More on the coronavirus, tail risk and policy error
In my last post, I told you “I think the coronavirus is a serious event risk. But I don’t think it is yet to the point where we have to worry about recession.” We’ve now had a few more days to consider what the coronavirus means to the global economy and how vulnerable the US is to a recession. And I stand by my prior analysis. But, it’s now much more clear that the coronavirus is a serious event risk and that financial conditions are tightening very quickly. The Federal Reserve needs to take these signals seriously to prevent worst-case outcomes, that include recession and crisis.
What we know about the economic impact of the virus
There are 361 known coronavirus deaths and 17,205 confirmed cases, according to numbers published by AP this morning. The Philippines reported the first death outside of China over the weekend. And many countries around the globe are reporting cases. The World Health Organization believes the coronavirus has the potential to become a pandemic and is calling its outbreak a global health emergency. So, this is a serious event risk, not to just China, but to the entire world.
The impact of the virus on the economy of China, the world’s second largest economy, has been pretty large. But, in terms of the economy, because a major Chinese city, Wuhan, is in lockdown, and because supply chains are increasingly at risk, there are increased risks of both negative demand shocks in China and a cut in trade flows. I want to focus on the oil patch because it is an important economic sector, global in nature , and potentially has a direct impact on financial conditions. So, its impact in China can resonate globally.
The Oil Patch
Oil demand in China has dropped by 20% – or about three million barrels a day, according to Bloomberg News.
The drop is probably the largest demand shock the oil market has suffered since the global financial crisis of 2008 to 2009, and the most sudden since the Sept. 11 attacks.
The result of this demand shock has been a drop in oil prices to where WTI is trading at $51.65 a barrel. At the beginning of January, WTI was above $60 a barrel. Now, Tracy Schuchart pointed out on Twitter yesterday that the S&P 500 energy sector entered a bear market on Friday, and that the sector had its worst January on record. That’s a big concern for me because the self-quote I made at the beginning of this post from Friday’s post carried on like this:
Regarding financial conditions, the recent fall in oil prices is worrying because it creates so much refinancing risk in the oil patch due to the amount of debt rollovers coming due. And I think that the brief yield curve inversion is a warning for the Fed about how it has to message and the tolerance asset markets have for perceived tightening.
High Yield
Does the Fed get this? How much longer does asset market volatility have to continue before we know financial conditions have tightened enough to really threaten recession? The answers to these questions are unclear. And until we know the answers, downside risk is magnified. And the contagion risk goes from coronavirus to lower oil demand to lower prices to an energy sector bear market to a rout in the US high yield sector, where energy firms are big players.
The US high-yield bond ETF that trades as $JNK just recorded its biggest weekly withdrawal in almost two years, of $1.1 billion. While junk bonds are supported by lower rates, they’re getting hit by both fears of a coronavirus-induced economic slowdown & lower oil prices. pic.twitter.com/f77WSb1ZAK
— Lisa Abramowicz (@lisaabramowicz1)
Remember my post on BBB fallen angels and fake ETF liquidity. High yield is where the rubber hits the road in terms of crisis.
My view
So, would I still end this post today as I did the last one, saying “Overall though, I don’t see reason to worry too much just yet.”? Yeah, sure… but barely. The US economy is still beyond stall speed at the moment. But, the event risk from this virus is large and growing. The amount of time we have to say there’s no reason to worry just yet can be measured in days, not months or even weeks. The potential for policy error right now has to rank high.
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