*** Please note: The below information was prepared as it stood, Friday 6th March 2020. While market conditions have changed significantly in the last 24 hours, the general sentiment and insights provided in this update remain current. We are monitoring the Covid-19 situation closely and will continue to provide updates as appropriate.
This morning the below missive titled ‘the way forward in four broad scenarios’ hit our inbox. Considering just how fast the ground continues to move beneath us, we thought it reflective of our own views and thus worth sharing.
We can look at the way forward in four broad scenarios:
- Widespread global pandemic a worst-case scenario provoking a sustained global recession, zero rates, unconventional policy responses and further material falls (>20%) in the equity market. We think this is a low-probability outcome.
- Rolling outbreaks globally short-term economic downturns of 2-4% followed by quick recovery. Policy responses could include zero rates and targeted fiscal stimulus. This scenario could see further markets falls potentially up to 10% or so but a bounce-back by the year’s end.
- Milder outbreak containment measures and the northern hemisphere Spring curtail the spread. This could see a short-term slow-down with rate cuts and limited fiscal stimulus. The market may already have seen its lows if this is the case, with a good chance of a 10-20% bounce.
- Quick resolution a medical breakthrough could see economic acceleration, a reversal in rate cuts, bonds falling sharply and a 20%+ rally in equities. Like the negative extreme, we see this as a low probability outcome.
It is in uncertain situations such as this with a degree of binary outcomes that portfolio construction becomes critical. We are positioning the portfolio to weather the more likely outcomes scenarios (2) and (3) and to take advantage of the buying opportunities that have emerged. However we also need to be mindful of protecting the portfolio in the case of a more extreme scenario positive or negative playing out.
Investment markets and key developments over the past week
- Share markets had a very volatile week – helped initially by more policy easing globally with both the Fed and the RBA cutting interest rates but only to get hit again by intensifying coronavirus concerns. While Chinese shares made it back to their January high and surged 5% through the week and US shares still managed to rise 0.6%, Eurozone shares fell 3.1%, Japanese shares fell 1.9% and Australian shares fell 2.7%. From their recent highs to recent lows US shares have fallen 13%, Eurozone shares have lost 16%, Japanese shares have fallen 14% and Australian shares have lost 13%. The flight to safety and expectations for more monetary easing saw bond yields plunge to new record lows in the US and Australia. Commodity prices were mixed with oil plunging as Russia refused to support further OPEC production cuts, but metal and iron ore prices rose. A falling US dollar saw the A$ rise.
- Coronavirus dominates most conversations now and it seems there are two extreme views. Some see it as just a bad flu (which in the 2017-18 US flu season saw 44.8m get sick and 61,099 deaths) and can’t see what the fuss is all about. Others think that it will trigger a major humanitarian and economic catastrophe. The optimist wants to lean to the first interpretation – while Covid-19 is more deadly than regular flu the actual death rate may be 1% or lower if those who get the virus but don’t get sick enough to seek help are included and it’s likely to be less contagious. But we also have to concede that we just don’t know for sure. There is much that is unknown about the virus itself and how long it will continue to spread. And there is also the human or behavioural reaction and the media frenzy that is helping to inflame it. Just look at the toilet paper frenzy – with the destruction of a truck load of toilet paper becoming a major national story and people getting into fights over it – to see that this can have a real economic effect even before the virus has really taken hold in Australia.
- Unfortunately, on the coronavirus data front it was more of the same over the last week. The number of new cases and deaths in China is continuing to trend down (which is good news) but the number of new cases outside China is continuing to rise rapidly (which is clearly bad news). Italy, Korea and Iran remain problematic, but the number of cases is also steadily rising in France, Germany, the US & Australia. (Singapore and HK seem to be containing it recently – showing it can be done.)
Source: PRC National Health Commission, Bloomberg, AMP Capital
Source: PRC National Health Commission, Bloomberg, AMP Capital
- With this has come an increasing sense of panic globally – as evident in a surge in Google searches for “coronavirus” and “hand sanitiser” and the run on toilet paper in Australia.
Source: Google, AMP Capital
- While there may be a boom in demand for hand sanitisers and toilet paper, the spread of the virus globally and the disruption that containment measures are causing is continuing to increase the risk of a longer and deeper hit to global and Australian economic activity. As such, it’s still too early to say that shares, commodity prices and bond yields have bottomed.
- On the positive side shares have had 12% plus falls, they are now very cheap compared to lower bond yields and interest rates, investor sentiment is now negative which is positive from a contrarian point of view, Chinese shares have been able to rally back all the way to pre virus levels, the US dollar has now fallen back sharply removing the risk of a “dollar funding” crisis and policy stimulus has ramped up dramatically over the last week with central banks led by the RBA and the Fed moving to cut rates and governments starting to boost spending as well. In terms of the latter, the G7 committed to use “all appropriate policy tools” to support growth. While the Fed really got the ball rolling on rate cuts, the RBA snuck in first with a 0.25% cut followed by 0.5% cuts from the Fed and the Bank of Canada and other central banks look set to ease too. The US also showed that fiscal support is possible in an election year – with an $8bn health package. Although its less than 0.1% of GDP, White House economic adviser Larry Kudlow has indicated that further limited (for now!) fiscal stimulus is being considered. While it may take a while to get Congressional agreement it’s hard to see either side of politics wanting to be seen as blocking help for the economy at this point.
- But while these things are all positive and maybe shares have already factored in the worst, we really need to see evidence that the outbreak is coming under control or will have a limited economic impact. At this point this is still lacking. Policy stimulus and support for badly hit businesses (to prevent insolvency) is necessary to minimise the economic fallout and super charge the eventual recovery, but it won’t stop the virus and the short-term economic disruption it is causing. Key to watch for in the short term are signs that the number of new cases (outside China) has peaked (as per the first chart) and/or indications that a vaccine or anti-virals will soon bring it under control or perhaps a refocus by authorities away from containment to just focussing on treatment of the really ill (as occurred with the albeit less deadly swine flu a decade ago).
- The ascent of Joe Biden has reduced one worry for the US share market. The success of socialist Bernie Sanders early in the US Democratic party primaries was weighing on investors because of his policies favouring a big increase in taxes, public spending and regulation reversing Trump’s pro-business policies. This got turned on its head over the last week as centrists rallied around Biden following his strong result in South Carolina, other moderate nominees dropped out concentrating the moderate vote on Biden and he did well on Super Tuesday. As such the betting odds of Biden winning the nomination have surged above 70%. If this continues Biden will win the nomination. Views remain that if the economy stays strong Trump will be re-elected. But if he doesn’t and the Democrat candidate is Biden it’s not such a big issue for US shares as Biden is not anti-business and is likely to be seen as ushering in a return to predictable and stable policy making.
Source: Bloomberg, AMP Capital
Major global economic events and implications
- US economic data was generally good with the February ISM manufacturing conditions index down slightly but more than offset by a rise in the non-manufacturing index, construction spending up solidly, jobless claims remaining low and February payroll employment up another strong 273,000 with unemployment falling back to 3.5%. Of course, this is all dated now given the coronavirus threat and the Markit business conditions PMIs were a lot weaker for February. The ongoing softness in wages growth at just 3%yoy indicates no constraint here on further Fed easing though.
Source: Bloomberg, AMP Capital
- It’s the threat posed by coronavirus that got the Fed moving with a 0.5% rate cut and indicating it’s prepared to do more. The track record of inter meeting Fed rate cuts with respect to the US share market is not that flash with US shares down one year after 5 of the last 7 inter meeting cuts since 1998, but it doesn’t help that three of those were in the tech wreck and three in the GFC. Expect at least another 0.5% in rate cuts from the Fed.
- Chinese Caixin business conditions PMIs for February fell sharply with the services PMI basically halving to 26.5. This is consistent with the previously released official PMIs and with what daily data for things like traffic congestion and coal demand had already been indicating. Car sales are down 89% in the first 23 days of February compared to a year ago. So far, the Chinese economy has been something like 45% shut for the last 5 of the 13 weeks in the March quarter which implies a 17% hit to GDP. Daily data is gradually edging up, so it probably won’t be anywhere near that bad and the February PMIs should mark the low point, but it will still be a big hit to GDP.
Australian economic events and implications
- The Australian economy expanded more than expected in the December quarter, but it was weak beneath the surface with private sector spending now flatlining for six quarters in a row and in any case it’s now ancient history with the March and June quarters now likely to see the economy contract. While January data showed a continued strong trade surplus, this was before the coronavirus hit that will show up from February. Meanwhile, building approvals saw a sharp fall and retail sales fell again in January not helped by the bushfires. The bottom line is that underlying growth was soft even before coronavirus came along and assessments remain that the hit from the bushfires and the virus – mainly to tourism, education and commodity exports – will see the economy contract in the current quarter. While the base case has been that growth will bounce back in the June quarter, it’s now looking like it will be negative too as the spread of coronavirus drags on global growth and economic activity in Australia. Particularly if the onset of winter sees coronavirus take longer to stamp out in Australia than in the northern hemisphere. As such it is likely to see two negative quarters in a row in Australia. Unfortunately, this would mark the first recession since the early 1990s. Hopefully we will bounce back quickly in the second half as things go back to normal helped by policy stimulus.
- Although Treasury has indicated that “at the moment we are not forecasting a recession for the Australian economy” it clearly sees the risk with an expectation that coronavirus will detract at least 0.5% from March quarter GDP and also affect the June quarter.
- Given the threat of recession in Australia on the back of the coronavirus outbreak – and the economy being a long way from the RBA’s full employment and inflation objectives even before the virus came along – further policy easing will be required. A fiscal stimulus package targeted to help businesses maintain jobs and cashflow and boost investment looks to be on the way – possibly in the week ahead. It’s likely to include tax breaks for increased investment and cash support to impacted businesses to maintain loan repayments, wages and employment. But while it’s looking to be bigger than was likely a week ago (with the PM upgrading it from “modest” to “measured”) it sounds like it might only be around $3-5bn which would only amount to around 0.2% of GDP. Ultimately total stimulus of around $20bn or 1% of GDP is likely to be required in order to include a boost to households in order to support aggregate demand, but this may have to wait till the May budget. So, for now much of the pressure remains on the RBA. As such expect another rate cut taking the cash rate to 0.25% next month. With the RBA signalling on several occasions that 0.25% will be the floor for the cash rate it is unlikely to see rates falling beyond this as there is not much evidence that zero of negative rates would help. But once rate cuts are exhausted at 0.25% the RBA is likely to turn to quantitative easing (QE) during the second half. Ideally this should be combined with broad based fiscal stimulus. It could see the 10-year bond yield fall to around 0.25%!
- While there has been some media talk that the RBA could just announce a target for the 10-year bond yield of say 0.25% and not actually do any buying of bonds (or QE) this would be seen as a very weak response. Japan has done something like this with so called “yield curve control” but it was backed by actual bond buying. Not doing QE would mean that its impact would be limited. As such while announcing a bond yield target may be an intermediate step, we would still see the RBA being forced to do actual QE and buy bonds.
- CoreLogic data showed continuing strong gains in home prices in February, but the rising threat from coronavirus poses an obvious threat to this via higher unemployment as the economy slows and as people put home buying on the backburner for a while.
What to watch over the next week?
- The increasing number of Covid-19 cases globally will no doubt continue to dominate in the week ahead as investors attempt to assess how long it will take to be contained and how bad the hit to economic activity will be.
- In the US, expect small business optimism (Monday) to fall slightly on coronavirus fears and core CPI inflation in February (Wednesday) to remain around 2.3% year on year.
- Chinese CPI inflation for February (Tuesday) is likely to fall back to around 5% year on year helped by fuel price declines with core inflation remaining benign at around 1.5%yoy.
- The ECB which meets on Thursday is expected to undertake further monetary easing to combat the impact of coronavirus – this may include another rate cut but with rates already negative the focus may be more on boosting liquidity and credit such as enhancing the cheap funding for lending scheme (TLTRO) and expanded quantitative easing.
- In Australia, expect coronavirus concerns to depress both the NAB business survey results for February (Tuesday) and the Westpac/MI consumer survey results for March (Wednesday). Housing finance commitments for January (Wednesday) are expected to show a further rise.
Outlook for investment markets
- Shares are likely to see further short-term falls given the uncertainty around the coronavirus both in terms of the outbreak’s duration and its economic impact even if it’s soon contained. But for the next 12 months shares are expected to see good total returns helped by an eventual rebound in growth and easy monetary policy.
- Low starting point yields are likely to result in low returns from bonds once the dust settles from coronavirus.
- Unlisted commercial property and infrastructure are likely to continue benefitting from the search for yield but the decline in retail property values and the hit to growth from the virus will weigh on near term returns.
- The base case is that capital city house prices will continue to rise on the back of pent up demand, rate cuts and the fear of missing out. However, poor affordability, the weak economy and still tight lending standards are expected to see the pace of gains slow and coronavirus is posing an increasing risk if people decide to put buying on hold and particularly if the economy gets knocked into recession by the virus resulting in higher unemployment.
- Cash & bank deposits are likely to provide very poor returns, with the RBA expected to cut the cash rate to 0.25%.
- The A$ has hit the expected level of US$0.65. If the coronavirus outbreak is contained in the months ahead allowing a relatively quick rebound in global growth, then the A$ is likely to drift up towards US$0.70 by year end. However, a drawn out hit to global growth from Covid-19 would likely see the A$ pushed to US$0.60 or even below. Given the uncertainty around the virus the short-term risks for the A$ are on the downside.