IN THIS WEEK’S BOTTOM LINE
CONTRIBUTED BY NICK DOWNING| OVERBERG ASSET MANAGEMENT
Global financial markets have gone into freefall as investors panic over the likely consequences of a global coronavirus pandemic. In the five trading days from the 14th-28th February, global equity markets dropped on average by 10% while the S&P 500 index fell over 12%, the steepest weekly decline since the 2008/09 global financial crisis, as investors reacted to the spread of the virus outside China.
The carnage continued on Monday 9th March with equity markets around the world suffering their worst daily decline since 2008, with most markets falling by more than 7%.
The central scenario that the coronavirus would be a China-only incident with temporary supply-chain disruptions and a stimulus led “V”-shaped recovery is giving way to fears of a more protracted global downturn.
A downturn exacerbated by a collapse in consumer spending, the mainstay of economic growth in developed economies. The economic impact of the coronavirus is turning from a localised supply-shock event into a global demand-led phenomenon, potentially leading to global recession.
These fears are likely exaggerated. Fear amongst consumers is being stoked by the apparent elevated mortality rates in Italy and Iran. However, there appears to be significant underdiagnosis of the coronavirus infection. The current mortality rate is likely to decline substantially as more patients are diagnosed. Moreover, the arrival of warm weather could curtail the spread of the virus. Meanwhile, in the extreme worst-case scenario, in which the virus continues to spread, there will be an effective treatment or vaccine in 9-12 months.
The number of new cases in China has fallen significantly, now less than 100 per day after peaking at 3887 on 4th February. Containment is effective. The World Health Organisation reported that “If this was an influenza epidemic, we would have expected to see widespread community transmission across the globe by now, and efforts to slow it down or contain it would not be feasible.” The virus, which is now spreading across the world will likely play out in a similar way to China. After a few weeks the rate of infection will peak and start to decline.
Financial markets are likely to remain volatile and on a downward trend until negative news-flow reaches a peak. Since no-one really know for sure how bad the virus outbreak will be or its economic effects, markets are prone to discount the worst. Hence the 10-year Treasury bond yield, now at less than 0.60%, is already priced at levels which predict a US recession.
Recessions in the US and other developed economies are possible, although unlikely, but even if they were to occur in the unlikely event that the virus takes longer to peak than it did in China, the recessions would likely be very short-lived. Recessions, defined as two straight quarters of economic contraction, are unlikely to continue into a third quarter.
It is instructive to follow China’s experience. The Shanghai and Shenzhen CSI 300 Index is actually up since the start of the year, making it the world’s best performing equity market over the period. News headlines are more than often a poor indicator of stock market performance. Market devastation is now occurring in the world’s developed economies, but as in China this too shall pass.
In time, the virus news-flow will improve and at the same time so will the level of support from central banks and governments, via monetary stimulus and fiscal spending. These will make up for the temporary declines in economic activity, financial stresses on company balance sheets and the associated contraction in global liquidity.
China, Hong Kong, South Korea and Italy have already implemented fiscal stimulus measures, while China and the US have initiated monetary stimulus. The Federal Reserve made its first intra-meeting “emergency” interest rate cut since 2008, reducing the fed funds rate on 3rd March by 50 basis points, a departure from its usual 25 basis point cuts.
Assuming the coronavirus passes in due course, as expected, monetary and fiscal stimulus may well boost financial markets to higher levels than they would otherwise have been without the coronavirus. The global economy was on the path to recovery before the virus struck and is likely to resume this positive underlying trend towards the middle of the year.
While bond yields have fallen sharply as investors flock to “so-called” safe-haven assets, pushing the US 10-year Treasury bond yield to less than 1%, this adds further to the attraction of current equity valuations and would justify even higher price-earnings multiples for shares.
The prospect of even greater monetary stimulus, comprising lower short-term US interest rates and a correspondingly weaker dollar, coupled with the rapid normalisation of China’s economy, bodes especially well for emerging markets. Emerging markets, which have underperformed developed markets over the past three years and are now at extreme relative under-valuation, should benefit from currency strength, lower interest rates and capital inflows as the world searches for higher yields.
Read More: Overberg Market Report 10 March 2020