Streetwise Professor

March 13, 2020

Wuhan Virus and the Markets–WTF?

What a helluva few weeks it’s been, eh boys and girls? By way of post mortem (hopefully?) rather than prediction, here’s my take.

Under “normal” circumstances, two factors drive asset valuations: expectations of cash flows, and the rate at which investors discount those cash flows. COVID-19–Wuhan Virus, to call it by its proper name–has has profound influence on both.

WV has caused a major aggregate supply shock, and an aggregate demand shock, and these amplify one another. The aggregate supply shock stems from shutdown of productive capacity due to social distancing. And people who aren’t working aren’t earning and aren’t spending, hence the aggregate demand shock.

These developments obviously reduce the income streams from assets (e.g., corporate profits). That’s a negative for stocks.

As an aside, these factors defy traditional policy prescriptions. Monetary and fiscal policy are focused on addressing aggregate demand deficiencies, i.e., trying to move demand-deficient economies (where demand deficiencies arise from price rigidity and nominal shocks) back to the production possibilities frontier. Supply shocks shrink the PPF. Pushing the PPF back to its normal state in current circumstances is a function of public health policy, and even that is likely to be problematic given the huge uncertainties (that I discuss below) and the dubious competence of government authorities (which I discussed last week).

The pandemic nature of WV also makes it the systematic shock par excellence. It hits everyone and every asset class, and cannot be diversified away. A big increase in systematic risk results in a big increase in risk premia, meaning that the already depressed expected cash flows on risky assets get discounted at a higher rate, leading to lower valuations.

A lot higher rate, evidently. Why? Most likely because of the extreme uncertainty about the virus. Data on how infectious it is, how many people have been infected, the fatality rate, how it will be affected by warmer weather, etc., are extremely unreliable. In other words, we know almost nothing about the salient considerations.

This is in part due to lack of testing, and to inherent defects in the testing: those who get tested are disproportionately likely to be symptomatic, exposed, or hypochondriacal, leading to extreme sample selection biases. The tests are apparently unreliable, with high rates of false positives and false negatives. The RNA tests cannot detect past infections. It is in part due to the novelty of the virus. Is it like influenza, and will hence burn out when temperatures warm? Or not?

Another major source of uncertainty is due to the fact that the initial outbreak in China was covered up by the evil CCP regime. (Which now, in an Orwellian twistedness that only totalitarian regimes can muster, is boasting that it will save the world. And which is blaming the United States for its own abject failures. Which is why I insist on calling it the Wuhan Virus–so go ahead, call me a racist. IDGAF.) Thus, data from Ground Zero is lacking, or wildly unreliable. (Ground One–Iran–is equally duplicitous, and equally malign.)

This huge uncertainty regarding a major systematic factor leads to even greater discount rates–and hence to lower stock prices.

And then there is the truly disturbing factor. These textbook causal channels (lower expected cash flows, higher discount rates) have in turn caused changes in asset prices that force portfolio adjustments that move us into the realm of positive feedback mechanisms (which usually have negative effects!) and non-linearities. This represents a shift from “normal” times to decidedly abnormal ones.

When some investors engage in leveraged trading strategies, big price moves can force them to unwind/liquidate these strategies because they can no longer fund their large losses. These unwinds move asset prices yet more (as those who placed a lower valuation on these assets must absorb them from the levered, high-value owners who are forced to sell them). Which can force further unwinds, in perhaps completely unrelated assets.

Not knowing the extent or nature of these trading strategies, or the degree of leverage, it is virtually impossible to understand how these effects may cascade through the markets.

The most evident indicators of these stresses are in the funding markets. And we are seeing such stresses. The FRA-OIS spread (known in a previous incarnation–e.g., 2008–as the LIBOR-OIS spread) has blown out. Dollar swap rates are blowing out. The most vanilla of spreads–the basis net of carry between Treasury futures and the cheapest-to-deliver Treasury–have blown out. Further, the Fed has pumped in huge amounts liquidity into the system, and these alarming spread movements have not reversed. (One shudders to think they would have been worse absent such intervention.)

One thing to keep an eye on is derivatives clearing. As I warned repeatedly during the drive to mandate clearing, the true test of this mechanism is during periods of market disruption when large price moves trigger large margin calls.

Heretofore the clearing system seems to have operated without disruption. I note, however, that the strains in the funding markets likely reflect in part the need for liquidity to make margin calls. Big margin calls that must be met in near real-time contribute to stresses in the funding markets. Clearinghouses themselves may survive, but at the cost of imposing huge costs elsewhere in the financial system. (In my earlier writing on the systemic impacts of clearing mandates, I referred to this as the Levee Effect.)

The totally unnecessary side-show in the oil markets, where Putin and Mohammed bin Salman are waging an insane grudge match, is only contributing to these margin call-related strains. (Noticing a theme here? Authoritarian governments obsessed with control and “stability” have a preternatural disposition to creating chaos.)

Perhaps the only saving grace now, as opposed to 2008, is that the shock did not arise originally from the credit and liquidity supply sector, i.e., banks and shadow banks. But the credit/liquidity supply sector is clearly under strain, and if parts of it break under that strain yet another round of extremely disruptive knock-on effects will occur. Fortunately, this is one area where central banks can palliate, if not eliminate, the strains. (I say can, because being run by humans, there is no guarantee they will.)

Viruses operate according to their own imperatives, and the imperatives of one virus can differ dramatically from those of others. Pandemic shocks are inherently systematic risks, and the nature of the current risk is only dimly understood because we do not understand the imperatives of this particular virus. Indeed, it might be fair to put it in the category of Knightian Uncertainty, rather than risk. The shock is big enough to trigger non-linear feedbacks, which are themselves virtually impossible to predict.

In other words. We’ve been on a helluva ride. We’re in for a helluva right. Strap it tight, folks.

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  1. Gee,I thought central clearing would solve everything ! A very concise summary. For those of us that no longer have access to a Bloomberg terminal, cN you recommend an open source to follow these spreads?

    Comment by Sotosy1 — March 13, 2020 @ 7:28 pm

  2. Uncertainty indeed!

    It really hurts, being run over by a stampeded of liquidity-starved hedge funds. I should have paid attention.

    Waiting for that ‘helluva right’ to appear. So long as I survive the bug, of course.

    Comment by Ex-Global Super-Regulator on Lunch Break — March 13, 2020 @ 10:21 pm

  3. I love your post, thought your work with Trafigura was great, but why Wuhan virus?
    Please amend to name that a recognised health service is using. This bigoted addition detracts from the article.
    Keep up the amazing research,

    Comment by John Robert McFarlane — March 14, 2020 @ 2:58 am

  4. Apparently it is just a pure miracle we survived Swine flu 10 years ago without all this hysteria.

    Comment by Andrew Stanton — March 14, 2020 @ 8:03 am

  5. The hysteria is now politically useful to bash Trump. Secondly we had or were having our own market “oportunity” in 2007-9. We had just elected the lightbringer- no bad publicity for him! The media now operates in full hysteria modes. People such as the appalling Maddow live on this and it distracts us from the contest between Crazy Grandpa Free S–t and Dribbles the Hair Sniffer. Finally there is uncertainty, everyone especially the markets have that and our own hysteria creates a negative feedback loop.

    Comment by Sotosy1 — March 14, 2020 @ 9:10 am

  6. agree there is systemic risk caused by an unpredictable event. Spread of the virus is not linear, and can’t be statistically modeled as an “iid” event. My gut says it is over by May. The panic is being led by the left wing media and the sheep are following. Hence, Oat Milk sales up by over 300% and fake meat sales up by over 120%. If conservatives were panicking we’d be out of bacon and ammo. Agree on buckling up. The blue checks on Twitter who hate Trump say he can do no right. Interestingly, in 2016 he was the only candidate talking about China. If he was collaborating with Putin, why a war in oil that will hurt leveraged frackers in Texas? How’s that all look in the rear view mirror?

    Comment by jeff — March 14, 2020 @ 10:10 am

  7. @Jeff–all true. BTW, I stocked up on ammo a long time ago 😉

    Comment by cpirrong — March 14, 2020 @ 3:55 pm

  8. @Andrew–I know, right? The Panicdemic is worse than the pandemic.

    Comment by cpirrong — March 14, 2020 @ 3:55 pm

  9. @John Robert McFarlane. Thanks for the kind words re work present and past. I will try to keep it up.

    “Wuhan Virus” is not bigoted. It is factual: Wuhan was ground zero. Is “Ebola” bigoted?

    Further, the current crisis is directly attributable to the criminal actions of the Chinese Communist Party, which chose to cover up when things could have been kept in hand. It is imperative to lay the blame where it lies–in China, with the CCP. This is especially true given the Orwellian attempts of the CCP to lay the blame everywhere else.

    So Wuhan Virus it is, and shall remain. Unless I can get “CCP Virus” to go . . . viral.

    Comment by cpirrong — March 14, 2020 @ 3:59 pm

  10. Then, there is Spanish Flu, Hong Kong Flu, German Measles, Zika Virus.

    Kudos professor for not kneeling at the feet of political correctness. #WuFlu it is.

    Comment by James Lovely — March 14, 2020 @ 5:05 pm

  11. @Sosotsy1–I just google “FRA/OIS spread” or “cross currency basis” and I can usually find an article with a chart taken from Bloomberg or some other data source. Not trading so I don’t need real time data, and what I can get in this way is usually sufficient for this purpose.

    Ironically, despite the fact it has been a well-known beacon since at least 2007, the St. Louis Fed’s FRED website–my usual go to data source–does not have OIS data. Ridiculous

    Comment by cpirrong — March 15, 2020 @ 1:52 pm

  12. @eJeff I did think this crisis would be a gold-plated opportunity for the American right to double down on their immigration rhetoric, heap further pressure on China regarding trade etc, put in place further surveillance infrastructure, boost the prepper community and NRA etc. Instead you’ve gone all ‘climate change’ on us.

    I hope your correct about it all being over by May. Which year?

    Comment by David Mercer — March 15, 2020 @ 2:31 pm

  13. CCP is no different from any other CP. They cannot help causing a Chernobyl, they cannot help trying to cover it up. Like the Bourbons, but in red.

    Comment by Ivan — March 15, 2020 @ 3:21 pm

  14. @John Robert McFarlane:

    Do work for the CCP? Thank you for parroting their propaganda.

    If you think the CCP has not bought off our media, I have a bridge in Brooklyn you must take a look at.

    Comment by Joe Walker — March 17, 2020 @ 12:50 pm

  15. Perfesser, many thanks!

    Comment by sotosy2 — March 17, 2020 @ 6:20 pm

  16. @Joe Walker–On your last point, it is quite interesting that the CCP banished reporters from NYT, WSJ, and WaPo–but NOT Bloomberg.

    There are no coincidences, comrade.

    Comment by cpirrong — March 18, 2020 @ 1:31 pm

  17. “COVID-19–Wuhan Virus, to call it by its proper name”

    Umm, not really. It’s technical name is SARS-CoV-2, see here;

    Which contains the following;

    “From a risk communications perspective, using the name SARS can have unintended consequences in terms of creating unnecessary fear for some populations, especially in Asia which was worst affected by the SARS outbreak in 2003.”

    Which does make one wonder if there could have been other unintended consequences of that particular decision, given the name was announced on 11 February.

    Comment by Ducky McDuckface — March 19, 2020 @ 5:03 pm

  18. @Ducky. LOLGF.

    Comment by cpirrong — March 19, 2020 @ 5:51 pm

  19. Still a hoax?
    Still referring to it as Wuhan virus even it it came from there?
    Yes it is bigoted and racist.

    Craig, you came from your mother’s vagina but Pussy isn’t your name!

    By the way, what will you do with your ammo:
    1 shoot the virus?
    2 shoot your fellow citizen for the final piece of toilet paper?
    3 turn it on yourself once you’ve realised that your non commodity focused articles are tripe?
    4 protect yourself from the commanderand chief’s heinous decisions?

    Comment by John Robert McFarlane — March 26, 2020 @ 7:33 am

  20. Spanish flu – given this name as Spain was not involved in the world war and UK, German, French journalists were not allowed to discuss it for morale but were allowed to cover its progression in Spain. Thus became known as Spanish flu
    German measles – Rubella, it’s not hard to remember. Named German as a German scientist discovered it. People with brains say Rubella.
    There were all sorts of words and expressions we used 100 years ago that were acceptable that no longer are.
    Wuhan virus is wrong.

    Comment by John Robert McFarlane — March 26, 2020 @ 7:57 am

  21. @McFarlane. Bullshit. The CCP is not a race. GFY.

    But thanks for the public service of telling us how things look from up Xi’s ass.

    Come around here and you might find out, talking that kind of smack.

    Comment by cpirrong — March 26, 2020 @ 9:45 am

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