Market Recap

Posted on February 21, 2020 by Gemmer Asset

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Gauging the Economic Fallout


Up until Thursday the markets remained pretty buoyant in expectation that the Coronavirus infection rate had peaked. This seemed to change on Thursday and Friday as attention turned away from infections towards the economic fallout.


The change of tone could be detected after Japan reported a miserable fourth quarter GDP number. Growth in the fourth quarter fell at an annual rate of -6.3% (chart below) after Japanese authorities bumped up the VAT from 8% to 10%.



Now of course this isn’t related to the Coronavirus, but it did seem to shift attention towards growth data. One last thing on Japan – this isn’t the first time growth has been wacked by a tax hike. In 2014 the VAT was also hiked and Japan saw an even larger contraction in growth.


More directly related to the Coronavirus was a poor PMI report in Australia and some disappointing trade numbers in South Korea. Both raised the prospect that global growth will be disappointing this quarter. More anecdotal, but still interesting:


– On February 14th Beijing’s city government said that people who enter the capital from any other province will have to self-quarantine for two weeks, Beijingers included.


– In Shanghai, property sales are currently about four times lower than what is usual for this time of year.


– Movie ticket sales in Shanghai have all but disappeared.


– Daily coal consumption in China, which tracks electricity consumption, has fallen by 70%.



– A related point – air pollution is tracking better than it would normally. If China isn’t growing it creates a lot less pollution.



– South Korea is starting to expand their testing. So far, they have tested 16K residents and the number of new cases is accelerating, as you can see below.



We are starting to see hints of a hit in the U.S., as well. Friday’s Markit purchasing managers’ report was the first that showed post virus weakness. This composite report of both services and manufacturing shrank in February for the first time since 2013. A fall in Chinese tourism played a role in the weakness.



The Markets Can Handle Short-Term Economic Pain….but?


The ultimate economic hit depends of course on the direction of infection rates in China and whether significant cases emerge in other countries. But it is worth keeping in mind that the markets will move well ahead of the data. For example, during the SARS crisis the markets hit a bottom when the number of new cases peaked (chart below).



This was despite the fact that the global economy still struggled over the next couple months with the fallout. Weak economic data in the next month or two will tell us very little about the market’s prospects.


At the moment we appear to have seen the peak in COVID-19 cases (chart below).



However, the data on South Korea noted earlier is worrisome.


Another thing worth pointing out is the fact that China is a much bigger player in the global economy today than it was during the SARS crisis. As Goldman noted this week:


“The Chinese economy is six times bigger now than it was then. As our economists have also pointed out, Chinese tourism alone now accounts for 0.4% of Global GDP, and the number of ‘missing work days’ in China will be roughly equivalent to the entire US workforce taking an unplanned break for two months.”


Wow. I had to look up the size of the Chinese economy in 2003. Goldman is right. In 2003 the economy was roughly $5 trillion in size (measured at purchasing power parity). In 2019 it was close to $30 trillion.


What this means for forecasts is that they have to be taken with an especially large grain of salt. Goldman crunched the numbers and they think global growth in the first quarter should be basically flat rather than the roughly +3% expected pre-crisis (chart below).



They also think we see a big bounce in the second quarter as people go back to work. But there is no way of knowing if infection rates will pick up again short-term. Markets may use this as a reason for a correction in the coming weeks. Time will tell.


Time to Refi Again


One bright spot this week is that financial conditions have eased globally as bond yields have fallen. For example, the yield on the 30-year Treasury pushed to all-time lows, as you can see below.



It’s been hard being a bond bear the last 39 years!!


It’s the same story for corporate bonds. The chart below shows the yield on the U.S. Aggregate Corporate index. Again, at the lowest level ever.



It’s only a matter of time before this new leg lower in yields feeds through into mortgage rates.


Yields have fallen at the same time inflation expectations have pushed lower. The markets pricing of inflation 5 years from now for the subsequent 5 years has fallen to lowest levels since 2016. It’s hard not to think this goes lower over the next month.



Finally, if inflation expectations continue to push lower (and the equity markets correct further), the chatter about another Fed rate cut will really pick up. On Friday the odds of at least one rate cut in 2020 stood at 90.5% (chart below). The odds of at least one rate cut by July are now up to roughly 75%.



This is really something. Either the markets are clueless or the Fed will be forced to follow market expectations once again. The chart below argues for the latter. It shows the yield spread between 10-year bonds and 3-month bills. It inverted again this week.




We suspect the Fed will be forced to cut if it stays this way for two-to-three months.


Have a good weekend.






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