05 Mar 2020

A week of surprises

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by Binay Chandgothia, CFA, Managing Director, Portfolio Manager and Head of Asia
Seema Shah, Chief Strategist

Deciphering what Fed movements, global health developments, and political shockers may mean for investors

  • The efficacy of Tuesday's surprise Fed funds rate cut is in question, as the market turmoil it's reacting to isn't necessarily economic, but situational. This kind of impact is hard to assess—and markets would likely prefer to see evidence that the virus has been contained.
  • Super Tuesday in the United States election cycle turns up even more surprises in this anything-goes race for President Donald Trump's challenger. An unexpected bump for Vice President Joe Biden seems to pare this down to a two-man race, and, if that's the case, markets prefer Biden over Vermont senator Bernie Sanders.
  • Coronavirus daily infection rates in China have dropped below 1% for 12 consecutive days, even as news outside China suggests an accelerating spread, with secondary infections becoming more prevalent.

The Fed decision

In a surprise emergency meeting, and for the first time since the financial crisis, the Federal Reserve (Fed) cut its key policy rate 50 basis points (bps). The intent was likely a proactive stance aimed at dwindling investor sentiment toward equity markets and growth, but, as things stand, markets still expect at least another 25bps cut at the FOMC March meeting.

While the Fed rate cut sent a strong signal that it will do whatever it takes to sustain the longest post-World War II expansion in the U.S. economy, its efficacy is in doubt, given the source of current market strife isn't economic, but a highly contagious virus (COVID-19). Such an impact is hard to assess in terms of persistence or magnitude. Markets may need to see evidence that the virus' spread is being contained before they start pricing in solid economic recovery. Fed Chair Jerome Powell acknowledged this at the post-cut press conference.

Rapid change in central banking stance

At the start of the year, we expected a benign monetary policy environment, where the speed of rate cuts would slow after a period that saw a net of 40 in the second half of 2019. COVID-19 turned that expectation on its head. We now expect significant easing by global central banks, both in developed and emerging economies. The Bank of Canada quickly followed the Fed's path, also cutting rates by 50bps, while the Bank of England appears set to reduce policy rates at its next meeting, if not sooner. The Bank of Japan and the ECB are in a tighter spot, with very limited room to lower rates further, and have voiced some understandable reluctance. However, they will both likely act to provide additional liquidity at a minimum.

GDP-weighted central bank policy rates
GDP-weighted central bank policy rates
Source: Bloomberg, Principal Portfolio Solutions. Emerging markets, Global and Developed markets policy rates are proprietary PPS indices with policy rates being weighted by current nominal GDP in dollar terms. Data as of March 4, 2020.

Central bank net rate cuts in the last 12 months
Number of rate cuts minus rate hikes
Central bank net rate cuts in the last 12 months
Source: Bloomberg, Principal Global Strategies. Data as of March 4, 2020.

But will monetary policy be a cure-all?

Bond markets have been on a tear, with U.S. 10-year Treasurys now trading around 1% (we started 2020 with yields around 1.90%). The curve has steepened, with the 2yr.–10yr. spread above 35bps and the 10yr.–30yr. spread above 60bps.

Equity markets were initially unimpressed but rallied subsequently, showing continued volatility.

Possible reasons for the volatility include:

  • Investors are looking for more visibility on containment of the virus before allocating capital.
  • Investors don't believe easing monetary policy will be effective in containing the economic fallout from the virusrelated disruption.
  • While the need to contain the spread of coronavirus is clear, those efforts are anti-growth by nature—which suggests that the monetary stimulatory effects may be nullified by viruscontrol measures.
  • Even if monetary policy creates demand, investors may wonder if supply chains are functional enough to meet it. Economic growth needs both.

We think monetary policy will be supplemented with fiscal loosening. China, Japan, Singapore, Hong Kong, Philippines, Korea, and Indonesia have all announced an intention to ease fiscally. Germany is suspending its fiscal rules to create room for a stimulus. How soon this fiscal impulse is absorbed by economies will determine the short-term success of such programs.

The U.S. presidential race

In addition to virus-related developments, the U.S. presidential election process began its roll into the big finale of the presidential race. On March 3, "Super Tuesday," 14 states held primaries to determine the Democratic candidate who will ultimately challenge Republican President Donald Trump.

Results showed the race winnowing down to a two-man show: Senator Bernie Sanders and former Vice President Joe Biden. According to Real Clear Politics, Biden is slated to win the majority of delegates in 10 of the states that held primaries on Super Tuesday, compared to Sanders' four.

Biden won the South (no surprise there) but he also took Texas's majority and won in other unexpected places, such as Minnesota and Massachusetts. The votes in California may take some time to be tallied, but so far Sanders looks like the lead vote-getter. Following the results, former New York City mayor Michael Bloomberg and Senator Elizabeth Warren each announced the end of their respective campaigns.

With more than half of the delegates needed to take the democratic nomination still up for grabs, there's still a long way to go before we get to know Trump's challenger. Important to note: If a candidate wins the plurality of the votes, but not 1,991 delegates needed for the nomination, there will be a contested convention in Milwaukee this July. A contested convention would surely be good for Trump.

Biden's moderate stance does come with caveats. He's calling for a corporate tax rate at 28%, up from the current 21% (Sanders is at 35%). He'd restore the top income tax bracket to 39.6% from 37% (Sanders proposes 52%). Still, if it's a Democrat occupying the White House, markets prefer Biden over Bernie.

COVID-19: an update

The story from inside China is turning positive, with the coronavirus daily infection rate having dropped below 1% for 12 consecutive days. As total active confirmed cases trend lower, quarantines are lifting, and businesses are resuming operations. Passenger traffic is the highest since the New Year holiday started. Car sales, truck traffic, and coal usage are all up from very low levels. And 65-70% of migrant workers have returned to work.

However, news outside the country suggests an accelerating spread, with secondary infections becoming more prevalent. The number of new infections outside China has risen from around 500 last week to more than 1,500, with South Korea, Italy, and Iran being the largest incremental contributors.

Looking Ahead

Growth Outlook
Growth will continue to be revised down. At the macro level, the OECD now forecasts global recession in 2020, driven by a potential contraction in China's GDP growth in 1Q 2020. Our own global manufacturing PMI index (provisional) dropped from 49.9 to 47.1 as China's PMI fell precipitously, while our leading indicator for global industrial production continued to signal sub-trend output growth.

Our recession dashboard currently shows six out of the 19 indicators in the recession zone, as compared to five in the month prior. But weak equity market returns could soon join the recession signalling category if markets continue their downward spiral.

Our original forecast for 2020 earnings growth to increase 8% for MSCI AC World in dollar terms is now at risk. The year could end with no earnings growth, unless the virus is contained in a timely manner.

A related question: Are policymakers pressing the panic button too soon? And could it overstimulate the economy? Certainly, if the virus is somehow quickly contained as it has been in several countries (for example, Singapore managed to swiftly control the spread without introducing Draconian measures), it could set the markets up for an interesting few months. With abundant liquidity, loosening fiscal stance, very low interest rates, and policymakers reluctant to roll back easing measures implemented with such alacrity, growth proxies (equities, oil, high yield spread products) could be propelled significantly higher.

Decisions for investors
While the economic and virus fundamentals are currently negative, a few positives have appeared on the horizon, such as:

  • Investor positioning has lightened especially for systematic and risk-parity investors who are forced to reduce risk when volatility rises.
  • Equity valuations have become more attractive. Adjusted for interest rates (risk premium models), they may even be in the cheap category (earnings yield of 5-6% vs. 10-year Treasury yield of 1-1.25%). But they aren't yet in the zone that triggers a strong buy signal.
  • Bond yields continue to be under downward pressure and with economic risks still biased to the downside, there is potential for them to fall even further. In that case, duration and quality credit products will likely perform well.
  • Our opinion over the past several months has been that markets will become more volatile as they grapple with a maturing growth cycle. 2019 didn't quite play out that way but 2020 is going to script. Our advice to investors will be to shun excessive changes during this period of heightened market anxiety, but focus on their core long-term asset allocations and use market setbacks to re-align to such.
  • Recent developments also show the immense value diversification brings to portfolios, with defensive fixed income allocations having shone through this period of turmoil by cushioning the declines in growth proxies.

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