Species Jump - Investing in the Time of Coronavirus
In 1918 much of the world was as rural as it was during the Renaissance. Today, roughly 54 percent of global population lives in an urban area.
A species jump occurs when a pathogen gets transferred from one species to another.
The coronavirus likely made such a jump from pangolins or some other wild animal that the Chinese eat or let freely roam in their food markets.
The coronavirus is now making its second species jump, this time from humans to the credit markets.
While the daily point swings in the Dow Jones Industrial Average and S&P 500 Index make headlines, the real damage will be done in the credit markets.
Patient zero in credit is the shale oil and gas producers.
The Russian and Saudi oil producers have ended any pretense of cooperation are now officially in a price war. They will both survive. U.S. shale producers will not.
Oil is at $32/barrel as I write this, down about 22 percent from Friday, and will probably be in the $20's before it's all over. The U.S. shale drillers are all going bankrupt. There's no way they are profitable at $30/barrel oil, let alone $20.
The lowest break-even cost of production for shale oil wells is $40/barrel, but some of the horizontal drilling wells have costs at $60 to $90/barrel. To put this in comparison, the Saudi's cost to produce oil is under $10/barrel, the least expensive in the world. NorthAfrica produces at around $20/barrel. Globally, the average is between $30 and$40/barrel.
No one wants to lend to a shale producer that will be operating at a loss for years to come.
Once the credit spigot gets turned off, these producers, which were already weak, will be insolvent.
When banks and other lenders take big write-downs in their oil and gas loans and/or bonds, it tightens credit in all other parts of their books.
This is how the coronavirus will spread through the credit markets.
Once the credit window closes, the coronavirus spreads throughout the financial system.
Remember, corporations have spent the last 11 years issuing debt to buy back their own stock. This trade was brilliant because interest rates were low and it was a tax-efficient way to get managers and shareholders paid.
Except it wasn’t brilliant. It was reckless.
Currently half of all U.S. corporate debt sits at BBB, one notch above junk bond status, which I have written about extensively. When these barely-investment grade issuers get downgraded to junk status, their cost of capital will increase dramatically, putting additional pressure on their finances just when their revenues are falling.
Profits will fall and so will profit margins as managers are slow to downsize. Cash will be prioritized for debt repayments, and the buybacks that provided a permanent bid under their stocks will be gone.
This will remove the last institutional bid for equities.
We Have to Destroy the Economy in Order to Save It
It would appear that the state of the art for battling the coronavirus is shutting down the economy.
China has done it, essentially quarantining 300million people, and the rate of new infections has slowed dramatically.
This is a medieval technique and as blunt an instrument as there is. However, it will likely be instituted globally to varying degrees. Italy is likely the first of many to follow China. Although draconian, it makes sense. When there is no vaccine, the nuclear option is the correct call because it is the only option.
Unfortunately, the cost of the nuclear option is high: the near shuttering of an economy.
Chart 1: China Composite PMI
In Chart 1, above, Chinese Composite PMI fell from 51.9 to 27.5, pre-and post-outbreak. In a lifetime of studying economics, I have never seen a decline like this.
Chart 2: Japan GDP
In Chart 2, above, Japan's GDP fell from 0.1 to negative 7.1.
I believe these extreme numbers are likely to spread globally.
The coronavirus is especially pernicious in that it attacks all parts of the economy, both manufacturing and services.
The service sector was the first to be infected. Basically, any consumer-facing business is in serious jeopardy.
The service sector includes:
- Events, and;
Other industries that are at considerable risk due to supply chain failure or second-level exposures include:
- Financial, and;
Needless to say, these are huge sections of the global economy.
The manufacturing sector is also in trouble because of supply chain disruptions. In short, if you don’t have all the parts, you can’t make the widgets.
Investing in the Time of Coronavirus
My base case scenario is for a sharp global recession as large parts of the world go on lockdown. I expect the numbers of infected patients to increase exponentially as more and more people get tested. (Only 6,000 people have been tested in the U.S.)
There exists a non-trivial chance of something darker, especially if the coronavirus lingers and spreads to the southern hemisphere countries as they head towards winter. While the lingering part is unknown, the spread to the southern hemisphere seems a high probability.
For comparison, the Spanish flu of 1918 infected 27 percent of global population (about 500 million people), and killed between 17 and 50 million. Of course, today we have much better health care and medical technology.
Unfortunately, the world is much more urbanized today that it was in 1918. Indeed, in 1918 much of the world was as rural as it was during the Renaissance. Today, roughly 54 percent of global population lives in an urban area.
Chart 3: Global Urbanization Trends
Obviously, people living in close proximity to one another makes the spreading of pathogens much easier.
If the U.S. market opens up down five percent today, it will be down about 17 percent from the all-time high. Actually, that’s not much if we are facing a global economic shutdown of indeterminate length.
Although I am loath to sell on red, I will be adding to my cash position, as I think we are in the early innings of this event.
However, I will be keeping my infrastructure investments, as a massive wave of global fiscal stimulus is now a virtual certainty and likely to happen this year.
 Source: Bloomberg.
 Source: Bloomberg.
 Wikipedia; S.V. “urbanization”; Available at: https://en.wikipedia.org/wiki/Urbanization#/media/File:Urbanization_over_the_past_500_years_(Historical_sources_and_UN_(1500_to_2016)),_OWID.svg; Accessed March 9, 2020.