How the Coronavirus Will Affect the Stock Market

The global economy has been slowing since mid-to-late 2018 as many economic indicators are showing, and the Coronavirus could tip the global economy into a recession. Most investors do not believe the Coronavirus is a serious threat to the economy since stock prices have ignored any possibility the virus can stop the Fed’s liquidity-infused Bull market. While investors hope for more stimulus, the Coronavirus will cause the global economy to shrink, which threatens to put an end to the Bull market in stocks.

There are plenty of articles and commentary on how the Coronavirus has temporarily ground the Chinese economy to a standstill but none of them are considering how a prolonged shutdown of the Chinese economy will lead to an even greater contraction in global trade. From a macro perspective, the Coronavirus will lead to a further contraction in World Dollar Liquidity, which will threaten to upend the stock market as the monetary system attempts to alleviate tightening financial conditions.

World Dollar Liquidity is the process in which U.S. Dollars are recycled through the global economy. As the world’s reserve currency, the amount of dollars needs to perpetually expand to create economic prosperity and to cover the increasing amount of global dollar-denominated debts. Dollars begin their trek through the global economy when U.S. consumers demand foreign-produced goods and services.

Foreign-produced goods and services are paid for in U.S. Dollars, most of which are exchanged by foreign corporations for local currency. Some dollars are held by foreign corporations to purchase commodities such as crude oil, which is priced in dollars. As dollars accumulate in a foreign central bank’s account, they become inflationary.

To tamper the inflationary effects of holding too many dollars, a foreign central bank will recycle the back to the United States by purchasing U.S. government debt in the form of Treasury securities. The dollars returning to the U.S. are multiplied slightly since foreign purchasers of U.S. Treasury securities are paid interest on the debt. The dollars received from selling debt are then spent into the real economy where they once again find themselves in the hands of U.S. consumers who want foreign-produced goods and services.

The Fed already initiated the largest contraction in World Dollar Liquidity when it began raising the Federal Funds Rate in December 2015 and unwinding its balance sheet in October 2017. The Coronavirus threatens to further contract World Dollar Liquidity since it is leading to a sharp decrease in Chinese exports to the United States. With China being the world’s largest exporter and one of our largest trading partners, any slowdown in trade will disrupt the global flow of dollars.

When the global flow of dollars is reduced, the global economy must contract until the economy is at a size where the remaining number of dollars can support the global economy. The global economy is trying to fight off the Fed’s contraction but it is slowly losing the battle. With the Coronavirus now in play, attempts by central bankers to pump liquidity into the global economy in hopes the virus can be contained will not stop the contraction in World Dollar Liquidity caused by the virus.

Due to the heavy hand of the Fed tightening monetary policy, there is already a shortage of dollars which will only get worse as fewer dollars are recycled through the global economy. This will put more pressure on the Fed to ease monetary policy at a time when the Fed has started backing off on the size of its overnight dollar loans. As Treasury yields continue to fall below the Federal Funds Rate, it will force the Fed to lower rates and significantly increase the size of its bond purchase program.

When the Fed eases, it is very bullish for bond prices. Monetary easing does not ease until yields are low enough to spur a substantial increase in lending demand. In the meantime, the risk of a dollar shortage is that foreign borrowers who need dollars to pay on their dollar-denominated debts will face delinquency and default without them.

To prevent a foreign financial crisis from a shortage of dollars, foreign central banks are easing in their local currency. Those who are short dollars end up selling local currency for dollars, which puts downward pressure on the local currency and upward pressure on the dollar. When the dollar is rising during tight financial conditions, it leads to even tighter financial conditions.

Tighter financial conditions lead to lower interest rates as does a decline in global trade, both of which together are likely to lead to lower long-term interest rates. From a monetary perspective, lower long-term interest rates are the only solution to a contraction in World Dollar Liquidity. U.S. consumers and businesses need to borrow dollars and spend them on foreign-produced goods and services to reignite the World Dollar Liquidity cycle. Once the economy contracts enough to scare the Fed into lower interest rates, bond prices are going to soar.

In 2016, the economy was facing a dollar shortage and China came to the rescue by injecting a massive amount of liquidity into the global economy. Unlike current liquidity injections of its local currency, China had a large surplus of U.S. Dollars in 2016, of which China used to reignite the World Dollar Liquidity cycle. Since the World Dollar Liquidity cycle does not care where the dollars come from, so long as they move through the global economy, China’s dollar-liquidity injection worked. Today’s liquidity injections are only temporary bandages as China no longer has excess dollars to pump into the global economy.

Those who own stocks and are buying stocks are betting the Fed’s monetary magic will reinflate the global economy, while those who own bonds and are buying bonds are betting the Fed will once again fail and the global economy will experience a massive deflationary shock. For bondholders, it is an easy bet to make since the Fed has never engineered a late-cycle recovery of the economy. The probabilities are high that the global economy will end up in a recession, that will end up making bondholders a huge return as interest rates collapse.

For the stock investors, a deflationary shock is the worst possible outcome, as it suggests another financial crisis and another Bear market is lurking in the shadows. The Coronavirus, even if contained in the next few weeks, will have already done enough damage to World Dollar Liquidity to raise fears of another recession. Once production and consumption are lost, they can never be regained. It will take time for the global economy to recover from the lost production, even if the Coronavirus disappears tomorrow.

From a macro perspective, the Coronavirus will affect global trade and World Dollar Liquidity, which in turn will cause the global economy to further slow. From an investing perspective, the U.S. Dollar should rise to validate there is a shortage of dollars, stock prices should show signs of peaking, Treasury yields should continue falling, Treasury bonds should continue rising, crude oil should continue falling and gold prices should start to roll over as long as financial conditions continue to tighten.

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