International Economic Week In Review For 2/24-2/28

Summary

• The coronavirus has the potential to cause a recession in some countries.
• EU President Lane offered an excellent explanation of why r* will be low for some time.
• The international ETFs crashed hard this week.

Investment thesis: The coronavirus is the one and only story this week. So long as there continues to be fear-based selling, avoid international ETFs. However, this could eventually lead to a "buy low" situation. So, keep your financial powder dry for a potential purchase as this story dies out.

On Thursday, I wrote the following list of events that will happen as a result of the coronavirus outbreak. Let me take that list in pieces, developing each observation in more detail:

The primary way that countries are combating the disease is by quarantining an entire area, which means the flow of goods into and out of that area is stopped, perhaps completely.

Add that to the inter-connectedness of the global economy and you have a recipe for economic growth grinding to a halt.

Starting in the last 1970s and early 1980s, the business world began to shift to a "just-in-time" inventory system. Instead of buying large quantities of raw materials and storing them on location until they were needed for production, businesses ordered goods from location X and had them delivered to location Y at just the "right time" for those goods to be used in the production of a final product. This trend accelerated after the World Trade Organization admitted China which, in turn, made itself the de facto global low-cost manufacturing hub. China's quarantining of large swaths of its country means that Chinese produced goods are stranded, which sends ripple effects through the global supply change.

These two points would slow manufacturing and production. This would, in turn, lead to the following developments.

Consumers' paychecks will be hit by a drop in hours worked, which lowers income. Consumers are also scared, which means they are less likely to go out and do things, which causes a drop in retail sales.

As orders slow, hours would be cut. This is the first step businesses use when faced with a slowdown. It allows them to cut their biggest cost (labor) while hopefully maintaining their current labor force.

Should the situation continue, businesses will start to lay off employees, increasing unemployment at the national level. This will lower earnings, which will decrease consumer income, leading to a decrease in spending.

The preceding events will lower consumer sentiment, which is a key component of consumer spending. Declining sentiment and lower income will further slow consumer activity. Then, add in a desire to avoid public places (like restaurants and stores), and you have a recipe for a drop in retail sales.

Assuming all these developments play out, the only tool to keep the economy going is fiscal spending.

In other news, a member of the BOJ's governing board argued for additional stimulus (emphasis added):

The Bank of Japan should review its policy framework for a better strategy to fire up inflation, its dovish board member said, calling for stronger action as the fallout from the coronavirus outbreak risks tipping the economy into recession.

Seeing as the Japanese economy contracted in 4Q19, it shouldn't be surprising that a central banker is arguing for additional stimulus.

EU banker Lane offered an excellent explanation of low interest rates and why they will probably be with us for some time (emphasis added):

First, there has been a trend decline in the underlying equilibrium real interest rate since the 1980s. The equilibrium real rate (typically labelled r*) is the rate required to match the desired levels of saving and investment. The combination of slower population growth, rising life expectancy and an ageing population acts through multiple channels to push up desired savings and reduce desired investment. A reduction in desired investment also reflects slower productivity growth and, possibly, shifts in the structure of the aggregate production function. In the wake of the global financial crisis, risk appetite may also have diminished, which provides a disincentive to invest, reinforces the precautionary saving motive and encourages a portfolio shift to less risky assets, such as sovereign bonds. Finally, the scars of the crisis have also affected desired savings and desired investment levels: many banks, firms, governments and households have focused on repairing their balance sheets or have been constrained by legacy effects when making investment decisions.

This is an incredible summation of the reasons why the r* is low and will be for some time. As a result, central bankers will have far less policy room in the event of a recession.

Earlier in the week, Markit Economics released the latest flash estimates for the EU, U.K., and Japan.

• While the EU manufacturing gauge is still showing a contraction (it rose from 48 to 48.4), services rose from 52.5 to 52.8, leading to a composite reading of 51.6.
• The UK is experiencing a post-Brexit bounce. Manufacturing rose from 50 to 51.9, and services dropped from 53.9 to 53.3, resulting in a 53.3. composite reading.
• Japan, however, is having problems. Manufacturing dropped over 1 point from 48.8 to 47.6. Services tumbled from an expansionary 51 to 46.7, resulting in a massive drop in the composite reading from 50.1 to 47.

While Japan's numbers were bad, the data from the EU and the UK was encouraging.

Let's turn to this week's performance table:There is no way to sugarcoat the above data. This is what a financial bloodbath looks like. Nine indexes were down at last 9.66%; six were off at least 10%.

The charts are just as ugly:Everyone is at or near two month lows on heavy selling. The only issue is the degree of the sell-off.

The yearly charts are downright brutal:A number of the charts show that prices are at or near yearly lows now.

The only good thing about these charts is that they might start to form bottoming formations, allowing us to nibble at cheaper shares in the coming months.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.