Important points of review:
- Recent uptick in coronavirus cases and fatality rates
- Potential impact to U.S., China, and global economic growth rates
- Plummeting U.S. bond yields that are at record lows
- New expectations pertaining to potential Federal Reserve action
- Reactions of U.S. credit markets
- What this all means for the investment environment in 2020
In addition to being a human tragedy of global proportions, the rising spread of the coronavirus numerically and geographically continues to create short-term pressures on financial markets. As quantification of economic impact remains a moving target, uncertainties over the past week have led to volatile equity markets and plummeting bond yields. Such volatility could continue as the medical community seeks better clarity on infection trends and treatment options and the financial markets look to identify realistic impacts to regional and global growth rates.
As of February 24, documented cases of the virus across the globe exceeded 80,000, with fatalities at about 2,600. While the large majority of these numbers remain in mainland China, it is the geographic range of the spread that has created worsening angst. In a matter of days, cases jumped from 31 to more than 763 in South Korea and from basically zero to more than 200 in Italy. While these numbers are small when taking into account total country populations, the rate of infection is driving concern.
Medical theories abound as to why, how, and how much the virus is spreading, and those judgments are beyond the knowledge and expertise of the financial world attempting to decipher the coronavirus impact to the world economy and global growth. So here are a few important points for investors to consider:
- Stocks have reacted negatively, with the S&P 500 now approximately 6% below its record high of a few weeks ago, but it is also the sharp decline in bond yields that has stunned the markets. As of the open on February 24, long-term U.S. interest rates have fallen to record lows, with the 10-year Treasury rate at 1.36%, eclipsing its previous all-time low reached in July of 2016 shortly after Great Britain voted in favor of Brexit. This drop on bond yields has of course been driven by a global flight to safety during this period of uncertainty.
- The lesser-followed U.S. 30-year yield also hit an all-time low of 1.81%. In Japan and Germany, long-term rates have further retreated into negative territory, with those countries now posting 10-year yields of -.07% and -.49%, respectively. We believe it is important for investors to bear in mind that these lower longer-term rates, all else being equal, should ultimately help equity valuations.
- Market expectations of the Federal Reserve to lower short-term rates has also changed materially in recent days because of the virus outbreak. Just weeks ago, consensus beliefs were solidly in the camp that the Fed would likely stay on the sidelines for 2020. However, Fed Funds futures markets are now discounting a better than 50% probability of one rate cut by the late-April meeting and two by the September meeting. We would caution investors that these probabilities are fluid and that the Fed itself has offered no signals it will follow such a path. Nonetheless, the market clearly expects the Fed to act if the virus does appear at some point to tangibly detract from economic growth in the U.S.
- Current estimates seem to be calling the global financial impact of the coronavirus over the remainder of 2020 to be approximately $1 trillion, or about 1.2% of aggregate global growth. That said, if the virus does ultimately become contained, or perhaps declines materially in the warmer spring months as some have theorized, the long-term impact to global growth could be transient and markets would then reflect a recovery back toward longer-term trends. While it is admittedly too early to tell if this will definitively prove to be the case, it is also too early to tell if it will not.
- Risk to U.S. growth in 1Q20 still appears somewhat muted. Most expectations are calling for GDP increases in the 2% range even when taking into account recent coronavirus data, with a net negative impact to 1Q20 US growth between .20% and .40%. The Atlanta Fed, commonly recognized as one of the better predictive sources, estimates 2.6% growth for the quarter.
- China, however, will undoubtedly feel a negative impact to first-quarter GDP growth, previously anticipated to be approximately 6%, as estimates now reflect a wide range anywhere from 0% to 4%, which would be the lowest in several decades. This could likely also materially impact global growth for the quarter.
- For this reason, we could see a scenario in which weaker-than-expected results in terms of the global and U.S. economies — as well as the first-quarter earnings reports of individual companies and the broader equity indexes — are essentially “given a pass” by the markets over the next few months as the long-term effects of the coronavirus are determined. A key element in this conclusion will be whether the Chinese labor force is able to return to work at nearly full capacity. This would help determine if global manufacturing firms can avoid the disruption of shifting their China-based supply lines through other regions.
- Of interesting note, in our opinion, is that U.S. credit spreads have not noticeably risen amid the virus scare as high-yield credit spreads remain close to multi-year lows at about 3.70%, while investment-grade spreads are at about 1.05%. This likely represents the market’s perspective that U.S. credit markets will benefit from the lower long-term rates and, at least at this point in time, will not be materially adversely impacted by the virus.
All considered, while investors should expect more volatility and perhaps another leg down in longer-term interest rates, we believe caution and prudence warrant a measured approach to any portfolio realignments. Coronavirus-based risks to the equity and credit markets are higher globally than here in the U.S., and flights to quality during any periods of increased volatility should reiterate that. In addition, in the event the virus proves to be contained in the months ahead, both U.S. and global markets likely stand to benefit and could be well-positioned for the second half of the year.
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