In This Issue
The spreading of COVID-19 outside China with no clear answers to containment and cure finally cracked investor sentiment in a dramatic/historic selloff. Bond yields have fallen to all-time lows, with the 10-year Treasury yield dropping by 74 basis points (bps) since January 31 to a stunning 0.76%1 and parts of the yield curve remaining inverted, anticipating an economic slowdown that is beginning to be reflected in forecasters cutting growth and profit estimates for the year. The affect to equities has been significant. The S&P 500 has declined 12% from recent highs, with Europe, Japan and emerging markets (EM) lower by 15%, 15% and 12% from their recent highs, respectively. Meanwhile, fear gauges like the Chicago Board Options Exchange (CBOE) Volatility index (VIX) recently hit 54 intraday on March 6, the highest since 2009.
The situation remains fluid and it's too early to sound the "all clear" until signs emerge that the outbreak's peak and/or cure is near. Encouragingly for risk assets though is that policymakers are beginning to panic, with the Federal Reserve (Fed) doing an emergency 50 bps interest rate cut last Tuesday and G7 policymakers indicating their readiness to deploy further fiscal spending responses. For now, an acceleration in global growth, which was our base case for 2020, has been delayed to the second half of the year. If we assume that the outbreak fears will fade sometime in the first half of the year (and it's only an assumption), then key catalysts on the other side for equity positioning will be manufacturing/export data, interest rates, policy responses and the dollar, as we explain below.
Despite the recent extreme volatility, we have remained favorable on U.S. equities, partly due to the Fed's deployable monetary firepower relative to foreign central banks. The Fed will likely cut rates further to backstop liquidity and growth. Uncertainty is the only certainty as it relates to the virus but the key questions for U.S. equities are where bond yields will be six months from now and whether economic activity is recovering.
The foundation is certainly strong, given a historically strong labor market with rising wages and labor force participation; improving housing sector buoyed by lack of supply, low mortgage rates and rising household formation; localization of supply chains; and an accelerating innovation cycle that has kept us comfortable that the secular bull market has room to run. Low bond yields make equities attractive from a valuation perspective (currently 404 stocks in the S&P 500 have a dividend yield above the 10-year yield), but if bond yields remain below 1% for a significant length, that is likely to stoke deflationary concerns, which ultimately could push back the recovery time for the U.S. economy and equities.
Global economic momentum is a major driver of international equity performance relative to the U.S., so we will be watching for any signs that cyclical momentum is starting to bottom. In particular, if evidence emerges that the coronavirus outbreak is contained, then interest rates in the U.S. should rise from their record lows, as economic growth and inflation expectations begin to stabilize. Historically, this has supported stronger relative performance among European and Japanese equities, given their index exposure to Financials and Industrials (31% combined in both indexes). If global growth stabilizes, the dollar being a countercyclical currency should ease, which should likely benefit EM equities through easier financial conditions and more stable commodity prices (Exhibit 1).
Manufacturing activity has collapsed in February as evidenced by China's Purchasing Managers Index (PMI), declining to 35.7 from 50 as authorities implemented quarantines and travel/work restrictions to help contain the virus. A rebound in manufacturing and trade flows as supply chains are restored could help non-U.S. growth and equity performance in general. According to the World Bank, manufacturing accounts for 29% of gross domestic product (GDP) for China, 21% in Japan and 15% in the Euro Area versus only 11% in the U.S. To this end, it's encouraging that economic activity is stirring back to life in China with some factories commencing operations, although at a lower capacity, and Chinese equities have almost reversed earlier declines anticipating a rebound. However, equities in other affected countries and major trading partners like South Korea and Japan are currently still trading near their lows for the year. A reversal in those markets would signal that stability first followed by a manufacturing recovery is likely underway.
Exhibit 1: Higher Interest Rates Have Benefitted for International Developed Equities While a Weaker Dollar Supports EMs.
Note: In the left chart, circles are used to highlight periods of rising rates where Japan and Europe outperformed the U.S. Monthly data going back to January 1998. *Indexes are the MSCI Japan, S&P 500, MSCI Emerging Markets, and MSCI EMU. Sources: Bloomberg; Haver Analytics. Data as of February 28, 2020. Past performance is no guarantee of future results.
Fiscal and monetary policy will be key for a sustainable recovery in global equities. Chinese stocks have outperformed other regions since coming back from the Lunar holiday partly due to government commitments to backstop growth. Since this outbreak, Beijing has implemented 34 easing moves that include rate/fee/tariff cuts, easing credit, and increasing government spending to support housing and autos, according to Cornerstone Macro (as of 3/1/20). Similarly, Hong Kong is implementing a $15.4B stimulus package, including cash payouts of $1,284 per adult to kick-start consumer spending. The International Monetary Fund (IMF) announced a $50B aid package for developing countries, while Korea has injected more than $13B in emergency funds to support growth, and Indonesia is working on a second stimulus package to add to easing measures by its central bank. These measures should help economic growth in developing economies begin to stabilize and bolster investor sentiment.
The outlook for Europe is slightly less encouraging. Europe was in the midst of a fragile recovery before this virus: While German PMIs were turning around, its industrial production continued to drop, and its fourth-quarter GDP was about flat, to go along with contractions in France and Italy. In time, as we look for the virus to be contained, manufacturing should bounce back, but growth may remain challenged in 2020. The labor market had pockets of weakness in countries like Italy, consumer expectations were already deteriorating for most countries, while trade was sluggish, to go along with a sputtering auto market. And even after Brexit, geopolitical risk remains front-andcenter, with deliberations in Italy and the UK over a potential digital tax being a source of tension with the U.S.
A fiscal policy framework that allows more pro-growth public spending and tax policies could help backstop growth in Europe. Leadership at the European Central Bank (ECB) and European Commission is encouraging governments to take a more aggressive fiscal stance, and there are some signs that the message is being heard. European Union (EU) budgets imply 40 bps of fiscal impulse, led by the Netherlands and Germany, while Italy plans to spend $8.4B to counter the impact of the virus on its economy. Reports also indicate German Finance Minister Olaf Scholz wants to suspend restrictions on the country's debt levels, and has stated Germany can react with "full force" if this virus evolves into a global crisis. While these measures could face political hurdles, we believe a fiscal response from Europe becomes increasingly likely if the impact to its economy from this virus continues to worsen.
After GDP fell sharply in the fourth quarter, Japan could enter a technical recession given the effect of this virus. Aside from weaker demand from China, reports indicate Japan is closing down schools, companies are halting business travel, and many are questioning whether this summer's Olympics could be cancelled.
Beyond this virus, the outlook for Japan should start to improve later in the year. Household spending is about 53% of GDP and should eventually pick up as the labor market remains strong, and consumer confidence and income growth have picked back up. Fiscal and monetary policy remain accommodative as well. Bank of Japan Governor Kuroda has signaled that the Bank can ease policy to avert a sharper slowdown in the economy, and the government may compile an early supplementary budget in the second quarter, targeting the services sector and household spending.
We advise investors to stay invested in their diversified strategic asset allocation portfolios, with a preference for higher-quality exposures like U.S. large-cap equities, given heightened global economic uncertainty due to COVID-19. We expect a U-shaped economic recovery later this year. Therefore long-term investors should consider a rebalancing opportunity in the coming weeks as more data is released, i.e., use the surplus gains in bonds to rebalance up in equities at more attractive prices. If the dollar weakens further and global factories rev back up, international equities are likely to recoup recent losses on a relative basis.
Last week's surprise interest rate cuts by the Fed and the Bank of Canada were motivated in large part by downside risks to real economic activity from the spread of COVID-19. Following a series of negative earnings revisions from the corporate sector over recent weeks, downgrades to official global growth estimates are also likely to be reflected in the new IMF World Economic Outlook forecasts due to be released next month. At the same time, the stream of media headlines on new cases and containment measures taken by individual countries continues. Over the weeks ahead, it will be important to keep the case count and the relative economic importance of affected countries in perspective. Italy and Iran for example, where the initial surge in new cases was a catalyst for the February selloff in global equity markets, account for less than one-fifth of China's economic output and around only one-quarter of its import demand combined. On a global basis, the total number of cases confirmed by the World Health Organization (WHO) reached 93,090 last week across 77 countries as of March 4. The overwhelming majority (86%) are still in mainland China, of which 84% have been confined to the epicenter of Hubei province. The main driver of the increase in market volatility since mid-February has, however, been the growth in cases in the rest of the world. China's aggressive response to the outbreak saw new local cases peak in early February, and the daily total has fallen to just over 100 as of early March. But new confirmed cases outside China surpassed new cases within the country on February 24 (the first day of 3%-plus market declines during the selloff) (Exhibit 2), with Korea now recording the highest share (42%) of the global total excluding China. The key risk for investors now is that a significant rise in non-China cases might lead to a wave of new official responses and private actions aimed at mitigating this outbreak, which could also have a dampening effect on economic activity around the world.
Exhibit 2: Market Volatility Has Risen with New COVID-19 Cases Outside China Surpassing New Cases Within China.
Source: World Health Organization. Data as of March 4, 2020. February 17 break in mainland China data due to change in WHO calculation methodology.
We would classify such measures into three broad types: 1) containment policies imposed by governments, such as travel restrictions, quarantines and bans on large public gatherings, 2) organizational responses, such as company furloughs, factory closures and cancellation of social events and 3) social distancing measures by individuals, such as avoiding outdoor entertainment or dining away from home. The economic impact of these measures would of course have to be weighed against any monetary and fiscal stimulus introduced by policymakers to create an offsetting increase in demand.
Most countries outside China have so far not chosen to pursue these types of actions as aggressively or on as wide a scale within their borders as has been the case on the mainland over recent weeks. This should reduce the risk of a worldwide economic contraction in the first quarter as is widely expected in China itself. And though conventional stimulus measures cannot directly address the spread of this outbreak, it is clear from last week's central bank actions and pledges of additional support from a range of governments across Asia, Europe and North America that policymakers are prepared to act if necessary. We therefore see a continuation of the global economic expansion as more likely than an outright decline in real activity at this stage. But it is nonetheless worth considering which countries have the potential to deal the biggest blow to global activity through their responses over the period ahead should the number of new cases continue to move higher.
We therefore outline the dimensions of global economic activity across a range of key areas such as GDP, trade and tourist spending, highlighting the largest global contributor countries in each category (Exhibit 3). This should serve as a point of reference as this virus develops.
Exhibit 3: Largest Contributors to Global Economic Activity.
Sources: World Health Organization; International Monetary Fund; World Bank, United Nations; BP Statistical Review of World Energy. Data as of 2018. COVID-19 cases as of March 4, 2020.
Immediately clear is that China and the U.S. dominate the rest of the world in the main measures of global demand and global supply. The two markets together account for around 40% of total world GDP, personal consumption, manufacturing value added and inward foreign direct investment; 20% to 25% of global goods trade; and by far the largest share of international tourism expenditures. This underlines the importance of China keeping its number of new infection cases under control as its local factories slowly begin to reopen and quarantines are gradually lifted. And it also highlights the pivotal role in the global growth outlook played by the U.S. (which still has a relatively low number of cases compared to other large economies) as it looks to get ahead of its domestic outbreak with the $8 billion of funding for state, local and federal health agencies announced last week.
With the highest number of confirmed virus cases outside China (and close to twice as many as a share of its population), Korea will also be an important market to watch as the world's fifth largest global manufacturer and fifth largest exporter after China, the U.S., Germany and Japan. Though it gets far less attention than China, Korea is also a critical link in global technology supply chains as a provider of intermediate hardware products. Semiconductors were 17% of total Korean exports in 2019, more than double the value of its auto shipments. And Korea was also the single largest global contributor to foreign value added in electronics exports from China at $31 billion (16% of the total) in the latest 2015 data from the Organisation for Economic Co-operation and Development. The potential need for aggressive containment measures by Korean authorities, firms and households could therefore hinder China's efforts to recover should there be any major disruption to shipments of electronic components to the mainland.
On the demand side of the global economy, Italy, Germany and Japan, in addition to Korea, will also be important for the growth outlook alongside the principal consumption sources of the U.S. and China. Both Korea and Italy (which has by far the largest number of confirmed cases in Europe and around 20% of all cases outside China) are also among the largest 10 world spenders on international tourism. The impact of any moves by local authorities toward severe travel restrictions in these two markets will therefore also be felt in the global leisure and hospitality sectors. And while Germany and Japan are often criticized for their large trade surpluses, both play a major role in global demand, with a combined import share of over 10% of the global total—comparable with that of China. Energy prices fell by more than global equity markets in the second half of February, and commodity producers have been among the weakest performers during the recent market volatility. The U.S. and China are still the largest world oil consumers at around one-third of the global total, but global prices would also be vulnerable to any future demand-driven weakness from a transportation sector slowdown in India, Japan, Korea and Germany (whose combined oil consumption exceeds that of China) should further spread of this virus within Asia and Europe make for more aggressive countermeasures in these countries.
Downside risks to economic activity around the word have clearly risen, with the outbreak now having spread to more than 70 countries outside China. And questions over the timing of the global peak in new virus cases, the policy responses of governments, firms and individuals and the ultimate success of mitigation and containment measures all make for high levels of uncertainty over the size of the negative impact on the global economy. It will nonetheless be important for investors to keep in mind the relative importance of individual markets to key areas of global activity.
The sudden onset of COVID-19 combined with uncertainty regarding the containment and duration of this virus is impacting global growth and driving a slowdown in many sectors, including some obvious industries like airlines, hotels and cruises. However, these industries will not be the only ones affected by this virus and there is uncertainty and little visibility into sales and earnings for 1Q'20. There is even less visibility for earnings estimates for the second half of this year and we are likely to see downward earnings revisions from companies for 1Q'20 and 2Q'20. This is a key component of the correction in equities over the last two weeks because earnings growth was expected to drive upside to equities in 2020.
The message most often heard is "it is too soon to tell" regarding specific sales and earnings impacts. Only a handful of companies have given initial estimates about the hit to 1Q'20 earnings from this virus, with even fewer venturing to estimate what the full year impact will be, highlighting the high degree of uncertainty about everything from the duration and extent of the spread of this virus, to the affect of mitigation and avoidance efforts and the disruptions to supply chains. As companies wait for more visibility to provide updates, this creates the potential for a particularly active earnings pre-announcement season for 1Q'20, with some companies possibly taking the opportunity to lower full year 2020 guidance. The market estimates are anticipating the eventual cuts to guidance and have revised 2020 earnings growth expectations from 9.5% to 7.3% since the beginning of the year, but we expect to see additional downward revisions as 1Q and 2Q are reported.
Not only are global supply chains and manufacturing disrupted by this virus, but there is also demand disruption as consumers and businesses alter their spending behaviors to reduce the risk of exposure to this virus. The most acutely impacted are travel and leisure, but there are also declines in demand for autos, electronics and commercial aerospace equipment. Factory closures throughout Asia are rippling through the highly interconnected global manufacturing supply chains, and the reduction in manufactured finished goods is driving reduced activity in the transportation industry. Lastly, all of these developments slow global growth and reduces the demand for commodities and pressuring commodity prices, which reduces the sales, cash flows and earnings for energy, metals & mining, chemicals, and other materials companies. We will monitor the updates to guidance, revisions to earnings and company commentary on the outlook for coming quarters and the second half of the year, but the near term outlook indicates the expectations for mid single digit earnings per share growth are likely to be reduced for 1Q and possibly 2Q'20. Importantly, as containment measures appear in the coming weeks and months, we could see sharp rebound in activity and earnings for these industries in the second half of the year. Volatility is elevated and the near-term earnings outlook is clear as mud, however, a diversified portfolio is built to withstand periods of episodic volatility like we are experiencing now.