The spread of the coronavirus to a growing number of countries has dramatically increased the probability of it crossing the threshold from epidemic to pandemic in the coming weeks. Beyond the human tragedy caused by the virus, the efforts to slow the spread of the virus are likely to have significant economic implications.
The good news is that within China the government seems to have been successful in containing the virus. New cases have fallen precipitously as a result of city-wide quarantines. Companies, such as Starbucks, that operate in China seem to confirm that the situation on the ground has improved. That said, China has repeatedly modified their counting methodology and we believe that the total number of cases in China was likely underreported. More importantly, the risk that the virus reappears in the country is high, and economic activity has yet to return to normal.
From an economic perspective, the ultimate damage to China will depend on how quickly the country can get back to work. In that regard, the high-frequency data is not yet very encouraging. Looking at coal consumption, transportation numbers and property sales suggest that activity is only modestly accelerating. Currently, it seems that Chinese economic activity is at 50-80% of normal. Consequently, Legal & General economists believe that 1Q growth will fall sharply and be down at least 10%. Of course, it’s unlikely that the country’s statistics office will publish such a negative number. This leaves economists at major banks in a tough position where their forecasts appear far too optimistic and yet we sense there is reluctance to deviate too much from the “official” numbers.
As the year progresses, the situation should improve as China is likely to deploy a series of aggressive stimulus measures. Yet the longer it takes for China to return to work then the more likely it is that the recovery is not as sharp over the spring and summer months. As is, Legal & General economists believe that China might struggle to grow 3% this year.
Outside of China, the situation remains in flux but the risk of global growth falling below 2% and a handful of developed market (DM) economies falling into recession is rising. As with China, it is the measures to contain the spread of the virus that are likely to reduce growth. Japan and Germany are particularly vulnerable to experiencing multiple quarters of contraction as growth was already weak in both economies. If the virus spreads to the U.S. in a meaningful way, growth here could fall below 1% and perhaps drop into negative territory—although there is more cushion in the U.S. than in many other lower-growth DM countries and the U.S. would seem to be one of the most insulated economies.
Leaving aside the question of whether asset prices are appropriately priced for the possibility of recessions in multiple DM economies for a moment, it is worth noting that a Coronavirus-induced recession would likely be shallow and technical in nature. In a normal run-of-the-mill recession, the economy experiences a period of contraction that rectifies the accumulated imbalances and malinvestment of prior years, which often results in meaningful job losses. But in the wake of the financial crisis there are few obvious sectors of the economy where there has been excessive investment—particularly after the shakeout in energy in 2015/2016. As such, it’s likely that the labor market remains tight and job losses are relatively subdued. Companies might even resort to labor “hoarding” and resist laying off employees because they fear they will not be able to hire them back when needed.
Without question, the virus will hurt corporate earnings. At the start of the year, most thought that U.S. earnings might grow 5-7% this year. But against a backdrop of weaker demand, elevated uncertainty and ongoing disruptions to supply chains, it is likely that U.S. companies see flat to negative earnings growth in 2020. For some companies, Coronavirus could contribute to rating agency downgrades, particularly if the virus upends a company’s previously articulated plan to deleverage.
All of this argues for some sort of central bank response to support economic activity and keep financial conditions from tightening too quickly. Yet comments from ECB President Christine Lagarde and James Bullard of the St Louis Fed this week indicate that a contingent of central bankers believe that the damage from Coronavirus does not yet merit a monetary policy response. While such sentiment has proven disappointing to markets, it is difficult to believe that central bankers will stand by and do nothing. Indeed, the U.S. rates market is now priced for more than three 25 basis point cuts this year and prices imply at least one cut at the March 18th meeting.
If central bank easing is a foregone conclusion, as we think it will likely become, there are still plenty of outstanding questions. Will the Fed synchronize their actions with other central banks like the ECB, BoJ, and Bank of England to create a coordinated response? How many cuts would the Fed do? One 25 basis point cut or perhaps a 50 basis point cut to get ahead of the market? When precisely will the easing come? Next week or later in March? Most importantly, will rate cuts and other monetary policy actions even help the situation? It goes without saying that monetary policy can do little to affect the course of a pandemic.
As investors digest the virus headlines, the corresponding implications for growth, and the perceived limits of central banks, it is not surprising that asset prices have reacted poorly. Looking at markets over the course of February, it would seem that interest rates and commodity prices are the two asset classes that have most fully reflected Coronavirus risk while equities and credit are playing catch up. For credit, this is not unusual behavior given the bid-offer in the asset class and corporate bond market liquidity. Yet in trying to determine how bad it might get, a historical perspective is helpful. The spread on the Long Credit Index was marked on Thursday at 165 basis points, which is 27 basis points wider year-to-date. However, that move wider only takes the Long Credit Index back to late September 2019 levels before the fourth-quarter rally. In contrast, the Long Credit index entered 2019 at 200 basis points and traded above 250 basis points during the 2015/2016 energy crisis.
In the credit portfolios that we manage at LGIMA for our external clients, the priority continues to be to deliver excellent downside risk management in periods of volatility while looking to take advantage of market dislocations. The portfolios remain conservatively positioned and as the market has widened this week they are performing as expected. Given the precipitous fall in WTI to below $45, energy bonds are under significant pressure and some weaker companies that we do not own have widened more than 100 basis points this week. While we continue to favor a handful of midstream/pipeline companies that have underperformed as oil has gone lower, it is important to note that we are underweight other high beta sectors of the market, such as emerging market sovereigns and quasi-sovereigns, that act as a hedge in volatile periods. These underweights along with a substantial Treasury position have provided ballast to the portfolios during the last week.
Finally, many LGIMA clients have asked our thoughts on interest rates at current levels. For the time being, we believe that the direction of rates at the long end of the curve will continue to be sensitive to the Coronavirus developments. We do not think anyone can rule out the possibility that the 10-year breaks 1% or that 30-year USTs trade below 1.5% in the near term. Given that many other sovereigns trade with negative yields, U.S. Treasuries may also be seeing spillover demand from investors that think German Bunds and Japanese JGBs have diminished value as a hedge. Longer term we would expect rates to be biased higher as the economy recovers from the virus disruption. However, if global yields remain depressed, U.S. fixed income markets are likely to continue to be well bid.
Markets Catch a Cold
Global markets have caught a cold. Fears of a Coronavirus pandemic are prompting employers to suspend business travel, emptying the shelves of grocery stores across the US, and causing investors to look for immunity in Treasuries. For defined benefit pension plans the prognosis could be grim.
Thoughts From the Active Fixed Income Team
It is difficult to characterize the volatility seen in fixed income over the last few days as anything but extreme. Having started the week at a yield of 1.67%, the 30-year Treasury briefly traded below 1.20% on Friday, March 6.
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