Monday Market Review March 2, 2020
While overshadowed by volatile financial markets last week, economic data included strong housing results and prices, decent increases in consumer confidence, as well as durable goods orders that declined less than expected.
Equities in both U.S. and foreign markets experienced their worst week since the financial crisis, driven lower by uncertainty about the economic impact of the coronavirus outbreak. Bonds fared well, though, coupled with treasury interest rates reaching new lows for the cycle. Commodities also suffered due to dampened prices for crude oil—affected by perceived lower demand.
Question of the Week
How damaging will the coronavirus (COVID-19) ultimately be for the global economy?
Considering the difficulties in precise real-time measurement, as well as determining the transmission mechanisms of the virus, the potential impact is still difficult to predict. Updates have been coming out on a daily basis in recent weeks, although the virus itself has been circulating since last November. The uncertainty about severity and the open-ended timeframe around the two key elements—human and economic—has been undoubtedly the catalyst behind last week’s financial market meltdown.
Pandemics, which are essentially widespread and more severe epidemics, are feared today for the same reason they’ve been feared throughout history, even though medical science has undoubtedly improved. (As an aside, despite the ominous sounding name, a ‘pandemic’ only describes the broader spread of a virus to multiple regions, as opposed to any gauge of its severity.) Initial causes and methods of transmission often begin mysteriously, which can create a sense of paranoia among the public. It is also a byproduct of an increasingly globalized world, where the speed of movement of people and goods can also exacerbate movement of diseases. This was most famously seen on a widespread scale in the Black Plague of the mid-1300s, which was likely carried to Europe by trading ships from the Far East. From there, the pandemic spread outward, destroying Europe, and surfaced again several times in subsequent centuries in a variety of regions. The widespread mortality shaped several civilizations for generations, including political and religious institutions, which goes along with the embedded social fear that accompanies pandemics. The other more recent noteworthy pandemic, the Spanish Flu of 1918, in the waning months of World War I, caused approximately 50 mil. deaths globally (nearly a quarter-million in the U.S.). However, it has been noted that the mortality number was made far worse by post-virus bacterial infections, as modern antibiotics had not yet been invented.
This pandemic event comes at a current political era where many leaders, including those in the U.S., are already skeptical of the high level of global integration. The trend has been away from ‘peak globalization’ towards a more protectionist paradigm, and events such as this don’t help the cause of those wanting a continued integrated world. At the same time, economic growth is still much more intertwined between nations, meaning that a slowdown abroad affects everyone—as both customers and manufacturing supply chains remain very globally dispersed for the world’s largest firms.
Where does the economic fear begin? The slowdown in growth starts with the obvious. As a starting bottom-up example, as a quarantine measure in China’s Wuhan province, the movement of residents was restricted in attempts to contain the virus’ spread. This means those residents: (1) can’t go to work, (2) can’t travel, and (3) essentially can’t buy anything. (Working remotely and shopping online would be available to some extent, but represent far smaller proportions. It also does not capture the secondary effects, such as a hesitancy to frequent shopping malls, sporting events, or public places, which could cause fears and sentiment to worsen.) This creates a downward spiral of no economic activity, which affects the economy directly—no buyers and no sellers of goods/services. This is a simple starting example from a local level, but this model of economic impact is easy to carry further in today’s interconnected system of manufacturing supply chains. Manufacturing has become so specific that, for example, an auto factory in Japan was forced to shut down temporarily as a key part only made in China was unavailable. This may happen further as manufacturing inventories are depleted and unable to be replenished quickly.
As with the epidemiological impact, the economic spread is also radial. Closely-tied nations in the Far East are the most affected for now, with the U.S. and Europe less so, although there are specific exceptions, such as in auto and parts manufacturing. The longer such an event carries on, or spreads, this isolated shutdowns would impact more industries and create deeper bottlenecks in global production and distribution. This is the essence of how such an event can significantly affect global growth. In a time where companies have been looking for supply chain sources outside of China, for a variety of trade policy and intellectual capital protection reasons, this may well accelerate the effort to diversify these global operations.
What do the numbers look like? It’s possible that China’s growth will dip to zero for the first quarter, and estimates for U.S. growth have already fallen from 2% or so down to near 1%, with perhaps similar or even slower growth in Q2, before an assumed recovery. With the outbreak’s timeframe remaining open-ended, numbers remain fluid, and could easily improve or worsen. In essence, the longer it lasts, the deeper the impact, which is not reassuring for markets that seek certainty above all else. The Chinese central bank has already accelerated monetary and fiscal stimulus measures to offset the impact of the economic slowing, and other central banks, including the Fed, appear likely to follow suit if conditions become severe enough. Already, fed funds futures markets rates are predicting a -0.50% rate cut in March and a total of four cuts in 2020, totaling -1.00% (even though these can change quickly). This represents a difficult situation for a central bank, which doesn’t want to be perceived as acting rashly, but also wants to avoid ending up ‘behind the curve’.
More directly, the catalyst has been from U.S. corporate earnings, with Apple and Microsoft (two popular tech stocks, driven by strong price momentum lately). The firms, no doubt to be echoed by others, noted that the shutdown in China may destroy all global growth in Q1. Again, based on the GDP estimates, this is not a surprise, but becomes much for tangible for equity investors when earnings-per-share are involved. For an equity market already looking a bit frothy in terms of valuations, this was the straw that broke the camel’s back.
While we’re hesitant to quote medical stats, which lie outside the financial realm, it appears that the total number of cases in China peaked in mid-February—which is positive news for that region—although it has spread to an increasing number of other nations. At the same time, it is unknown whether the cases spread more recently, or they were only captured on tests more recently. Eventually, assuming cases peak elsewhere (as similar viruses in past decades have, with SARS in 2002-03 being the most commonly-used comparative), economies will open again, and the flow of goods/services will eventually create a snapback in the quarters following the crisis. But, again, the longer the crisis, the longer the bounceback will take. The following article from a China expert provides an interesting, and balanced, narrative about the issue relative to prior pandemics: https://us.matthewsasia.com/resources/docs/pdf/Sinology/022420-Sinology.pdf
It’s important to remember that equity markets have corrected by -10% at least once per year—based on historical averages. It’s been some time since we’ve seen a correction, so when you couple higher valuations and needing an excuse for profit-taking, you’ll often get one. Hoping for the best, this will result in minimal human and economic damage, and end up as another small blip on the chart of financial history.
In short, equities experienced their worst performance week since the financial crisis over a decade ago. U.S. stocks started off poorly, down nearly -3% on consecutive days Monday and Tuesday—representing one of the -10% corrections on record. This week’s volatility was especially aggravated by the low volatility environment we’ve become used to over the past few years. Every sector fared negatively, with energy slightly worse than average, due to plummeting oil prices, and staples and healthcare slightly better, due to their defensive characteristics. Real estate fared just as poorly, in keeping with fears of a possible recession.
The deteriorating sentiment coincided with coronavirus infections spreading beyond China, to South Korea and Italy, and mid-week, reports of cases in California. Naturally, this raised concerns over a spreading pandemic and its associated negative human and economic impact, as discussed above. There are other factors, though, such as the success of presidential candidate Bernie Sanders in primaries/polls that increase his chances of the Democratic nomination—especially with Super Tuesday upon us (a day where a third of overall party convention delegates are chosen in 14 states). Certainly, a candidate with self-described socialist tendencies is concerning to financial markets and business executives, let alone specific sectors such as pharmaceuticals under a ‘Medicare for All’ plan.
Foreign stocks in both developed and emerging markets also experienced losses, however, not as severe as in U.S. markets. Interestingly, declines in Japan and emerging markets were not as severe as those in Europe and the U.K. Commodity-sensitive markets such as Brazil, Mexico, and Russia were among the worst-performers. Chinese markets fared surprisingly well, with tempered losses, due to reports of new virus cases declining, some affected areas reopening, and aggressive government stimulus to help stop the damage.
U.S. bonds offered positive returns, as expected, given the extreme flows away from equities. Amazingly, we reached a new all-time modern low in yield for the 10-year treasury at just above 1.1%, while the middle of the curve dipped below 1%. As is common with crisis events, long treasuries fared best—last week gaining nearly 5%. High yield and floating rate debt each posted losses. Foreign developed debt performed positively, aided by a -1% drop in the dollar, while emerging market bonds fared poorly along with other higher-risk assets. Last week in fixed income is important to remember next time investors read yield forecasts, that particular low levels are an anomaly and unlikely to occur again. We’ve heard this many times over the past decade(s), and reiterates the need for core fixed income in a portfolio—no matter where rates currently stand.
Commodities performed poorly across the board, with fears of slower economic activity putting a damper on demand, with the energy sector ending the week as the worst performing and precious metals also losing ground, surprisingly. The price of crude oil fell sharply, by over -15% on the week to under $45/barrel. As in prior weeks, this was related to higher recession risks posing continued threats to demand.
(0) The second estimate for Q4 U.S. gross domestic product was unchanged at 2.1%, in keeping with general expectations from the economist community. It appeared that exports strengthened a bit, as did inventories—which could result in a reversal backward in that segment for Q1. Other positive developments included investment in structures falling less than in the first estimate, while residential investment also strengthened. On the downside, personal consumption, equipment and intellectual property weakened. Core PCE inflation was revised downward to an annualized rate of 1.3%, which pulled the year-over-year rate down to just over 1.5%.
Estimates for first quarter 2020 GDP have steadily eroded as impacts from coronavirus-related shutdowns of Chinese factory facilities and retail establishments is likely to substantially weigh on results—as has the escalation of medical cases globally with an uncertain ending point. The estimated 2%-or-so estimates have deteriorated to the far lower region of about 1%, as supply chain impacts make their way through. Interestingly, the closer-to-real-time New York Fed’s Nowcast still points to growth of 2.1% for Q1, and the Atlanta Fed’s GDPNow is pointing to a very robust rate of 2.6% (!). While these have declined slightly in recent weeks, stronger results in domestic housing and manufacturing sentiment seem to be keeping the stats elevated.
(0) Personal income for January rose by 0.6%, beating expectations of 0.4%, led largely by inflation adjustments for government transfer payments. The measure is up 4.0% on a year-over-year basis. Personal consumption, on the other hand, rose at a paltrier 0.2% rate, falling short of the estimated 0.3% increase—up 4.5% year-over-year. These pushed the savings rate up nearly a half-percent to 7.9%. PCE inflation rose a tenth on both a headline and core level during the month, bringing the year-over-year headline gain to 1.7% and core to 1.6%.
(+) The advance goods trade balance for January showed a decline in the deficit by -$3.2 bil. to -$65.5 bil., tighter than the -$68.5 bil. level expected by consensus. Trade volumes fell overall, with goods imports down nearly -$5 bil., mostly due to a sharp drop in industrial supplies, while other capital goods and autos also contributed. Goods exports fell by just over -$1 bil. It appears that a residual impact from previously-higher tariffs on Chinese goods likely played a role in the composition of the report, which should taper off, aside from impact from the coronavirus effects, which escalated in Feb.
(0/+) Durable goods orders in January fell by -0.2%, which outperformed the expected -1.4% decline, including some positive revisions for prior months. It appeared to be weighed down by the transportation segment (autos and defense aircraft). Core orders, on the other hand, rose 1.1%, beating expectations for a meager 0.1% rise. Year-over-year, total durable goods orders are down -4%, while removing transportation orders ends up with a flat result over the period. Core capital goods shipments also rose 1.1% in January, exceeding consensus assumptions of no change.
(+) The FHFA house price index for December rose at a pace of 0.6%, beating forecasts of 0.4%. Every region saw gains, led by the East South Central (KY through MS) and South Atlantic (MD on south) regions up a percent each. Year-over-year, this index grew at 5.2%, which continues to be a robust real pace, even considering more robust inflation generally in recent months.
(0/+) The S&P/Case-Shiller home price index of 20 key cities rose by 0.4% in December, matching consensus expectations. Prices fell in only one city (Cleveland, by a tenth of a percent), while rising the most in Phoenix and Seattle, at just below a 1% pace for the single month. Year-over-year, the pace of increase ticked up by nearly a half percent to 2.9%.
(+) New home sales for January rose by 7.9% in January to a seasonally-adjusted annualized rate of 764k units, including positive prior-month revisions, and beating forecasts calling for 718k units. This brought the year-over-year rate of change to almost 19%. While sales fell in the South, they rose in all other regions, notably in the West. The months’ supply of new homes ticked down by -0.4 to 5.1. The median price is 14% higher than a year ago, at $348,200. The trend of new home sales continues to improve, with some signs of better inventory in the works, stronger homebuilder sentiment and (again) lower interest rates, which helps affordability.
(+) Pending home sales reversed course from the prior month by rising 5.2% in January, beating forecasts calling for 3.0%. Year-over-year, the pending sales number ticked down by a tenth, though, to a growth rate of 6.7%. Regionally, the South and Midwest led with gains of over 7%, while sales in the West fell by a percent. This pending figure, as usual, points to an approximation of ‘existing’ sales for coming months.
(-) The Conference Board’s preliminary index of consumer confidence for February rose by 0.3 of a point from the revised earlier figure to 130.7, missing the median forecast of 132.2. Assessments of present conditions fell by nearly -9 points, while expectations for the future rose over 6 points. The labor differential, which measures the ease in finding employment, also fell. It’s possible that coronavirus concerns played a role in the less optimistic data, although it wasn’t referenced as an issue specifically.
(+) The final February Univ. of Michigan consumer sentiment surveyrose by 0.1 point to 101.0, beating forecasts calling for 100.7. Assessments of current conditions rose by a point, while expectations for the future fell by a half-point. Inflation expectations for the coming year fell by a tenth to 2.4%, while those for the coming 5-10 years were flat at 2.3%. This survey did not include the recent escalation of coronavirus concerns, which could make their way into March data.
(0) Initial jobless claims for the Feb. 22 ending week rose by 8k to 219k, above expectations calling for 212k. Continuing claims for the Feb. 15 week, on the other hand, fell by -9k to 1.724 mil., but above the median forecast calling for 1.711 mil. No anomalies were reported, other than claims rising at a far faster rate for the week in IL and NY. Overall, the data continues to point to very benign labor market conditions.
Have a good week.
Ryan M. Long, CFA
Director of Investments
FocusPoint Solutions, Inc.
Sources: FocusPoint Solutions, American Association for Individual Investors (AAII), Associated Press, Barclays Capital, Bloomberg, Citigroup, Deutsche Bank, FactSet, Financial Times, First Trust, Goldman Sachs, Invesco, JPMorgan Asset Management, Marketfield Asset Management, Morgan Stanley, MSCI, Morningstar, Northern Trust, PIMCO, Standard & Poor’s, StockCharts.com, The Conference Board, Thomson Reuters, T. Rowe Price, U.S. Bureau of Economic Analysis, U.S. Federal Reserve, Wall Street Journal, The Washington Post. Index performance is shown as total return, which includes dividends, with the exception of MSCI-EM, which is quoted as price return/excluding dividends. Performance for the MSCI-EAFE and MSCI-EM indexes is quoted in U.S. Dollar investor terms.
The information above has been obtained from sources considered reliable, but no representation is made as to its completeness, accuracy or timeliness. All information and opinions expressed are subject to change without notice. Information provided in this report is not intended to be, and should not be construed as, investment, legal or tax advice; and does not constitute an offer, or a solicitation of any offer, to buy or sell any security, investment or other product. FocusPoint Solutions, Inc. is a registered investment advisor.
Notes key: (+) positive/encouraging development, (0) neutral/inconclusive/no net effect, (-) negative/discouraging development.