February 12, 2020
The Coronavirus and Its Impact on the Global Market
The Coronavirus and Its Impact on the Global Market
February 12, 2020
Will the inevitable economic recovery take the shape of a V, U, Bathtub or L?
Global markets have reacted to the novel coronavirus (nCoVid19) outbreak in varying degrees of distress, increasing short-term volatility and leaving investors concerned over slowing economic growth in China, at least in the near-term. The outbreak, which started in Wuhan, one of China’s most populous cities, has resulted in over 48,000 confirmed cases across 26 countries, and over 1,300 deaths, as of this writing.1
For investors, we believe the question is what shape the eventual economic recovery - V, U, Bathtub or L – will take. We believe this is dependent on how quickly the markets recover; speed is of the essence. In our view, U.S. and Chinese central banks should react quickly if further damage is done to the global economy, and it is our view that China will, in fact, do “whatever it takes” to help.
But investors need to watch the clock. If the recovery is fast, all should normalize quickly. However, if the recovery lags and spills into the third quarter of 2020, watch out. We believe leverage stresses will increase and credit will take a hit. Financial conditions will tighten.
Investors also will need to keep an eye on the calendar for economic data, which we think is likely to be pretty bad over the next month. It is important to understand that poor economic data can lead to exacerbated headline risk encompassing the viral period. Of note:
The fundamental response has been OK, but the clock is ticking. . .
Global financial conditions are currently easy, as central banks across the globe have effectively enacted a “put option” policy for mitigating downside risk. We would question, though, whether a put policy is enough to right a listing global economy in rough waters. Rates are low, will likely remain low globally (not rise, as previously expected). We are not sure whether this is enough to offset weaker global demand, which some are hoping is merely delayed, not destroyed.
However, much of this depends on the length and depth of the coronavirus shock. In a scenario where earnings slow to or below a certain threshold, corporate leverage ratios will uptick and should negatively impact credit markets.
As mentioned, one key is the Chinese central bank. It is our expectation that the central bank will go big on stimulus programs, not unlike European Central Bank Chairman Mario Draghi’s “whatever it takes” mantra not so long ago. Possible outcomes of a stimulus program include an explosion of government spending above its current 14% of GDP level, an aggressive easing of the reserve ratio requirement and an onrush of liquidity injections. We also see China easing up on delevering programs as a credit stimulus, as well as enacting a series of tax, fee and regulation cuts. China will be fiercely determined not to let the epidemic bring down their economy.
Pricing: Rates and FX Relative to the Credit Markets
In general, rates and the U.S. dollar (USD) have repriced a global reflation trade that was the consensus prior to the nCoV, while credit and spread markets have not reacted as much. But this should change if the recovery takes longer than expected.
o If the coronavirus hits the U.S. in any meaningful way, we expect the rate cuts to be fast and furious.
o We see fatter left tail (downside) on distribution of risks
o Investment Grade currently sits at a 96 bp Option-Adjusted Spread (OAS), 3 bps wider YTD. The yield is currently 2.64%2
o Cyclical themes we like include communications, gaming, financials, and select energy (pipelines)
o There is a ton of supply out there
o Of interest are building materials, food and beverage, transportation and select retail
o BBs are quite tight, while Bs – and some select CCCs – represent the best value
o In terms of USD denominations, we see opportunities in Ukraine, Egypt (based on an IMF package and reforms) and Nigeria (valuations)
o In local currencies we have interest in Brazil, Russia, Indonesia and Mexico, as all these governments, and others, have plenty of room to cut rates
The Powell Testimony: The U.S. Economy is still “in a good place” BUT, we will do “whatever it takes” if and when necessary
U.S. Federal Reserve (Fed) Chairman Jerome Powell testified in front of the U.S. Congress on February 12. Our key takeaways include:
o As a reminder, small business accounts for approximately 65% of job creation in the U.S. As importantly. . .
o . . .Economics 101 reminds us that jobs create income, which in turn leads to increased consumption, which in turn represents approximately 70% of GDP
o Almost all small business categories are performing well.
o The formula: Potential GDP = labor force growth + productivity growth
- Labor force growth is roughly 0.5%
- The average growth of Productivity (on a 4-quarter basis) has been 1.7% since 2016; the last data point we have is 1.8% year-over-year
- Contained Unit Labor Costs may also extend the cycle
o Technology led Capital Expenditure (CapEx) is likely underestimating productivity, to the point where we expect CapEx/Business Investment to rebound after sings of weakness 2019
o The Fed is willing to let the economy run hot. Ultimately its goal is to achieve inflation symmetrical at 2%
o Exogenous shocks related to the coronavirus will lead to aggressive action by Powell. The bar has been lowered for rate cuts, and multiple cuts if needed. In the end, Powell wants inflation core PCE at 2% and will act accordingly to get there.
In summary, there was a lot going on in the world before the coronavirus outbreak and we expect some short-term economic distress followed by a recovery. But the ultimate shape of the recovery - V, U, Bathtub or L – will be dependent on a number of factors outlined in this piece. In short, stay tuned!
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