global equities in history”, Morgan Stanley writes on Friday.

“While equity valuations remain rich versus history, weaker stock markets and lower bond yields have pushed equity risk premiums higher, and are now cheaper relative to the last 10 years”, the bank adds.

(Morgan Stanley)

The selloff in credit stateside was broad-based. Bloomberg’s Sebastian Boyd notes that out of more than 4,300 investment grade bonds that moved on Thursday, only 285 tightened. 93.4% of them widened.

“It would be wrong to exaggerate the scale of [Thursday’s] pirouette [as] lots of bonds are still tighter from a week ago”, Boyd went on to say, but did note that “in a normal market, moves of this size are rare”.

Treasurys look poised to give back some of Thursday’s gains, and that would be bullish for cyclicals, value, and small-caps, which were bludgeoned during the selloff. Early on, long-end yields were higher and the curve steeper, but we’ll see how it pans out as the US session goes on.

The bottom line is that Thursday will go down as a blip or a shot across the bow, but given the lack of a crystal ball or a direct line to the “brain” of the virus, nobody knows which.

So much of this has become self-referential and self-fulfilling in both directions. On the downside, more lockdowns wouldn’t just sap confidence and damage investor psychology, they would also imperil earnings, undermining an already tenuous fundamental case for stretched equities, thereby discouraging the ubiquitous “sideline” cash from jumping in.

On that note, I’ll leave you with a quick excerpt from BMO’s Ian Lyngen, Benjamin Jeffery and Jon Hill:

The second wave has arrived; or at least that is the impression one would get by glancing at the selloff in risk assets and the outperformance of 10- and 30-year Treasuries. Increasing incidence of COVID-19 cases have been reported in several states; the drop in domestic equities speaks to the reality that the pandemic is the most powerful influence on the global outlook. This observation can almost go without saying — had it not been for the Fed’s caution against extraction of too much optimism from the May employment report and the growing sense that the market had ‘moved-on’ following the recent refocus on social unrest. With the coronavirus once again front and center, attention will undoubtedly return to the daily stats — with the emphasis on south/southwest. Needless to say, it’s a non-ideal situation for the market, the economy, and the population as a whole — even if general expectations are for a less intense return of COVID-19. In addition to the case count, the prospects for re-lockdowns will be closely scrutinized; the economic ramifications of which would likely echo the initial round, but on a smaller scale. Our base case scenario is that the unfortunate directional change in the pandemic was not unexpected; although the drop in stocks might offer a different interpretation.