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361 Capital Market Commentary | February 24th, 2020

Just when you thought it was safe to travel to Italy, Japan, South Korea and Iran. Could the incubation period for COVID-19 be up to 28 days, or are global travelers not taking enough precautions? Until we know the answers and have a supertanker full of the vaccine, these hot spot outbreaks are likely going to continue. The outbreak in Northern Italy will be especially difficult to control given the ability to travel across borders so easily. I have to think that most travel and tourism will be shut down across Europe until the WHO knows much more about the virus. Keep an eye on Japan given that the world is planning on visiting them in July/August for the summer Olympics.

The spread of the virus has quickly reversed the risk-on sentiment of the markets into one of risk-off. Demand for mega-cap tech stocks has shifted into buying of Government bonds and gold. The U.S. Treasury yield curve is again inverting as global economies are grinding lower and uncertainty rises. China is doing everything it can to restart its factories and get commerce moving again, but the recovery is uneven as virus flareups across its cities send citizens into a new retreat. Meanwhile, Chinese borrowers are in trouble and will require another round of government stimulus and assistance. Expect Chinese central bank liquidity to resemble a fire hydrant for the time being with the remaining world’s central banks standing by to follow with their own hydrant wrenches.

While global central bankers attempt to keep the markets calm and stable, the next move will be dictated by investors who have been on a buying spree across both equities and fixed income. Will they stay put in equities at these elevated valuations with growing earnings uncertainties? The Treasury markets have quickly shifted to bet on three rate cuts for 2020 from near nil before the virus outbreak. Who is wrong, bond or stock investors? It would seem prudent to have some flexibility in your portfolios right now in the event that this period of volatility lasts longer. And keep an eye on credit spreads. If there is a canary in the coal mine, this will let you know. Spreads were near all-time lows last week but will widen out if crude oil trades into the $40s. Just too many energy companies with their backs against the wall and all access to capital closed for them.

So, a lot to think about for the markets right now and I didn’t even mention the week’s political news and events. It will be a very busy week for the Democrats. Another debate, several televised town halls followed by the South Carolina primary, and then Super Tuesday. Will the field let Bernie Sanders run away to gather up all of the delegates? Or, will any alliances be made ahead of the big primary day to keep the race tight into the convention? The betting markets continue to push Trump’s odds higher with each gain by Bernie. But just like the Super Bowl, you can’t heavily discount any one team. There are still too many variables and any party could come out on top.

And don’t forget that any number of Independent candidates can file to be on the November ballot at any point during this summer. You just never know who might step up to try and run through the middle of the voters. Was that Mitt Romney eating dinner with The Rock Sunday night at Capital Grille?

Just as we were focused on the China virus counts, Korea, Japan and Italy surprise us…

Where Coronavirus Confirmed

As a result of the virus case explosion in Northern Italy, Milan has gone into shutdown…

Tweet from @silvia_sb

France is preparing for the worst…

France’s tourism sector has taken a beating following the coronavirus outbreak, according to the country’s finance minister.

“We have less tourists, of course, in France, about 30%, 40% less than expected,” Bruno Le Maire told CNBC’s Dan Murphy on Sunday at the G-20 Finance Ministers and Central Bank Governors’ Meetings in Riyadh, Saudi Arabia…

France is one of the most visited countries in the world. According to the country’s Ministry for Europe and Foreign Affairs, 89.4 million visitors toured France in 2018 and tourism accounts for nearly 8% of its gross domestic product.

(CNBC)

A top global bank CEO says the markets need to be more concerned…

Markets are underpricing the risk that the coronavirus outbreak poses to the global economy, and central banks need to help business survive the impact of the virus, the chairman of Swiss lender UBS, Axel Weber, said.

“There is going to be quite a bit of impact that is going to go beyond the first quarter and that is where fiscal response, providing businesses with some tax relievers, some emergency funding, that is going to be very important for putting businesses through,” Weber said in a Bloomberg TV interview.

(Reuters)

Welcome to the newest trend in conference seating arrangements…

Press Conference WHO-China
(@onlyyoontv)

As reported in the Global Times, Chinese car sales are forecasted to collapse…

Chinese car sales
(@C_Barraud)

Goldman Sachs cut its Q1 U.S. GDP forecast over the weekend to 1.2% based on China’s slower COVID-19 recovery…

Despite a negligible hit to aggregate US activity from supply chain production disruptions under our baseline scenario, we have nevertheless increased our estimated growth drag from the coronavirus given the slower than expected pickup in Chinese activity and travel. We now estimate a 0.8pp growth drag in Q1 (from 0.5-0.6pp previously), with positive growth effects of about 0.3pp in Q2, 0.3-0.4pp in Q3, and 0.1pp in Q4 as activity normalizes. While this would imply a modest hit to annual-average GDP growth of 0.1pp, the risks are clearly skewed to the downside until the outbreak is contained. Based on our estimates, we have taken down our Q1 annualized GDP growth forecast by 0.2pp to 1.2%.(Goldman Sachs)

Deere reported last week so we received a recent outlook on U.S. farming as it relates to China…

Tweet from @carlquintanilla

Again, China means everything now to the global fashion and designer industry which will be hit especially hard…

The coronavirus outbreak has kept as many as 1,000 Chinese fashion buyers from Europe’s top fashion shows this month as the luxury industry faces its biggest threat since the 2008 financial crisis.China has become all-important to the global luxury and fashion industries as a driver of sales and a core manufacturing hub. Chinese consumers accounted for roughly 40 per cent of the €281bn spent on luxury goods globally last year, according to Jefferies, but drove 80 per cent of the growth, powering sales increases at companies such as LVMH and Kering.

The outbreak has also started to disrupt supply chains for more mid-market apparel, with retailers and fashion brands expressing concern about whether Chinese factories will be able to deliver autumn-winter collections as planned.

Luxury Goods
(FinancialTimes)

As the global crisis weighs on oil prices, energy prices continue to make new lows on many measures…

Tweet from @TayTayLLP

The Tokyo Olympics begin in July…

Unless a vaccine is developed, tested and mass produced ASAP, it would be difficult to see a million people traveling to Japan right now. The country is still allowing Chinese tourists to visit even though its country is the root cause of the issue. The U.S. moved to a Level 2 travel alert to Japan for U.S. citizens over the weekend sending a crimp into many Spring Break and Cherry Blossom plans for March. Unless COVID-19 improvements are seen quickly, I have got to think the IOC will be looking for a delay in the summer games maybe into the Fall or even into next year. If the Olympic Committee is interested, I have prepared an updated logo and mascot.
Tokyo 2020 updated log and mascot

This must be the first time that the Fed has warned on technology and utility stock prices in the same sentence…

Tweet from @HayekAndKeynes

Magazine cover alert last week…

The Economist cover
(@TheEconomist)

Speaking of, the Big Four had generated 45% of this year’s S&P 500 returns through Friday…

S&P Dow Jones Indices
(@hsilverb)

Sending the Growth vs. Value relationship to further outperformance…

Growth vs Value

And valuations back to near record highs…

Valuation gap between growth and value

A weekend glance at the top holdings in the S&P 500 shows the continued outperformance of its largest weightings…

S&P 500 Top Holdings
(Morningstar)

This outperformance by the top 10 giants has led to a further concentration in its holdings…

Total US Equity Market Concentration
(@RBAdvisors)

Now for those who don’t believe that active into passive leads to unnatural buying in the largest capitalization equities…

Here is a snapshot of the top positions, weightings and performance of three large cap core active mutual funds who lost the most AUM in the month of January. Look closely at the performance of their stocks versus that in the S&P 500 Index above. As the three funds below are getting redeemed, the positions below are being sold with most of the proceeds being reallocated into the passive S&P 500 (or maybe the Russell 1000) index fund. As this happens, active fund manager ideas are being sold and passive index names are being bought (no matter what the valuation).

Large Cap Core

The markets are now betting on three Fed Fund rate cuts in 2020…

Probability of 3 Fed Rate Cuts in 2020
(WSJ/DailyShot)

And bond funds are seeing massive record flows…

Record pace of inflows to bond funds
(WSJ/DailyShot)

BofA even noted that global interest rates traded at 5000-year lows last week…

Here is a 75-year chart of the 30-year yield which traded below 1.9% on Friday and near 1.8% today.

CBOE 30-Year US Treasury Yield
(@SJD10304)

The Coronavirus outbreak has shifted investors to favor strong company balance sheets over weak ones…

Company Balance Sheets
(WSJ/DailyShot)

Speaking of weak balance sheets, the number of companies downgraded to junk status is rising…

Macy’s downgrade to junk status by S&P Global has taken the total number of US “fallen angels” — companies that have lost their coveted top-quality ratings — to six this year, almost half of the total for the whole of 2019.Policymakers have long raised concerns about the growing mass of bonds rated triple B, one notch above junk, as companies have loaded up on cheap debt in recent years. Market-watchers warn that a slew of downgrades into junk territory could trigger sales by investors bound by strict requirements to own only higher-rated debt. Such selling pressure could ricochet through the market, sending prices tumbling.

The six fallen angels of 2020 compare to 13 for the entirety of 2019. Kraft Heinz, with $32.5bn of total debt, was also downgraded this week, in the wake of Apollo Investment Corporation, Spirit AeroSystems — a supplier to the Boeing 737 Max — and energy companies EQT Corporation and EQM Midstream Partners, according to S&P Global Ratings. The total debt affected by the rash of downgrades comes to $41.9bn, not far off the $52.8bn total of last year.

(FinancialTimes)

Fallen angels

So what you are saying is that investors are going to where the investments are…

Institutional investors “used allocate to PE for three reasons: outperformance versus public markets, predictability as there was strong persistency of top quartile managers, and the belief that PE was fairly uncorrelated,” said Bryce Klempner, a partner at McKinsey and one of the authors of the report.“Uncorrelation was a myth to begin with,” he went on. “The extent of outperformance and persistency have declined but have not disappeared. Both are still valid reasons for investors to look to PE. However, there’s another reason to be in the asset class now, which is exposure.” The number of private equity-owned companies has doubled since 10 years ago, Klempner pointed out, and the number of publicly traded companies is half that of 20 years ago.

(InstitutionalInvestor)

10 Largest PE Funds
(@NickatFP)

The economic data is going to get volatile, but in the meantime, that was a very surprising Philly Fed figure last week…

Tweet from @Not_Jim_Cramer

And with interest rates headed toward nil, the housing data is still trending up and to the right…

Tweet from @stlouisfed

Updating our Bernie & Trump chart from last week…

The market continues to bet that a Sanders nomination victory = a Trump reelection victory.

Predictit probability
(WSJ/DailyShot)

Expect the age of voters to help predict the outcome of the upcoming primaries as well as the finals…

So, it might be a bit foolish to ignore a Trump victory on the heels of a Bernie nomination. Anything can happen in the finals.

Younger generations outvoted

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