After polling many of our top investment staff globally, there is agreement that the virus will be a temporary problem. Of course, the global economy had already been badly hit by China’s slump and now it is further worsening, especially in the Asia Pacific region, but even to quasi-recessionary levels in the West. Indeed, there is even a significant chance that the virus and economic conditions will deteriorate well into the 2Q, but this chance is much lower than the odds for improvement.
China’s economy is already rebounding and the political leadership is pushing the theme that the worst of the virus is over and that people should start working again, although with some extra caution. Thus, China’s crucial portion of the global production cycle is resuming, and in many high tech sectors it did not slow there much at all. There is a definite possibility of a return to contagion in China, but the odds are high that the nadir in production has been seen. Consumers in China, thus, should strongly rebound too, with most firms like Apple and Starbucks reporting that most stores have re-opened.
Coupled with this positive trend is that a market consensus is emerging, with which we agree, that central banks will very soon start easing policy further and governments will increase fiscal spending. The Federal Reserve (Fed) could well cut rates before the 18 March meeting (or signal that they will cut 50 bps at that meeting), with a total of 75 bps of cuts most likely through June. The great majority of other central banks globally should ease policy further too. Fiscal stimulus is constrained in the US by political scuffling as to how to pay for it, but some agreement will be made for vaccine research and implementation, as well as for other issues directly connected to the virus. German fiscal stimulus is constrained by law, but some euro-area stimulus can be achieved. Japan also has tools to use, as do China and other Asian countries.
Also, according to discussions by the medical experts offered to us by the brokerage community, most seem to agree that while more dangerous than the common seasonal flu for elderly and the infirm, this virus is not greatly more dangerous to others unless very heavily exposed. There remains great uncertainty about its transmission, partially due to the unreliability of tests and the apparently long gestation period, often accompanied by having little symptoms throughout infection. It is unclear how many infections and deaths from this virus are supplanting those from the seasonal flu and how this season will compare historically, but outside of China, it may not, by some measures, compare tremendously worse globally, especially due to the attention given to it.
Notably, in this era of heightened political tension and heavy criticism, there is a global shift toward more caution by governments and corporations. No one wishes to be blamed for being the source of the virus and additionally, compliance plays a much larger role in the world today. Thus, various prohibitions have expanded globally, but none as severe as China’s experience. Of course, in a few cases, shutdowns have been caused by lack of parts from China and in other cases, the lack of demand from the slow consumer goods and service sectors are the cause for such. In sum, strong caution has worsened GDP in the short run, but may help GDP in the long run, as besides the obvious reduction in spreading disease now, the prohibitions give a chance for warmer weather ahead to kill the virus, as well give time for vaccine creation and medical industry preparation. Japan, as host of the Olympics for the world, is burdened with extra responsibility for caution, which it is duly taking.
Unfortunately, US equity market valuations, especially for the growth sectors, became “priced for perfection” before the virus struck, due to confidence in US President Trump’s re-election and low interest rates continuing to push up equity valuations. Many investors and models were investing primarily on this momentum and the lack of perceived volatility ahead. Thus, the correction was extremely sharp by historical standards and the markets have returned to autumn levels much like the early 2018 experience. By historical standards, the S&P500’s P/E multiple remains somewhat high, but such is greatly supported by low interest rates. Earnings estimates for CY20 are already being cut, and much more of such is likely, but if the cuts are concentrated in the 1H20 and if coupled with a diminishing virus infection rate, 2H20 earnings estimates remain firm, equities can be supported at current levels. Of course, if this virus greatly worsens and global recession is extended, then global equities could fall as much as a third from present levels.
Confidence in the future of global earnings growth will also be affected by the prospects for the US elections in November. Although Super Tuesday this week may lead to Vermont Senator Bernie Sanders wrapping up the Democratic nomination, there is a major chance that we will not know the nominee until July. Thus, while the markets will likely be tempted to think that Trump will beat Sanders, they should not be too confident in any election prediction, especially until the virus peaks. The fate of Congress is very important too and is highly unpredictable in an increasingly negative virus and economy scenario.
A key question for the duration of the market and economic corrections is whether weakness in equities will spread to credit markets. Banks will be loath to be the villain in causing a greater calamity, but some credit markets may not fund the weakest companies. China is allowing some companies to default and as long as they are not systemically important, like Lehman was, the US and Europe will not save all companies. The rating agencies will be careful not to be too harsh, but in the last two weeks they already created some new major fallen angels and there are prospects for several more. If major outflows from high-yield funds continue, it could cause major difficulties for some companies who need to refinance.
Fortunately, the core financial system globally is reasonably solid and as long as its weakest links do not become overly dire, the system should hold firm. Numerous hedge funds and other speculative investors, however, will not likely survive and have to discard their holdings if they have not already done so, due to margin borrowing restrictions. The US and European housing markets are quite expensive, but speculation does not seem to have become too intense and consumer incomes are reasonably acceptable compared to low mortgage costs associated with low interest rates, unlike the 2006–2007 experience with rapidly rising interest rates.
With the Fed cutting rates, there is some chance that the yen strengthens further, but confidence in the Japanese economy, including by domestic investors, is not high, particularly due to the multiple shocks to GDP in recent quarters, compounded by the virus effects. Thus, the typical flight to yen safety is likely to be much softer than before. At least the US will retain positive interest rates in the current scenario, whereas Japan’s are likely to remain negative for quite some time, at least up to 10-year yields. When the virus subsides globally, the yen should return to its previous range.
Of course, it is difficult to time the peak of the spread of the virus and even more so when the markets think the peak is nigh. Both may occur soon, and at worst, we expect that such will occur before too long. In the meantime, help nears from monetary and fiscal policy, but unfortunately, the virus is not the only important consideration. Elections and geopolitics remain important to global markets too.
