Market Update 13 March 2020

Investment markets and key developments over the past week

Share markets collapsed over the past week as concerns about the global economic impact of coronavirus intensified, while oil prices plunged as part of the secondary impact and as concern grew that the global policy response would be inadequate…only to then see losses reduced on Friday as optimism about a robust policy response increased. For the week, US shares lost 8.8%, but this was cutback from a 16.5% decline by a 9.3% rally on Friday, after President Trump stepped up efforts to combat the virus. Eurozone shares lost 19.8% for the week, but closed before most of Friday’s US rally, Japanese shares fell 16%, Chinese shares fell 5.9% and Australian shares lost 10.9% (albeit a late rally on Friday saved it from what otherwise would have been a 20% fall). From their recent highs to their recent lows US shares have fallen 27%, Eurozone shares have fallen 34%, Japanese shares have fallen 28% and Australian shares have fallen 26%. Bond yields surprisingly rose over the last week - possibly because some fund managers had to sell bonds to cover redemptions in the face of losses elsewhere in their portfolios. Bond yields rose sharply in Italy on deficit concerns. While the iron ore price rose slightly, oil prices plunged and metal prices fell. A rebound in the US$ saw the A$ fall below $US0.62.

So why all the crazy volatility in markets? E.g.) Australian shares down 8% at one point on Friday only to close up 4.4%, or US shares down 9.5% Thursday and then up 9.3% on Friday. Put simply, markets are trying to grapple with immense uncertainty around the depth and duration of the coronavirus’ impact on global growth, what the secondary consequences might be and how much this will be offset (and the eventual recovery boosted) by policy support from governments. Liquidity pressures - for example, as some fund managers may have to sell assets that have gone up in value (like government bonds) to meet redemptions - are likely adding to the volatility.

The news on coronavirus and its economic flow-on just seems to go from bad to worse and so its little wonder shares, commodity prices and bond yields have remained under pressure and very volatile:

• New cases are still rising globally – although they have collapsed in China (highlighted by President Xi visiting Wuhan) they continue to surge elsewhere. The US and Australia are no longer immune to this. See the next two charts.

• The World Health Organization (WHO) has finally called it a pandemic, which is a statement of the obvious, but it adds to the sense of panic.
• Social distancing policies are spreading globally and are now even commencing in Australia. This will clearly hit economic activity, but the experience in China and in the 1918 Spanish flu pandemic (next chart) show that it works.

Social distancing helps - 1918 Spanish flu

• Further, the first really big secondary effect showed up as a 30% or so plunge in oil prices, as OPEC and Russia failed to agree on production cuts in response to slumping oil demand on the back of the virus, which then saw Saudi Arabia announce much lower prices and higher production. All of this led to concerns about a slump in US oil related capital expenditure and worries about energy companies not servicing their loans.
  

While it seems somewhat irrelevant for now, there are some positives that investors need to allow for in assessing the outlook for the next 6-12 months:

• After 30% or so falls, shares are now cheap, particularly against ultra-low bond yields & interest rates. Forward PEs are now well below long term averages.

• Investor sentiment is now very negative – with the VIX (or fear index) at levels last seen in the GFC, which is positive from a contrarian point of view. 
• While it may not be enough just yet, government support and policy stimulus is ramping up dramatically, with the US Federal Reserve (Fed), Bank of England (BoE), European Central Bank (ECB), Bank of Canada (BOC) and the People’s Bank of China (PBOC) all easing monetary policy, most central banks including the Fed and Reserve Bank of Australia (RBA) providing liquidity support to funding markets, significant fiscal stimulus in the UK and Australia, the US moving towards fiscal stimulus and President Trump declaring a national emergency to free up funding, Angela Merkel saying Germany will do “whatever is necessary” and her Government announcing a package of measures to address the economic impact of the virus, the European Union (EU) relaxing government spending rules, Canada set to announce fiscal stimulus in the week ahead, etc. More stimulus will be needed, but policy makers are moving in the right direction rapidly. Stimulus and central bank liquidity support won’t stop the virus or the economic disruption, but it will help limit the secondary economic fallout and help boost the recovery.
• While the collapse in the oil price will weigh on US oil company capital expenditure and debt servicing, it’s actually a net boost to developed countries via consumers who now have more spending power, albeit they may not spend it for several months. Australian petrol prices are likely on the way to below $1.10/litre which will save the average family around $13 a week on their petrol bill compared to what they were paying in December. (Last night I filled up at $1.12, way down from around $1.70 a month or so ago.)

But while these things will help minimise the downside and boost the recovery, we really need to see evidence that the virus and its economic impact will come under control such that shares and other investment markets can be confident that the worst has been factored in before markets will bottom. Right now, this is still lacking. However rapidly improving valuations and policy stimulus provide confidence that growth will rebound once the virus runs its course and that share markets will be higher in 6-12 months. Key to watch for in the short term are: signs that the number of new cases (outside China) has peaked – the shift to the northern summer may help here (although it’s not so bright in Australia as we approach winter); signs that corporate and household stress is being kept to a minimum; signs that market liquidity is being maintained and supported as appropriate by authorities; and more policy stimulus to minimise the fallout from shutdowns.

On the policy front, the decisive fiscal stimulus in Australia shows what needs to be done. The Federal Government’s stimulus package gets my tick. The A$17.6bn package is mostly front-loaded over the next year and particularly the next few months. Combined with the A$2.4bn health spending package and the A$2bn in bushfire assistance, it will actually get us a bit above the roughly $20bn (or 1% of GDP) in fiscal stimulus over a year that I thought was necessary. The measures, focussed on boosting investment, maintaining wages and employment and providing a cash boost to welfare recipients (much of which will get spent) - are all in the right areas. This won’t stop the virus or the lockdowns, which risk extending into August in Australia given our approaching winter, and so probably won’t stop a recession, which runs the risk of extending into the September quarter. Along with monetary easing however, it may help Australia avoid a second consecutive quarter of contraction in the June quarter; and even if it doesn’t, it will minimise secondary economic effects (and hence the depth of the downturn) and will help boost the recovery once the virus runs its course, hopefully sometime in the next few months.

President Trump and ECB President Lagarde botched things mid-week, but look to be getting back on track. Trump’s error-filled and not-enough Oval Office address on Wednesday just added to market panic, as did the impression from the ECB President that it wasn’t about to support Italy. However now (after sharp market falls), it seems as if the message is getting through. Trump’s Friday address was far more forceful in declaring a national emergency (that frees up $US35bn in funding), declaring a moratorium on Federal student interest, boosting Covid-19 testing and buying oil for the strategic reserve. The Democrats and the Administration also look to have reached agreement on a spending deal. It’s not yet the 1% of GDP stimulus that the US needs, but it seems both sides of politics agree the need to do a lot more - neither Trump nor the Democrats want to get the blame for a recession, but it may take more market falls beforehand. Similarly, Europe also seems to be headed to significant stimulus, with a reduction in borrowing spreads being one goal.

The big and rapidly growing risk for President Trump is that the US economy slides into a recession that combines with his policy failure that allowed around 30 million Americans to go without health insurance ahead of a health crisis, to see him lose the election. As things stand now, this is looking increasingly likely. Trump’s betting market probability of re-election has plunged in the last few weeks. The good news is that moderate Joe Biden continues to consolidate his position as front runner for the Democrat nomination. While he may want to raise corporate tax rates, his steady hand may be seen as welcome by markets through periods like the present and in general he is seen as business friendly.

Major global economic events and implications

US small business confidence surprisingly rose in February and remains high and jobless claims remain low, while core CPI inflation came in a bit higher than expected in February. Unfortunately, activity data is likely to slow in the months ahead and the inflation data is irrelevant given the deflationary hit coming from lower oil prices and a likely recession.

Chinese export and import growth fell in January and February on the back of disruptions, particularly exports. More weakness is likely in exports, although imports may improve as economic activity returns to normal. Chinese core inflation weakened, leaving plenty of room for policy stimulus.

Australian economic events and implications

Australian business confidence (as measured by the NAB) and consumer confidence (as measured by Westpac and the Melbourne Institute) both fell further in February and March, no doubt reflecting coronavirus concerns. While housing finance commitments rose strongly again in January, this is set to slow again in the months ahead as coronavirus temporarily impacts buyer demand.

RBA Deputy Governor Guy Debelle indicated “quantitative easing” (QE) would likely be the next step if it cuts rates to 0.25% (which we expect to occur in April) and confirmed media talk that the RBA will do it by announcing a target for the bond yield (say 0.25%) rather than a target for bond buying as occurred in the US. The mere threat of bond buying may turn out to be enough to hit the yield target. Japan has done something like this with so called “yield curve control” but it was backed by a bond buying target too. Targeting a yield without much actual bond buying may limit the transmission channels of QE via a lower A$ and forcing bond investors to take more risk, hence its actual economic impact. Therefore yield targeting may just turn out to be an intermediate step to the RBA being forced to do actual QE.

What to watch over the next week?

The increasing number of Covid-19 cases globally and spreading lockdowns will 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, the Fed (Wednesday) is likely to reinforce that it stands ready to ease further if needed, following its 1% rate cut and re-start of quantitative easing on Sunday. On the data front, expect another solid rise in February retail sales, a bounce in industrial production and continued strength in the NAHB’s home builders’ conditions index (all due Tuesday), a fall in housing starts (Wednesday) but a rise in existing home sales. Manufacturing conditions indexes for the Philadelphia and New York regions for March are expected to fall.

The Bank of Japan is likely to ease monetary policy further on Thursday.

Chinese economic activity for January/February is likely to show a sharp contraction as a result of lockdowns. Expect a fall in January/February industrial production, retail sales and investment of around 3% year-on-year.

In Australia, expect the minutes from the last RBA meeting, due Tuesday, to contain a strong easing bias. Meanwhile, ABS house price data (also Tuesday) for the December quarter will show a 4% rise consistent with private sector surveys long ago released. Labour market data for February (Thursday) is expected to show a 10,000 gain in jobs, with unemployment rising slightly to 5.4%.

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. But on a 12-month horizon, 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. 
• Our base case is that capital city house prices will continue to rise, but at a slower pace than has been the case. However, this is now under threat given the expected recession in response to coronavirus disruption. A sharp rise in unemployment would pose a major threat to the property market. Hopefully stimulus measures will head that off, as occurred in the Global Financial crisis. 
• Cash & bank deposits are likely to provide very poor returns, with the RBA expected to cut the cash rate to 0.25%.
• The deepening hit to global growth from Covid-19 is now likely to see the A$ pushed to $US0.60 or even below. Given the uncertainty around the virus, the short-term risks for the A$ are on the downside.