The Greatest Trade

A letter from March 1, 2020

Every trader’s career is defined by a handful of big trades. When I look back, the spread of Covid in the beginning of 2020 was one of my defining moments. As early as January 2020, I was watching Covid spread across China and realized that a global pandemic was just weeks away. The public fear and lockdowns would cause havoc in the financial markets. On a trip to the US in early February, I told friends and relatives that the US was going to see a huge pandemic, that Trump wouldn’t handle it very well, and that this would all be bad for the economy, society, and politics. Most people reacted with incredulous disbelief.

To position for the impending global pandemic, I bought puts on the S&P 500 and went long Treasuries, Eurodollar futures, and Fed Funds futures in larger than my usual size, betting that the Federal Reserve would cut interest rates from 1.5% to 0 within several months. Even as equities and yields started to slide in February, it was clear many investors were still complacent about how violently the market would collapse. On March 1, 2020, I wrote the following letter to friends as a warning of what I thought would transpire. The rest is history.

Dear friends,

I’ve had some time over the weekend to collect my thoughts about the covid19 virus and how it will affect the global economy and the markets. I’ve had some peace and quiet on my plane ride to Bhutan, so this writing is the result of stepping back and doing some deep thinking on the second and third order effects of this virus, as well as lessons from the past that are either useful to forming my view or should be discarded.  If we’ve spoken about the market during the past week, my views may have been changing fluidly or incomplete. This writing represents my updated views and how I plan to position going forward. Feel free to ask me questions because my views evolve constantly day by day, week by week as conditions develop and new information arrives. 

Geo Chen

How is the spread of covid19 going to play out? 

One has to look at how much has changed from 2 weeks and 4 weeks ago to fully comprehend the speed of the virus’s spread and impact. Change is happening on an exponential, not linear scale, so we must not underestimate how quickly things can turn from bad to worse over the span of weeks and months.

Some countries will experience severe shocks similar to what happened in Wuhan and what is happening in Iran. Slow public health response and overwhelmed hospitals will result in a higher mortality rate in these countries relative to the rest of the world. Case counts will accelerate exponentially until the government and citizens take draconian measures similar to what we saw in Wuhan. These unfortunate countries will likely be poorer developing economies with dense cities, a weak health system, and poor government response to the pandemic (some countries in Latin America, Middle East, Indonesia, Philippines, Pakistan, India, Bangladesh come to mind as vulnerable). I would not be surprised to see social unrest and regime change in some countries as a result. 

Developed countries with better governance will manage to slow down the acceleration of cases and bring the daily case count to a linear trickle thanks to a strong and aggressive public health response and informed population. I really hope Japan, Italy, and Korea end up on this list but it’s too soon to say. China, HK, and Singapore are evidence that the exponential acceleration of cases can be slowed to a steady trickle IF the government takes effective and extreme measures (such as large scale testing, quarantining those with symptoms, contact tracing and forcing potential cases to stay at home, controlling the flow of foreigners into the country, canceling large events, and instilling a healthy respect for the virus so that people practice good hygiene and social distancing). 

The US is beginning the acceleration phase of the pandemic and will like reach a stage where the daily case count is in the hundreds. Because of the failure to test early for covid19, we’ll see a catch up period where those with symptoms or people who had contact with suspected cases start getting confirmed as being infected, at the same time the virus spreads throughout the population. The acceleration in case count and fear could extend into late March and then slow down in April. The fear level in the US will likely determine the fear level in markets as the US financial market is the leader for the rest of the world. 

Countries that attempt to bring economic and social activity back to normal will likely see a reacceleration of cases, forcing them to scale back. This will keep economic activity dampened for the rest of 2020. China will be a test case as they are trying to get people back to work. Previous pandemics have seen 2-3 waves over 12-18 months, and there is no reason to believe covid19 will be any different. 

How will this impact global economic activity? 

I need to stress that there is no precedent for covid19 and its economic impact, so one must throw out all comparisons to previous pandemics and economic shocks. The global travel and transportation is much higher now than at anytime in world history, while the spread of information is faster and therefore can affect human fear and behavior much quicker. We’ve also seen a buildup in complacency in financial markets that has most assets either overvalued or priced to perfection. Another difference is that the covid19 pandemic hits at the heart of every citizen in this world, whereas previous crises had an uneven impact depending on geographic location and wealth. The GFC was a financial shock driven by factors that were not well understood by most people outside of the financial community, and therefore did not affect human social and economic behavior until unemployment had risen sharply and financial asset prices had fallen far enough to create a negative wealth effect. Covid19 on the other hand is creating a demand shock in real time as people scale back travel, large meetings and events, while social distancing measures prevent factories from operating at full capacity, freight volumes plummet due to canceled flights, and supply chain problems hit manufacturing. 

What we’ll be facing is a demand shock and supply shock happening simultaneously, which has not happened in postwar economic history. The supply shock shouldn’t be underestimated. Factories can’t operate when your foreign workers are stuck in their home country, or you can’t house workers 4-6 to a room in dormitories. Manufacturing cannot happen when you are missing part that is made in a factory that isn’t running due to not enough workers, or can’t ship to you because the availability of air cargo shipping has plummeted. More and more I’m reading evidence of supply chain disruptions at tech companies such as Apple and at automotive companies around the world. This demand and supply shock will happen on a global scale, as opposed to previous downturns that originated in one region and emanated outward through financial and systemic contagion. Because the spread of the virus, change in behavior of businesses and humans, and fear escalate much faster than economic data can track, we can’t rely on economic data to tell us the economic impact in real time. Therefore I wouldn’t be surprised if we see recession in many major economies, as going into this year we had many countries sliding into recession already (Japan and Germany). Unemployment rates should turn higher as companies cannot survive a simultaneous demand and supply shock for more than a quarter or two without shedding headcount. 

Equities - more downside to come

Going into February, equity valuations were lofty and the US market was experiencing a mini bubble driven by zero commission retail trading, expectations for a global recovery, and easy monetary policy. Therefore the market has been vulnerable and has a lot more to drop as fear spreads and economic fundamentals deteriorate. Within 1-2 weeks I think we will see the SPX reach bear market territory (2500-2700) due to retail investor capitulation and fear. I have some 2900 Mar 6 SPX puts that were previously far out of the money but are now much closer to the strike. 

Any stabilization would require the Fed to cut at least 50 basis points on or before their meeting on Mar 18. I also do think that this current wave of fear will subside as the US experiences a come-down from the peak fear cycle and learns to live with the new normal (the situation that Singapore is in now). After a period of stabilization we may see a second wave of selling take hold as the true economic impact becomes evident from emerging data and the pandemic spreads within major countries and spreads to new ones. After all is said and done, a drawdown in the SPX of 30-50% from the high is not out of the question due to the preexisting conditions in the market I stated above, as well as the fact that conditions will deteriorate much faster than monetary and fiscal authorities can react. 

Interest rates to zero

Based on my view on the economy and the equity market, I see potential for the market to price in a 50 bp cut in March and a cumulative 100 bp within the next two meetings (Mar and April). This view sounds extreme, but the market is very aggressive in pushing pricing for cuts, while Fed chairman Powell has a track record of not disappointing the market and tends to passively follow market pricing. By June the data may show that we have rapidly slid into economic recession so I wouldn’t be surprised if we see the market price 0% interest rates by then. I was previously long Fed Fund futures May contracts, but have decided that in order to express my view on the magnitude and speed of cuts over the next 3 months, I should focus my interest rate longs on the June 2020 Eurodollar contract.  

“Interest rate cuts aren’t going to slow down the spread of the virus, so why would central banks cut so aggressively?”, someone asks. This is true, but that question misses the point. In a recessionary environment, financial conditions tighten, corporates come under stress, and the cost and scarcity of credit and liquidity skyrocket. Market dislocations and deleveraging become the norm. Falling asset prices crush consumer sentiment and create a feedback loop that can’t be stopped without aggressive monetary response. The Fed can’t address the root cause of the problem, which is the virus, but they need to do everything they can to address the SYMPTOMS to prevent the financial and economic impact from getting worse than it would become otherwise. After the Fed reaches the lower bound, the logical next step would be to restart QE by extending the quantity and maturity of bonds that they are purchasing through their current Tbill purchase program. This will be the sign that the end of the bear market is near. 

Gold - buy the big scary dip

Gold made a new high above 1700 due to expectations of Fed rate cuts and economic weakness. Since then its correlation to equity markets has reversed from negative to positive as forced liquidations and deleveraging are resulting in gold selling off along with the rest of the market. While discomforting, this is a familiar correlation regime if you look back to what happened in 2008, when gold rallied hard into the beginning of the year, dropping sharply and made an interim low in Oct 2008, then rebounded. In Q3 of 2009 after the Fed was pumping liquidity via QE and releveraging was taking place, gold started its epic bull run to 1900. 

I have a small allocation to gold but I would not be looking to add until we have seen signs of releveraging and liquidity returning to the market. After that point I expect gold to resume its bull market rally and break to new highs above 1900 and beyond, thanks to a global flood of liquidity and fiscal stimulus as we come out of the other side of the virus crisis. It’s still early to buy the dip as we’re just starting to see the start of deleveraging, so we have a few months to go before gold is a buy. 

”So, what’s the good news???”

Historically, pandemics have fizzled out after 12-18 months. Previous they ran out of victims to infect as the wider population developed an immunity to it while measures were taken to prevent its spread. In the case of covid19, perhaps we will even see a vaccine in the next 1-2 years. By the time we come out of the other side of this crisis, monetary and fiscal authorities will have deployed stimulus on a scale similar or greater to what we saw during the GFC. The recovery should be swift and powerful and a great opportunity for those who raised liquidity and had ammunition to invest. 

I don’t see Donald Trump emerging from this unscathed, as he has demonstrated a lack of urgency to address the growing pandemic in the US, and has done very little to instill trust in the government’s handling of the situation. His decision to cut funding to the CDC will come back to haunt him in a big way. This could be good or bad news to you, depending on where you lean politically. 

Disclaimer:

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