In the past few days, concerns about the spread of the coronavirus have increased as the epidemic has now moved decisively beyond the borders of China.
Although the pace of increase of infected individuals in China has slowed, the growth in cases outside of China is accelerating, with clusters emerging in other regions. In the near term, that trend is likely to continue.
The global economy will unquestionably feel the negative impact in the first half of the year. China appears to be the most vulnerable, but economists are now projecting U.S. growth to be negatively impacted in Q1 and Q2, with expectations for a rebound to follow later this year.
The potential for the Fed to cut rates or for global central banks to engage in a more coordinated policy response has risen considerably. Such a move is unlikely to have any real economic benefit in the near term but could still provide a boost to investor confidence.
Investors should be prepared for volatility to persist in the near term as conditions evolve and capital markets digest the flow of news.
We’ll continue to closely monitor the macro environment, market conditions, and your portfolio for any actions that may be appropriate.
Headlines in recent days have been dominated by developments related to the unfolding coronavirus epidemic that has now moved decisively beyond the borders of China. Most notably, the rapid increase in the number of confirmed cases in Italy, Iran, and South Korea signal that the epidemic is entering a new phase, moving from what had been largely a problem in China toward a global pandemic. Health authorities had warned of the virtual impossibility of containing the outbreak, so its spread wasn’t unanticipated. Even so, these developments confirmed that was the case.
The reaction in the capital markets was swift and unambiguous. As noted in our commentary earlier this week, “the degree of uncertainty speaks to the fact that the situation continues to evolve rapidly.” That’s still the case, as evidenced by the continued news flow over the last two days and the sharply negative reaction in equity markets. As such, we felt it appropriate to further refine our views in light of those more recent developments.
In our comments today, we’ll briefly address four dimensions of the outbreak: the human health toll, capital market reaction, economic impact, and monetary policy response.
Human health toll
In recent days, the number of confirmed cases has continued to grow, although the pace has slowed. As of Friday morning, nearly 84,000 individuals globally have been infected, with the overwhelming majority (nearly 79,000) in mainland China. According to a February 27 report from the World Health Organization, the virus has now spread to 47 countries, including nine in the preceding 24 hours.
While the virus’s spread appears to be slowing within China, it’s accelerating elsewhere. Perhaps the most troubling development relates to the rapid increase in the number of cases in South Korea (with the largest concentration outside of China) and Italy and Iran, representing meaningful outbreaks outside of Southeast Asia. In response, the World Health Organization earlier today declared that it now deems the risk of the spread and impact as very high at a global level.
Additionally, significant questions remain around the incubation period and transmission risk, particularly when an infected individual shows no symptoms. The result is that more countries are taking active steps to prepare for a potential outbreak. Restrictions on international travel are expanding, and impacted regions are being subjected to quarantine. As a preventative measure, there are also a growing number of cancellations of public events.
Even the best efforts to contain its spread have practical limits. Given these developments, we believe that the virus spread is likely to accelerate outside of China in the coming days and weeks.
Bottom Line: Although there are some indications that the growth of infected individuals has slowed considerably in China, the growth in cases outside of China is accelerating, with clusters emerging in other regions. Given that, we should be prepared for this trend to continue.
Capital market reaction
Capital market sentiment turned decidedly negative coming into the week, predominantly on the news of its spread outside of China. That accelerated yesterday. By the end of the day on Thursday, major U.S. equity indexes entered correction territory (defined as a 10% decline from its high). The S&P 500 was down 12% from its February 19 high, with global markets also declining. The MSCI EAFE Index was off about 11% from its mid-January high, while the MSCI Emerging Markets Index has declined by about 12% over that same time frame.
Conversely, the flight to quality drove U.S. Treasury prices higher and yields lower. The 10-year Treasury yield closed the day fractionally below 1.30%, down sharply from 1.60% just two weeks ago.
We would offer a little perspective on this week’s move:
- Headlines last evening focused on the fact that the 1191-point decline in the Dow Jones Industrial Average Index was the largest ever. We would note that the 4.42% decline, while significant, does not rank even in the 100 worst days for either the S&P 500 or the Dow.
- Market declines of more than 10% aren’t uncommon, occurring on average once every two years. The last correction in U.S. equities occurred in Q4 2018 and was followed by strong equity market returns last year. There’s no way to determine when or where the market will stabilize, but the pullback thus far remains well within the norms of what could be anticipated in the context of an ongoing bull market.
- Sharp market selloffs are often followed by rapid recoveries, illustrating that volatility has two sides.
- While equity valuations were arguably not at extreme levels leading up to the recent correction, they have been trimmed considerably in the past week, taking some froth out of equity prices that were pushed higher over the course of 2019. As a result, expected returns for equities have improved.
- Conversely, Treasury yields have fallen on the back of this week’s flight to quality. At the same time, credit-sensitive areas of the bond market have been caught in the same “risk-off” shift in sentiment that has weighed on equities. While credit conditions also remain volatile, it’s likely that some relative opportunities will be created, and we would anticipate that taxable bond managers, in particular, will be evaluating those opportunities and repositioning portfolios at least at the margins over time.
Bottom Line: Investors should be prepared for volatility to persist. As interest rates, credit spreads, and equity valuations are impacted by evolving market conditions; we will continue to evaluate potential opportunities that may be created and remain in direct discussions with individual managers to gauge the appropriateness of their positioning.
Coming into the current epidemic, U.S. economic data was on an upswing, with even the manufacturing sector, which had been hard hit last year, showing signs of improvement as trade war fallout faded. Expectations were for the U.S. economy to grow by about 2% in 2020, with global growth to perhaps tick up to around 3.5%, led by emerging markets and a projected 6% growth pace in China.
Those expectations are being recalibrated rapidly as economists attempt to absorb the scope and scale of the outbreak and its impact on growth in the impacted regions and globally. The process of implementing quarantines and lockdowns in heavily impacted regions, while necessary to attempt to slow the spread of the virus, has a negative impact on the local economies. The unanswerable questions are how extensive those measures will ultimately be and what the impact they’ll have on the economy of the affected region and globally.
The psychological effect on consumer behavior is also real, as individuals in the affected regions change their spending behavior to varying degrees. In addition, the continued effect of production shutdowns in China remains a challenge for various businesses dependent upon global supply chains. In that regard, the economic headwind is both a supply-and-demand issue.
In recent days, expectations have been ratcheted down. Early indications were for a negative drag of perhaps 0.25% in Q1 in the United States, although they were generally accompanied by a cautionary note given the significant degree of uncertainty about the outbreak itself. More recently, updated forecasts suggest that U.S. growth through the first half of the year could be trimmed to 1.0–1.5%.
Still, the baseline view is that the underlying strength of the U.S. economy should be enough to withstand the negative effects of the current outbreak. The first half of the year is expected to be softer, with the potential for a second-half pickup still anticipated.
Bottom line: The global economy will unquestionably feel the negative impact of the coronavirus epidemic in Q1 and Q2. At present, China appears to be the most vulnerable to a sizable drag on growth, with some economists suggesting that growth could stall out there completely in Q1. Economists are now projecting U.S. growth to be trimmed to about 1.0–1.5% in Q1, with a rebound to follow later this year.
Monetary policy response
The Federal Reserve has been in an easing mode since last year when policymakers stepped back from their policy of gradual tightening in the face of softer conditions precipitated by the trade war with China. In recent days, the calls for additional rate cuts have intensified, although the Fed has held steady for now, but left the door open to act. That point was reinforced in a statement today issued by Fed Chair Jerome Powell that stated, “The fundamentals of the U.S. economy remain strong. However, the coronavirus poses evolving risks to economic activity. The Federal Reserve is closely monitoring developments and their implications for the economic outlook. We will use our tools and act as appropriate to support the economy.”
Fed fund futures provide a clear picture of market expectations, which have changed dramatically in the past month. Coming into the year, futures were pricing in a likelihood of one rate cut, probably in the second half of the year. As of this morning, that probability has spiked; futures are now pricing in a 100% expectation for the Fed to announce a cut of at least 0.25% at or before its March 17-18 policy meeting.
The question it seems is one of impact, and that’s a debate that is being played out given the nature of the challenge to the economy. Fears of health risk aren’t going to be alleviated by lower interest rates. Consumers concerned enough about being exposed aren’t going to be more likely to go out for dinner or book a flight because the Fed has trimmed rates by 50 basis points.
Moreover, monetary policy is a blunt instrument and not a scalpel. It’s arguably not an effective tool to address a health epidemic. Conventional wisdom is that changes in rate policy take perhaps 12-24 months to filter into the broad economy. Even if the viral outbreak is severe in the United State (which is not a given at this point), any rate cut at this point is unlikely to be particularly effective in providing a near-term buffer.
The case for cutting then appears to hinge on its symbolic relevance, providing a bit of confidence to the markets at a time in which such a signal would likely be well received. Whether or not the Fed decides to take that step remains a question, yet there is a growing expectation that it will. Certainly, the potential for further rate cuts has increased, and, conversely, the likelihood of any need or desire by the Fed to raise rates has faded even further.
As evidence grows that the virus will spread further globally, there’s also a growing probability of a more coordinated response by major central banks. Should that occur, the nature of any policy adjustments will vary given the range of tools available to the Fed, European Central Bank, Bank of Japan, and People’s Bank of China. Regardless, given ongoing developments, the probability of a policy response appears to be rising.
Bottom Line: The potential for the Fed to cut rates or for a more coordinated global policy response has risen considerably. Such a move is unlikely to have any real economic benefit in the near term but could still provide a boost to investor confidence.
Although our focus and responsibility are clearly within the realm of the financial in serving our clients, the primary source of risk and concern today lies unquestionably outside of that. We acknowledge the health risk and human cost and share those concerns as we observe the daily developments and the spread of the virus.
As we’ve noted in recent months, the U.S. economy was showing signs of reacceleration after weathering the storm of last year’s trade war with China. In our Road Ahead commentary issued in December, we noted that there was little evidence of the typical issues that tend to presage a recession:
- A surge in inflation requiring the Fed to raise policy rates to cool growth? Not present.
- A bubble in asset prices? While valuations in some areas were elevated, they were far from bubble territory.
- Excess capital expenditure investment by businesses? If anything, that has been persistently soft in recent years.
A policy misstep? The potential for the trade war to expand was a risk, although the easing of rhetoric and agreement of the Phase 1 deal alleviated that risk.
The other risk that we cited as being always possible was the unforeseen, exogenous shock. That’s what is unfolding now. Although the primary risk is noneconomic, it still has a decidedly economic dimension. We believe that it’s necessary to be appropriately humble in also acknowledging the limits of quantitative analysis given the nature of the risk and the degree of uncertainty that exists.
For investors, periods of heightened volatility can be troubling. We acknowledge that fact and would also note that we aren’t immune to that as we have monitored developments in recent days. As we evaluate potential actions, it’s critically important that we do so through the lens of a disciplined investor. In that context, and within the spirit of a long-term, strategic approach, we continue to recommend that investors remain committed to their long-term strategy as outlined in their investment policy statement. To that end, we recommend that:
- Appropriate consideration should be given to short-term cash needs (typically defined as six months or longer) to provide adequate liquidity during the current period of volatility.
- Consideration and reaffirmation of your strategic asset allocation targets as summarized in your investment policy statement. Those targets should reflect a portfolio structure and plan necessary to achieve your long-term return needs in the context of your tolerance for risk.
Within the context of your investment policy and as market conditions warrant, we will continue to monitor your portfolio allocations for any need or opportunity to rebalance back to your strategic targets.
As always, we’ll continue to closely monitor both the macro environment and market conditions and your portfolio specifically for any actions that may be appropriate. If you have any questions or concerns, please contact your PMFA advisor.
Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain.
Data sources for peer group comparisons, returns, and standard statistical data are provided by the sources referenced and are based on data obtained from recognized statistical services or other sources believed to be reliable. However, some or all of the information has not been verified prior to the analysis, and we do not make any representations as to its accuracy or completeness. Any analysis nonfactual in nature constitutes only current opinions, which are subject to change. Benchmarks or indices are included for information purposes only to reflect the current market environment; no index is a directly tradable investment. There may be instances when consultant opinions regarding any fundamental or quantitative analysis may not agree.
Plante Moran Financial Advisors (PMFA) publishes this update to convey general information about market conditions and not for the purpose of providing investment advice. Investment in any of the companies or sectors mentioned herein may not be appropriate for you. You should consult a representative from PMFA for investment advice regarding your own situation.